Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Perfect World Co., Ltd. (NASDAQ:PWRD)

Q2 2010 Earnings Call Transcript

August 16, 2010 9:00 pm ET

Executives

Vivien Wang – IR Officer

Michael Chi – Founder, Chairman and CEO

Kelvin Lau – CFO

Analysts

Richard Ji – Morgan Stanley

Wallace Cheung – Credit Suisse

Alicia Yap – Citigroup

Tian Hou – Auriga

Wendy Huang – RBS

Eddie Leung – Banc of America

Paul Keung – Oppenheimer

Adam Krejcik – Roth Capital Partners

Yvonne Yang – BNP

Andrey Glukhov – Brean Murray Carret & Co

Tucker Grinnan – HSBC

Ming Zhao – SIG

James Lee – CLSA

Atul Bagga – ThinkEquity

Mike Hickey [ph] – Janco Partners [ph]

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Perfect World Q2 2010 earnings conference call. At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. (Operator instructions) I would now like to hand the conference over to your host today, Ms. Vivien Wang, Investor Relations Officer. Please go ahead ma'am.

Vivien Wang

Thank you, operator, and thank you, everyone, for joining us today for Perfect World’s second quarter 2010 earnings release conference call. We distributed our unaudited earnings release earlier today. You may find a copy of the press release on our official web site or through the newswire.

Today, you will hear from Mr. Michael Chi, our Chairman and CEO, who will give us a brief introduction and overview. Mr. Kelvin Lau, our CFO, will then discuss some of our latest business and operational developments and take us through our financial performance in the second quarter of 2010. Following the prepared marks, Mr. Chi, Mr. Lau and I will be available to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectation. Potential risks and uncertainties include, but are not limited to, those outlined in our public filings with the SEC, including our annual report on Form 20-F. For more information about these risks and uncertainties please refer to our filings with the SEC.

Perfect World does not undertake any obligation to update any forward-looking statements as a result of new information, future events or otherwise, except as required under applicable law. Our earnings release and this call include discussion of certain non-GAAP financial measures. Our earnings release contains a reconciliation of the non-GAAP measures to the most directly comparable GAAP measures. And it’s available on our Web site, at www.pwrd.com under the IR section.

I would now like to turn the call over to Michael.

Michael Chi

Thank you, Vivien, and thanks everyone for joining us today. The second quarter results largely came in line with our expectations. We experienced a slight sequential revenue decline in the second quarter. During the second quarter we decelerated some promotional and monetization activities within our games, in order to further nurture our games and lengthen the lifecycles.

The pipeline of truly genuinely differentiated 2D, 2.5D and 3D games continues to be encouraging. We are effectively utilizing our specialized game engines and production studios to build solid franchises in each of the market segments. A number of our games in the pipeline are very exciting, but as we learned from previous experience, it is best for us to take time in testing and fine tuning new games before officially launching them. This way we will avoid potential issues and the risks of losing players at what is essentially the most critical period of a new game.

Some of the games that we are excited about include ‘Forsaken World,’ our newest 3D

Western-themed MMORPG and ‘Dragon Excalibur,’ our first 2D real-time MMORPG. We are also anticipating the launch of ‘XiaoAoJiangHu,’ which will be known as ‘Swordsman Online’ in Western markets. This game is based on a famous martial arts novel written by renowned author Louis Cha, and is highly anticipated by gamers.

One of our key competitive advantages continues to be in research and development. In order to further strengthen our game development capabilities and increase our talent in creating new and innovative games, we continue to invest in build our R&D team. During the quarter, we acquired a majority stake in Runic Games, a top-tier game development studio based in the U.S. This strategic investment immediately strengthened the global R&D capabilities, and as we work closely with Runic Game’s professional and experienced team, we seek to create global titles that cater to the tastes of both Eastern and Western gamers.

Our overseas penetration continues to progress and we are pleased with our development thus far. During the second quarter, we signed several licensing agreements and launched a number of our games in various markets through overseas operators. We also acquired C&C Media, our long-time Japanese operation partner, to further expand our overseas operating capabilities and capture the growth opportunities in Japan. We continue to launch games through our wholly-owned subsidiary in the U.S. and seeking healthy growth from North America operations. In the near future, we will be launching our games through our newly established European subsidiary.

Making strategic acquisitions that are complementary to our core business remains a large part of our growth strategy. We are seeing an increasing amount of potential in the broader entertainment industry in China, and believe that furthering our involvement in the industry will lead to further benefits to our core business through content generation and co-promotion. Therefore one of our controlled entities, Beijing Perfect World Cultural Communication Co., Ltd., recently signed agreements to invest in and take majority stakes in Beijing Xinbaoyuan Movie & TV Investment Co., Ltd. and Shanghai Baohong Entertainment & Media Co., Ltd. Both companies are engaged in film and television production and distribution business, and we are excited to work together with such a reputable team to further the development of the entertainment industry in China.

As the number of Internet users in China continues to rise, we believe there are vast opportunities for the strongest players in the online game industry. We continue to strengthen our platform by investing in R&D and expanding through M&A. However, due to this we have experienced some added pressure on margin and temporary fluctuations in our results.

We believe this is a necessary step for the long-term benefit of our company and remain fully confident in our ability to sustain growth with our strong development and operation team, stable portfolio of existing games, and exciting pipeline. We have noted the price at which our ADSs are currently trading and after reviewing our financial positions, in particular, the cash currently available to us, we are considering a potential share repurchase program. However, such program needs to be approved by our board of directors. We will announce the details of the program if and when we receive the board approval.

As we continue to allocate resources to longer-term projects to lengthen the life cycle of our games, we will remain focused on managing the steady, long-term growth of our company while maximizing shareholder value over time.

With that I will like to pass the call to Kelvin.

Kelvin Lau

Thank you Michael. During the second quarter, we rolled out some exciting special packs, including “Drum Your Heart Out” for Hot Dance Party, “The Rookie and the General” for Chi Bi, “Rise of the Dragons” for Fantasy Zhu Xian, and the “The New World” for Zhu Xian.

Shortly after the quarter end we also rolled out "New Three Kingdoms" for Chi Bi. We are also making positive progress in the overseas market. During the second quarter, we signed agreements to license “Battle of the Immortals” and “Hot Dance Party” in the Russian Federation and other Russian speaking territories, and Fantasy Zhu Xian in Taiwan, and we successfully launched “Pocketpet Journey West” in Korea, “Zhu Xian” in Russia and Korea, and “Battle of the Immortals” in Vietnam and North America.

Following the quarter-end, we signed an agreement to license “Pocketpet Journey West” in Russia. We also launched Fantasy Zhu Xian in Taiwan, and Chi Bi in North America.

Now, I would like to take you through to our second quarter 2010 financial highlights. Our total revenues were RMB 594.2 million in 2Q '10. That is comparative to RMB 625 million in 1Q '10 and RMB 521.3 million in 2Q '09.

Our online game operations revenues were RMB 533.3 million in 2Q '10, as compared to

RMB 569.7 million in 1Q '10, and RMB 475.1 million in 2Q ’09. The slight decline in online game operation revenues from 1Q '10 was primarily due to deceleration of some of the in game promotions and monetization activities in the second quarter, in order to further nurture our existing games and lengthen the life cycle of the games. This was partially offset by additional online game operation revenue from Japan, as we acquired C&C Media in the second quarter.

The aggregate average concurrent users or ACU for games under operations in Mainland China was approximately 886,000 in 2Q '10, as compared to 993,000 in 1Q '10 and 761,000 in 2Q '09. The active paying customers or APC for games operated in Mainland China under the item based revenue model was approximately 1.433 million in 2Q '10. That is compared to 1.670 million in 1Q '10 and 1.877 million in 2Q '09.

The average revenue per active paying customer or ARPU of games operated in Mainland China under the item based revenue model was RMB 292 in 2Q '10 as compared to RMB 406 in 1Q '10 and RMB 237 in 2Q ’09. The decline in ACU from 1Q '10 was mainly due to the underperformance of recently launched new game as well as more aggressive anti-cheating efforts we adopt. The decline in APC and ARPU for 1Q '10 was mainly due to the declaration of some of the in game promotions and monetization activities in the second quarter.

Our overseas licensing revenue were RMB 55.1 million in 2Q ’10, as compared to RMB 53.4 million in 1Q '10 and RMB 46.2 million in 2Q '09. The increase from 1Q ’10 was mainly attributed to the successful launch of “Pocketpet Journey West” in Korea, “Battle of the Immortals” in Vietnam and “Zhu Xian” in Korea and Russia through various local

Operators. This was partially offset by a decrease in licensing revenues from Japan as we acquired C&C Media, our Japanese operation partner, and started to consolidate C&C Media’s online game operation revenue in 2Q '10.

Our film, television and other revenues were RMB 5.7 million in 2Q10, as compared to

RMB 2 million in 1Q10 and Nil in 2Q09. Our gross margin was 83.6% in 2Q10, as compared to 86.1% in 1Q10 and 87.2% in 2Q09.

Our operating expenses were RMB 275.1 million in 2Q10, as compared to RMB 214.8 million in 1Q10, and RMB 174.9 million in 2Q09. The increase from last quarter was mainly due to the following factors, an RMB 38.8 million increase in sales and marketing expenses. This was mainly a result of the consolidation of C&C Media, higher advertising and promotional expenses associated with the launch of large expansion packs for “Zhu Xian” and “Fantasy Zhu Xian,” and expenses related to attending a nationwide industrial exhibition in the U.S. in 2Q10.

Number two, an RMB 12.9 million increase in R&D primarily due to an increase in the staff cost as we continued to expand our R&D talent pool, and as a result of the consolidation of Runic Games. This was partially offset by the capitalization of development costs of RMB 11million for the two online games under testing.

Number three, an RMB 8.7 million increase in G&A expenses. This has mainly resulted from the consolidation of C&C Media, and was partially offset by a decrease in professional service expenses.

Our income tax expense was RMB 29.6 million in 2Q10, as compared to RMB 28.7 million in 1Q10 and RMB 19.8 million in 2Q09. Net income attributable to the company’s shareholders was RMB 196.6 million in 2Q10, as compared to RMB 305.2 million in 1Q10 and RMB 262.6 million in 2Q09. Non-GAAP net income attributable to the company’s shareholders was RMB 221.7 million in 2Q10, as compared to RMB 327 million in 1Q10 and RMB 282.9 million in 2Q09.

Basic and diluted earnings per ADS were RMB 3.93 and RMB 3.71 respectively in 2Q10. This compares to RMB 6.12 and RMB 5.75, respectively, in 1Q10, and

RMB 5.21 and RMB 4.94, respectively, in 2Q09. Non-GAAP basic and diluted earnings per ADS were RMB 4.42 and RMB 4.19 respectively, in 2Q10, as compared to RMB 6.56 and RMB 6.16, respectively in 1Q10, and RMB 5.61 and RMB 5.32 respectively in 2Q09.

In terms of financial guidance, based on our current operation, total revenue for the third quarter of 2010 are expected to be between RMB 594 million and RMB 624 million, representing an increase of 0% to 5% on a sequential basis. This reflects expected growth from the online game operations.

With that now, I would like to turn the call back to Vivien.

Vivien Wang

Thank you Kelvin. This concludes the prepared remarks for today. We are happy to take your questions now. Operator, we’re ready for questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Richard Ji from Morgan Stanley. Please ask your questions.

Richard Ji – Morgan Stanley

Hi, Michael, Kelvin, Vivien, good morning.

Michael Chi

Good morning.

Vivien Wang

Hi.

Richard Ji – Morgan Stanley

Good morning. Thank you for taking my call, and I have two questions. Let me start with the 3Q outlook, and obviously 2Q is slightly weak, and for 2Q you guided for revenue stabilization and even slight recovery on a sequential basis. Is that largely due to more favorable seasonality or the fact that you have revamped your in game promotion and almost at the end of the so called anti-cheating initiative?

(Foreign Language)

Michael Chi

Hi Richard. The guidance we gave I think for Q3 is 0% to 5%. We have already considered all the factors which will affect our revenue growth in Q3. In our estimation, which include we expect we’re doing more monetization for our games in Q3, because I think one of the reason is the seasonality reason. We expect our domestic revenue to grow in Q3, but on the other hand we also estimate that our overseas licensing revenue will go down a little bit in Q3 because we have – that is why I mentioned in the earnings remarks we have four new games launched in the overseas market, which I think drove our overseas licensing revenue in Q2.

We don’t expect there will be so many titles in the overseas market in Q3. So there will be some decline in the overseas licensing revenue in Q3. So net-net, altogether based on our best estimation right now is the guidance of 0% to 5%.

Richard Ji – Morgan Stanley

Okay, thank you. And the second question is regarding your new game launch schedule; obviously we heavily anticipate the debut of your new game such as Forsaken World and XiaoAoJiangHu. Can you give us some update on your planned launch schedule for these new games? Thank you.

(Foreign Language)

Michael Chi

It is Michael. (Foreign Language)

Vivien Wang

Richard, to answer your questions, we will most likely launch (inaudible) in September. So, there will be a little revenue contribution coming from those new games in Q3, and we plan to launch Dragon Excalibur in Q4. This game has been under testing for quite a while, so we have a lot of confidence in this game as well. In terms of (inaudible) to further beef up the content, and improve the quality of our game, we currently plan to launch the game in Q2 or Q3 next year. The exact launch date depends on the testing result. Thanks. Thank you Richard.

Operator

And your next question comes from the line of Wallace Cheung from Credit Suisse. Please ask your question.

Wallace Cheung – Credit Suisse

Hi, good morning, Michael, Kelvin, and Vivien just two quick questions. Number one, can you describe a bit more like in terms of domestic revenue in the second quarter, which game actually has performed better, and which game actually not – actually performed below your expectations? And the second question is regarding the marketing expenses has actually seen a big jump, can you give us more color how much actually coming from the new acquisitions like from the C&C Media, and also how much actually from the growth of the existing games? Thank you.

(Foreign Language)

Michael Chi

Good morning Wallace. Your question number one, domestic revenue, I think in Q2 Zhu Xian still our number one revenue contributor in Q2, and then number two is Perfect World II, and then number three is Battle of the Immortals. If you compare with Q1, yes, what we mentioned and I think we stopped – we slowed down a little bit on monetization and the promotional activities for these games. So they have some decline in terms of revenue for these games in Q2.

So your second question is marketing expenses, yes, after we completed the deal of acquisition of C&C we consolidated all the financial numbers of C&C. So, part of the reason for the increase in sales and marketing expenses is due to the consolidation of C&C's financial statement, including the sales and marketing expenses. Another reason for the increase in the sales and marketing expenses is in Q2, we launched two big expansion [ph], one is for Fantasy Zhu Xian, another one is for Zhu Xian. So we incurred additional promotional and sales and marketing expenses for these two games.

So I think these are three major reasons for the increase in the sales and marketing expenses for Q2.

Wallace Cheung – Credit Suisse

Hi, thank you. A quick follow up is like so, going forward like say third quarter and the fourth quarter is going to be more normalized kind of situation than M&A, so how do we see the margin expansion [ph] of sales and marketing expenses, and we heard that you did some cost control measures in June, but at the same time (inaudible) subsidy, and give us more on the trend going forward. Thank you.

(Foreign Language)

Michael Chi

It is Michael. (Foreign Language)

Kelvin Lau

And that is why Wallace, that is what I mentioned before, I think we have tight control on the sales and marketing expenses. So until now we have imposed a lot of control on our sales and marketing expenses, and also that is why I mentioned before I think, our sales and marketing expenses on a quarter-over-quarter basis will a little bit fluctuate because the sales and marketing expenses largely depends on the launch date of all those expansion packs and all those new game launch.

So, as Michael said, we are going to launch a new game by the end of Q3. So, in Q3 we are going to incur quite a bit on the sales and marketing expenses.

Vivien Wang

And as what Michael just said, for the long-term growth of our company, we have been ramping up our R&D capability a lot recently, which has put pressure on our margin, especially in Q2. We expect to see continued pressure in the margin in Q3, but going forward as we gradually launch our new game, the margin on pressure should be gradually released. Thank you.

Wallace Cheung – Credit Suisse

Good day, Michael, Kelvin, and Vivien. Thank you.

Vivien Wang

Thank you Wallace.

Operator

Thank you. And the next question comes from Alicia Yap from Citigroup. Please ask your question.

Alicia Yap – Citigroup

Hi, good morning Michael, Kelvin, and Vivien. I have two questions. My first question is regarding the industry dynamics and the growth potential, can you share with us your view regarding the challenges and the issues faced by the industry and also with Perfect World specifically, what is your view about the industry’s growth for this year, and separately given your more aggressive acquisitions of R&D team over the past year, should we expect more slowdown in future team acquisition or should we expect you to continue to seek for more R&D acquisition?

(Foreign Language)

Vivien Wang

From a lot of the industry data, it seems that the growth rate has been slowed down a little bit, but it is because the base has been becoming a lot bigger. Relatively speaking, we believe the whole industry will still enjoy a decent growth in coming years. Of course, in a lot of the industries, we have to experience sort of spiraled [ph] activities over time or you know over the long run, there might be fluctuations here and there, but if normal we still have a lot of confidence in the long term continued growth of this whole industry.

Of course, we believe that there will be a lot of innovations in this industry to continue to just kind of drive the growth of the whole industry. And coming back to our company specifically, we have been very focused on R&D. We have been ramping up our R&D capabilities a lot. And so, we believe this is necessary for the long term growth of our company, especially given that the competition is getting a little more intense. Over time, we do need to ramp up R&D capability ahead of time to make sure to drive the sustainable growth of our company. So, we’re still actually looking for M&A opportunities for acquiring some of the R&D people [ph] to further ramp up our R&D capability. Thank you.

Alicia Yap – Citigroup

Thank you. My second question is more housekeeping, in terms of the growth margins, it came down to about 33.6 this quarter, will that remain low at this level after the C&C consolidation, any room for improvement in the coming quarters, and lastly on the deferred revenues, it seems like it jumped quite substantially from last quarter, any reasons for that? Thank you.

(Foreign Language)

Kelvin Lau

Alicia, this is Kelvin. Yes, in Q2, our gross margin I think dropped from 86% to 83%. I think this is largely due to the consolidation of C&C because C&C's operation, I think the gross margin is lower than Perfect World’s gross margin. So this is one of the key reason why the gross margin dropped in Q2.

Going forward, I think if we can have continuous growth in our domestic revenue, I think there is possibility that there is some room to improve our gross margin going forward, if we can increase our revenue going forward when we launch more games, more new games. That is number one. The further revenue increase, I think, largely because of the consolidation of C&C. When we acquired C&C there was a large amount of revenues sitting in their balance sheets. So, when we consolidated the financial statement, this created a big increase in the revenue in Q2.

Alicia Yap – Citigroup

Great. Thank you so much.

Operator

Thank you. And your next question comes from the line of Tian Hou from Auriga. Please ask your question.

Tian Hou – Auriga

Hi Michael, Kelvin, and Vivien. I have two questions, one is Michael talked about – you guys are thinking about a share repurchase program, and you use a very specific language to the cash available to you, so I just wonder what do you mean by cash available to you. You have about 250 million some in cash now, so how much is available to you. So if you wanted to cash share purchase program, what you are going to do to make the cash available to you. So that is number one question. I will ask the second as a follow up to this.

(Foreign Language)

Kelvin Lau

Tian, thank you. We always are thinking about the best use of cash, I think as management of Perfect World. So, right now in terms of cash we have about 250 million equivalent US dollar cash on hand. But, I think, as what Michael mentioned we are adding quite a lot of M&A potential projects, including acquisition of R&D teams and also some of the projects on hand. So, as what Michael said, we are right now considering our financial position, in particular, the cash current liability [ph] to us before we can confirm the share repurchase trend.

So, as what Michael mentioned, okay, with our financial position right now, we’re seriously considering the share repurchase program. Once if and when about [ph] the program, we can make announcement public.

Tian Hou – Auriga

Okay, got it. The second question is you guys invested in the major stock in film and TV distribution production companies, I wonder how much is in your guidance is there any revenue contribution from them?

(Foreign Language)

Kelvin Lau

In my Q3, we didn’t consider any revenue coming from the newly acquired (inaudible) because the deal still hasn’t been completed yet, it still hasn’t been closed yet.

Tian Hou – Auriga

Okay. That is all my questions. And are you going to close any time soon in Q3 though?

Kelvin Lau

We plan to close the deal in Q3.

Tian Hou – Auriga

Q3. So, okay, I got it. Thank you.

Operator

Thank you. And your next question comes from the line of Wendy Huang from RBS. Please ask your question?

Wendy Huang – RBS

Thank you. My first question is based on my calculation, it seems that your domestic operation revenue declined by almost 100 million, I mean, why your ACU also declined sequentially. I understand that you slowed down (inaudible) of certain games, but why did ACU also decline in the quarter, what specific games or title contributed to that decline in ACU and revenue?

(Foreign Language)

Kelvin Lau

In Q2, the decline in ACU is mainly because of the I think the (inaudible) from Fantasy Zhu Xian. Fantasy Zhu Xian ACU numbers adding from a decline from January to May, when we calculated the ACU, we did the average. So, if the ACU declined from January to May, so Q2 average is lower than Q1 in terms of ACU. So, and also mentioned, and we brought on more aggressive anti-cheating activities to keep away (inaudible) in games.

So, these are two major reasons why our ACU number declined in Q2. In terms of APC decline, it is because we are still down, our monetization and promotional activities for our games like Perfect World II and Zhu Xian. So, the APC number declined in Q2 to this level.

Wendy Huang – RBS

So, what is (inaudible) and Fantasy Zhu Xian in July and August so far?

Kelvin Lau

In fact, for Fantasy Zhu Xian we launched a big expansion pack in May. After we launched the big expansion pack for Fantasy Zhu Xian, right now we can see the ACU number is quite stable right now.

Wendy Huang – RBS

Okay. My second question, Michael you actually mentioned that you expect several innovations going forward to drive the industry growth, so can you maybe elaborate a little bit what kind of innovations you expect, is it related to the game segmentation, or marketing, or (inaudible)?

(Foreign Language)

Vivien Wang

Every and any industry as it grows will collect experience from some of its stages, you know, after it kind of gradually grows. Typically, the industry will be more focused on segmentation. So, Wendy you are definitely right, going forward, we will more look into segmentation in terms of our effort. Thanks.

Wendy Huang – RBS

So, can I follow up on that, what kind of segment do you think is yet to be taken because currently obviously the martial arts segment, the dancing game segment, even the (inaudible) action game segment, we are already seeing some blockbuster titles there, so what new segments could be the potential next one to create hit games?

(Foreign Language)

Vivien Wang

Actually in each of the segments, we can still make a lot of innovations in terms of the product design to make the gamers experience better, so we are more focused on making our games better, more innovative to kind of in each of the different segments to further drive the user experience and our games growth.

Wendy Huang – RBS

Thank you. Thanks Vivien and Michael.

Operator

Thank you. And your next question comes from the line of Eddie Leung from Banc of America. Please ask your questions.

Eddie Leung – Banc of America

Hi, good morning everyone. I have a few questions; the first one is regarding your acquisitions of the two TV and movie production houses, could you remind us of the potential impact on your cost in the near term, after you consolidated the two entities. Thanks.

(Foreign Language)

Kelvin Lau

Eddie, I think according to accounting regulation standard I think for all those TV or film movie studios, the accounting treatment is quite different from that of the online gaming, because when we incurred all those print or TV potential expenses I think all this film or TV potential expenses, we will capitalize in the balance sheet. And when the film or TV was launched, I think probably then we can recognize the revenue, and then realize the cost accordingly.

So, I think in the short run I don’t expect there will be a very significant impact P&L because all the TV or film production cost will be capitalized in the balance sheet.

Eddie Leung – Banc of America

Understood. My second question is regarding your Japanese operations, is there any seasonality in Japan for online games?

(Foreign Language)

Kelvin Lau

Eddie, up to now we still haven’t seen I think very significant fluctuation in terms of revenue in the Japan market based on our C&C financial statement [ph]. I think there is some, but I think will not be very significant in terms of the seasonality factors in the Japan market.

Eddie Leung – Banc of America

Got that, and then finally, could you comment on your licensing strategy because I mean in the history of your company, you guys are focusing on in-house development, will these strategies be changed in the near term?

Vivien Wang

Eddie, can you repeat your question?

Eddie Leung – Banc of America

Just want to get a sense on your licensing strategy, because you guys have been focusing in in-house development. So, I just want to see whether this strategy could be changed in the near future.

Vivien Wang

You mean licensing new?

Michael Chi

Yes.

Eddie Leung – Banc of America

(inaudible).

Vivien Wang

Yes, understood.

(Foreign Language)

Vivien Wang

We are actually pretty open to any opportunities that will drive the growth of our company. In the past, we have been discussing with some of the developers, but so far we haven’t come to any licensing deal, because it has to be a very good title at the right price. It depends on a lot of factors. We will carefully consider all those factors. Thanks.

Eddie Leung – Banc of America

Okay. Thank you very much.

Operator

Thank you. And the next question comes from the line of Paul Keung from Oppenheimer. Please ask your questions.

Paul Keung – Oppenheimer

Hi, good morning, Michael, Kelvin, and Vivien. Two questions, first is if you take the first half results, and listen to the comments and commentary across the industry to date, what you see as you know is the rapid deceleration in growth. On a year-over-year basis, there has been a series of quarters of sequential declines shifting growth to overseas markets and to what you call your nontraditional core MMOs [ph] from social games.

And then what is more interesting if you look at the commentary about the business going forward, there is a sizeable jump in growth and in the fourth quarter next year, will most of that growth come again from domestic markets core MMO again, so I guess my question is what do you see as an investor in this space, do you see on the horizon, a competitive environment where you go back to more consolidation with the larger players, (inaudible) and is there something occurring of the existing gamers that caused the slow down now, or maybe a better way to answer that question is do you see a mix of your business also changing in light of those trends if you go out two years?

(Foreign Language)

Vivien Wang

Michael just said, we actually don’t anticipate any significant consolidation in the industry as a lot of companies are still at a early stage in terms of growth. Coming to our company specifically, our goal or our vision is to become one of the largest online game provider in the world, in the globe. So we have been trying a lot of things, for example, ramping up overseas operations. We are also trying to tap into the social networking game and the web game industry by some of the small investments. If these investments turn to pay out, if we notice any meaningful growth in those sectors, we will definitely ramp up – further ramp up our investments in this new upcoming segment. But up to now we still think MMORPG will be the dominating market segment in the industry. Thanks.

Paul Keung – Oppenheimer

Thank you. And my second question is more on housekeeping, does your guidance take in effect the one day moratorium on the games a couple of days ago, and how significant is that one day off?

Vivien Wang

Can you repeat your question? Sorry Paul, can you repeat your question?

Paul Keung – Oppenheimer

Can you just, does your guidance take into affect the one day moratorium on games, and if you guys participated in that and how significant is that to the quarter in general?

(Foreign Language)

Kelvin Lau

Yes, Paul, yes, that will be also considered after taking to consideration, I think the impact I think from this one day shutdown of the service because of the lowering [ph] of the event. We already considered this, but I think one day impact this will not be very significant, only one day.

Paul Keung – Oppenheimer

Okay, thank you.

Operator

Thank you. And the next question comes from the line of Adam Krejcik from Roth Capital Partners. Please ask your questions.

Adam Krejcik – Roth Capital Partners

Yes, hi. Thanks. My first question is on marketing. I was just wondering if there is any other marketing channel or strategies you can implement today. It seems like the return on each marketing dollar spent is a lot less than it was in the past. So are there any new channels or new strategies that you can do to market your games more efficiently, more cost effectively, and then I have a follow-up. Thanks.

(Foreign Language)

Vivien Wang

You know, every country or enterprise is trying to optimize the marketing dollars, but no one is there to say that the current status is the most efficient method. As a matter of fact, a lot of companies are trying different ways, different methods to adjust their marketing dollars to look for better methodology or better strategy or better capital marketing dollars that are suitable for those specific companies.

Coming to our company specifically, we have been trying to adjust our marketing dollars up-and-down to try to look for the best way or the most efficient way to market our games. Of course, we noted that any new channels, new methods that are very efficient we will adjust accordingly. But we think actually the quality of the game is the most important thing. We have been ramping up our R&D capability and trying to improve the quality of our games. We think this is the most important thing. If the quality of the game is very high, we certainly have a lot of ways to save our marketing dollars. Thank you.

Adam Krejcik – Roth Capital Partners

Okay. That is helpful. Then my second question is just on the margins. It sounded like earlier you said there was a potential for further margin pressure because of sales and marketing for new games in Q3 and Q4 as well as R&D expansion. Did I understand that correctly or am I missing something? Thanks.

(Foreign Language)

Kelvin Lau

Adam, your assumption is correct. As Vivien mentioned, I think we are going to launch Forsaken World in late Q3. So that incurred a bit of sales and marketing expenses in Q3 to promote this new game. And also Dragon Excalibur is going to be launched in Q4 this year. So, I think in the second half of this year, we got interest quite a lot on the sales and marketing expenses. As what Michael said, we hoped, we strongly believed and also we strongly believed that there have been two new games launched in second half of this year.

We really hoped these two new games to become successful. The good performance of this two – coming from these two games we believe that there are likely to have some improvement going forward.

Adam Krejcik – Roth Capital Partners

Thank you.

Operator

Thank you. And your next question comes from the line of Yvonne Yang from BNP. Please ask your questions.

Yvonne Yang – BNP

Hi. Good morning Michael, Kelvin and Vivien and thanks for taking my questions. I've got two questions. One is – the first one is about the rise of web based games. As we continue to see the quick surge of user base of web based games, should we look at this as a potential cannibalization to MMORPGs in some way or shall we consider this as a positive initiative for MMORPGs? And secondly, I also have a housekeeping question on tax rates. What is the expected effective tax rate for the second half? Thank you.

(Foreign Language)

Vivien Wang

Yvonne, regarding your first question, we are not noticing any cannibalization between web games and MMORPGs as for now. We actually think you know the takeoff of web games might be a positive for MMORPGs because it helps the growth of the whole industry, as well as migrating users.

Kelvin Lau

Yvonne, regarding the effective tax rate, the increase on our estimation in the second half of this year, our effective tax rate will be around 10% to 13%. I think the major reason for the increase of the effective tax rate is because of the consolidation of C&C, because the income tax rate, the maximum income tax rate in Japan is about 40%. I think this is the major reason for the increase in the effective tax rate.

Operator

Thank you. Thank you. And the next question comes from the line of Andrey Glukhov from Brean Murray. Please ask your questions.

Andrey Glukhov – Brean Murray Carret & Co

Okay. Thanks for taking the question. I guess two things. First, if we consider your raised ARPU, it's still about 30% above the levels that you had at the end of last year. So as you kind of progress with your efforts to cool off the monetization in some of the games, what do you think is going to be the trend in ARPU over the next few quarters?

(Foreign Language)

Vivien Wang

Compared to last year, there is some growth in the income for it [ph], but I think this is normal because it only means that more gamers are more used to spending online. Going forward, we are not either aggressively increasing the APRU or decreasing the ARPU. We would like the ARPU level to progress naturally.

Andrey Glukhov – Brean Murray Carret & Co

Okay, that helps. And my second question is somewhat technical, I apologize. Kelvin, traditionally the company expensed all R&D as incurred, and if I understood the prepared commentary right starting this quarter, you guys started to capitalize some R&D. Can you help us understand – can you quantify the impact of the capitalization on the operating margin this quarter?

Kelvin Lau

Yes, Andrey, I think the main reason why we’re again starting from this quarter we started to capitalize our R&D expenses. I think, the major reason is because we prolonged or lengthened our testing period. Because according to US GAAP, when a software product that means our online games have established technological feasibility, that means all the R&D expenses incurred during the previous – from the time when the technological feasibility has been established to the time when the product are available (inaudible) commercial launch.

I think all these R&D expenses allowed it to be capitalized. I think previously yes, our – for all our games, our testing periods were short to about only one to two months. By that time, all those R&D expenses incurred during the testing period are very insignificant and very small, so we just charge all those R&D expenses right away to the P&L. But I think right now the situation has been changed because we tightened our strategy – we take a longer time on testing the game before we commercially launched the game.

So during the testing period, because the test period has to be prolonged and R&D expenses have been increased to a significant amount. So we made a judgment in a sense that it is more appropriate for us to capitalize this significant amount of R&D expenses.

Andrey Glukhov – Brean Murray Carret & Co

I'm sorry, can you quantify what was the capitalization on the quarter so that we can get a clean sort of sequential comparison here?

Kelvin Lau

Andrey, we already stated the amount in the earnings release. I think the total amount of capitalized R&D expenses in Q2 is RMB 11 million.

Andrey Glukhov – Brean Murray Carret & Co

Okay, thank you.

Operator

Thank you. And the next question comes from the line of Tucker Grinnan from HSBC. Please ask your questions.

Tucker Grinnan – HSBC

Yes, thank you for the call. First question, looking at the mix of domestic versus international M&A and R&D spending, how do you think about the mix in terms of returns, risks, opportunities and is it linked for example to a longer term target in terms of the revenue contribution? There's been some discussion you know that the international contribution has declined. It's about 9% of revenues. Do you see that going up over time and do you see R&D spending and M&A linked to that revenue contribution?

(Foreign Language)

Vivien Wang

So far we noticed that the return of our overseas investments are very promising. It allowed us the investments – the returns are actually even higher than our original expectation. Going forward, we will continue to look into investment opportunities, but very prudently. Our goal is for every single of our investment or M&A projects to be successful, to the value accretive. In the long run, we do see a lot of potential coming from overseas in terms of the growth of those revenues in bottom-line, but as far as the domestic operation, we do believe that the Q2, the downward trend for Q2 is a short-term temporary fluctuation. We have a lot of confidence in further driving up our domestic growth as well.

Tucker Grinnan – HSBC

Thank you. So a second question looking at the domestic business in terms of M&A and growth, is the investment in the television and distribution business a shift in strategy towards a broader approach to media and content, or is it more a reflection of what assets are available and a price? Several operators, I think you guys in the past have suggested that online games, studio R&D teams are expensive and therefore per your comment the consolidation was going to be slow. So is the decision to get into the TV and content business driven more by asset prices or is it driven by a shift in strategy?

(Foreign Language)

Vivien Wang

First of all, if you were pretty familiar with the TV and movie industry, in China you will notice that this is actually a new upcoming sector that has a lot of potential in the long run. So, we do expect a decent growth of the whole TV and movie industry in China in the coming years. So we believe this is a good investment for us in terms of growth, opportunity, and return. And secondly, if you look back from our experience, we did generate a lot of synergies between our online games and the TV drama series or movies.

Still we believe this is a good investment as well in terms of getting complimentary assets to generate synergy with our core gaming business, of course, not every single one of our TV or movie project can directly link to our game, but some of them we’re looking for synergies between our games and those TV movie projects. Lastly, we want to emphasize that as a prudent management team, we are not getting towards high-risk type of investments, or expansion.

We’re very prudent in terms of each product that we’re investing. And so far the return of our project has been pretty decent. Going forward, we would like to keep our track record in terms of a high successful return. Thanks.

Tucker Grinnan – HSBC

Thanks. And my last question on the stock buyback. In the past you guys have very clearly suggested you didn't think it was management's role to comment on the stock price, that you would focus on operations and the market would determine what you were worth. Is there – has there been a change of view? Why are you focused on stock buyback now? Obviously you do have the cash. Again, is there a trade off in terms of near term M&A opportunities versus stock price?

(Foreign Language)

Kelvin Lau

As what we keep on seeing there as a management, we always think about how to best use our cash – of our cash. So, I think share buyback I think is one of the ways to use our cash. And also of course the use of cash also including M&A projects, further investment in R&D capability, I just want to try to re-emphasize we are considering this share repurchase program. If and when we get board approval, we will make a proper announcement.

Tucker Grinnan – HSBC

Thank you.

Operator

Thank you. (Operator instructions) And the next question comes from the line of Ming Zhao from SIG. Please ask your questions.

Ming Zhao – SIG

Thank you for taking my question. I just have one question on the sales and marketing expense. Someone asked this question before and you answered that you had promotions on two games expansion packs. But if we look at the size of the sales marketing expense, it's a lot higher, it's almost 50% up quarter-over-quarter. And if we compare that with this fourth quarter, which had the RMB 17 million, the amortization of intangibles, your marketing expenses is very high. So I just want to understand more about this on the P&L. My question is in this sales and marketing spend, how much is that due to the consolidation of C&C's marketing expense, and how much is due to resolving the issue with discontinuing using the ground force in marketing? How should we look at this line going forward? Thank you.

(Foreign Language)

Kelvin Lau

Yes, Ming, let me reemphasize again, I think the major reason for the increase in sales and marketing expenses in Q2 is mainly because of two expansion packs that we launched of Zhu Xian and Fantasy Zhu Xian. And you are right, another reason is due to the consolidation of the C&C financial statement, because the sales and marketing expenses in Japan is also considered to be one of the big piece of the total sales and marketing expenses.

Another reason for the increase is we participate in the E-Free exhibition in LA this year. This also further increases our sales and marketing expenses in Q2. Another reason is, I think you also heard about from the news that we asked some of our ground force promoters to take rest for several months. I think based on this event, we paid compensation to all those ground force promoters. So that is another reason for the increase in sales and marketing expenses.

Ming Zhao – SIG

Thank you. And how should we look at this line going forward? I understand there's a ChinaJoy you have to promote the Forsaken World. But in terms of increase from these factors, what kind of pictures should we look at this time going forward?

(Foreign Language)

Kelvin Lau

We already mentioned this I think for Q3, I have mentioned already. So we’re going to spend additional sales and marketing expenses to promote Forsaken World, which is going to be launched in late Q3. So, for sure, the sales and marketing expenses continues to go up in Q3.

Ming Zhao – SIG

Okay, thank you.

Operator

Thank you. And your next question comes from the line of James Lee from CLSA. Please ask your questions.

James Lee – CLSA

Thanks for taking my question. My first question is regarding the US operations and maybe Kelvin can give us an update on that and maybe revenue contribution for 2Q, and also expect the revenue contribution in 3Q. And also there's one piece of C&C I was missing. I just want to follow up Eddie's question, your guidance assumption for C&C in 3Q. Thanks.

Kelvin Lau

Hi James. Regarding the US operation, we want to tell you this, US operation already contributed meaningful revenue to the whole group, to the whole Perfect World group already. Right now, in Q2 we launched the Battle of

the Immortals in May in North America. So, recently we just launched Chi Bi in North America. So, we are happy with the performance of US operation, because I think quarter-on-quarter I think we are keeping very good result to the group, to Beijing. So, we are happy, and for sure, our US operation is making profit right now, and contributing quite meaningful revenue to the whole group.

In terms of C&C, yes for our Q3 guidance we already consider the contribution of revenue, and also profit from C&C already. And C&C right now are operating six games in Japan, including four games from Perfect World and two Korean games. C&C is making profit. So we are happy with their performance, and happy with the management team.

James Lee – CLSA

Okay. And Kelvin, is there any way you can give us any additional clarity regarding C&C in terms of your guidance assumption for 3Q? A little bit of help there would be nice. Also on the US operations, can you give a sense – what revenue scale you consider meaningful contribution at this point in time?

Kelvin Lau

James, as you know, our policy is not to disclose anything specifically, or the breakdown of the revenue, including our historic data including our guidance. What I will tell you is C&C right now all really contributing quite meaningful revenue contribution to the whole group, and they are making profit. And also in our guidance, we also considered already and in the contribution from C&C and also our North American revenue contribution. Thanks.

James Lee – CLSA

Okay, thanks.

Operator

Thank you. And your next question comes from the line of Atul Bagga from ThinkEquity. Please ask your questions.

Atul Bagga – ThinkEquity

Hi guys. Thanks for taking my questions. A couple of questions for you, I wanted to understand, if I look at sequential your expenses were up about 10.5 million and if we include the capitalized R&D that is up about $12 million sequentially. I was wondering if you can give some breakup, how much of this is coming from C&C, and I assume that this will also include half quarter expenses from Runic. So, I was very interested in knowing how much of the expense contribution is coming from Runic, and I’m assuming in the third quarter, we will see the full quarter expenses from Runic.

(Foreign Language)

Kelvin Lau

I think the major – the increase in R&D expenses for Q2 is largely coming from Beijing or China here, because we increased by a lot in terms of headcount our R&D team. The impact from C&C is very minimal, because right now in C&C in the whole team not so many R&D people. I think most of the teams are operational people. They currently [ph] got a few R&D people to do the (inaudible). So the impact is very minimal.

The impact on Runic also is I think compared with China is very minimal, because right now the team is Runic is not that big, which can create a lot of impact on the R&D expenses for the whole group. So, the major increase I think is mainly coming from China, because we increased a lot a local R&D people.

Atul Bagga – ThinkEquity

Got it. And so just to be clear, in the third quarter we should not expect any meaningful growth in expenses because of full quarter contribution from Runic? Is that right?

(Foreign Language)

Kelvin Lau

That is why I said, Right now the team in Seattle – I think Runic comparative there is more, I think with the whole R&D team in China here. So, I think the impact – I think even Runic had a full quarter R&D expenses consolidated into my P&L in Q3. The impact would be very minimal.

Atul Bagga – ThinkEquity

Got you.

Vivien Wang

But of course, we’re looking to further expand our R&D team, and ramp up our R&D capabilities. So the total R&D expenses will still keep growing.

Atul Bagga – ThinkEquity

Okay, and second question just on the philosophy of ARPU, so last quarter your ARPU was 306, and you had mentioned that in the second quarter you have kind of reduced the monetization because you wanted to increase the longevity of the game, and if I heard it correct, I think you mentioned somewhere on the call that you are looking to increase monetization a little bit in the third quarter. I am just trying to understand what is the kind of optimal monetization level that you think is healthy for the longevity of your games?

(Foreign Language)

Vivien Wang

There might have been a misunderstanding in terms of the coalition between promotional activities and ARPU. There are no direct link between promotion and ARPU level, because when we do large-scale promotions on the one hand, of course the high spending gamers might be spending more. But on the other hand, there may be a lot of low spending customers coming into the game because of that promotion. So there might not be a direct link between the promotion and the ARPU level. Thanks.

Atul Bagga – ThinkEquity

Thank you.

Operator

Thank you. And your next question comes from the line of Mike Hickey [ph] from Janco Partners [ph]. Please ask your questions.

Mike Hickey – Janco Partners

Thank you Michael, Kelvin, and Vivien for taking my questions. Just curious on the recent R&D acceleration, how much of that expansion has been devoted to casual web based games?

(Foreign Language)

Vivien Wang

So far, we are mainly focused on MMORPG development. Thanks.

Mike Hickey – Janco Partners

Okay. And then just a follow up, and I am curious why you are being more patient on the web-based games, or casual market where it seems to be more consistent with how your business is today versus allocating resources to film and television?

Vivien Wang

Can you repeat that question?

Mike Hickey – Janco Partners

Yes, I’m curious why you are taking a more patient approach to the casual market versus you seem to be kind of allocating away from where your main business is. It seems like you have the best internal resources for game development, and it seems like the operating margin potential market growth from casual games is a better opportunity, so I’m just kind of curious why you are kind of taking a wait and see approach?

(Foreign Language)

Vivien Wang

We think those platform type of companies with a lot of user base may benefit some more from the take off of web game, casual game, social networking game type of business. And in terms of us when we look at investment areas, of course we’re looking for high return area for our business, and in terms of TV and movie investments, we think this is a good investment for us with high return and can generate synergies with our core MMO gaming business.

Of course, we are very prudent in terms of investing in different areas. We are taking small steps in trying out all those different areas, including web game, casual game and social networking game. Yet we started to notice any promising trend, where we will certainly invest more in this area to generate higher returns to the company. Thanks.

Mike Hickey – Janco Partners

Thank you.

Operator

Thank you. Due to time constraints, we would like to conclude this call now. I would like to turn the call back over to Ms. Vivien Wang for closing remarks. Please go ahead ma'am.

Vivien Wang

Thank you. This is the end of the conference call. The web cast replay will be available at Perfect World’s official website www.pwrd.com under IR section. If you have any additional questions please feel free to contact us. Thank you very much.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may now all disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Perfect World CEO Discusses Q2 2010 Results - Earnings Call Transcript
This Transcript
All Transcripts