Changyou.com's (CYOU) CEO Tao Wang on Q2 2014 Results - Earnings Call Transcript

Jul.28.14 | About: Changyou.com Limited (CYOU)

Changyou.Com Ltd. (NASDAQ:CYOU)

Q2 2014 Earnings Conference Call

July 28, 2014 7:00 AM ET

Executives

Tip Fleming – IR, Christensen

Rucia Ren – Finance Director and Acting CFO

Tao Wang – CEO

Analysts

Eddie Leung – Bank of America Merrill Lynch

Tian Long – Credit Suisse

George Meng – Morgan Stanley

Natalie Wu – CICC

Thomas Chong – Citigroup

Operator

Thank you for standing by, and welcome to the Second Quarter 2014 Changyou.com Limited Earnings Conference Call. At this time, all participants are in a listen-only mode. There will be a presentation, followed by question-and-answer session. (Operator Instructions). I must advise you that this conference is being recorded today, 28 July 2014.

I would now like to hand the conference over to your first speaker for today, Ms. Tip Fleming of Christensen. Please go ahead, Mr. Fleming.

Tip Fleming

Thank you, operator. On the call today are Mr. Tao Wang, CEO; Mr. Dewen Chen, President; Ms. Rucia Ren, Acting CFO; and Ms. Wendy Pan, CIO. I’ll lead off by providing business highlights on behalf of Mr. Wang, and then pass the call to Ms. Rucia Ren, Acting CFO, who will discuss results for the quarter just ended. After the prepared remarks, she will be joined by the other officers to answer questions.

Before we continue, please allow me to read Changyou’s Safe Harbor statement. Statements that are not historical facts, including statements about the company’s beliefs and expectations are forward-looking statements. These statements are based on current plans, estimates, and projections, and therefore you should not place undue reliance on them.

Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. For more information about the potential risks and uncertainties, please refer to the company’s filings with the Securities and Exchange Commission, including its registration statement and most recent Annual Report on Form 20-F.

Now, let me proceed to provide business highlights on behalf of Mr. Wang. The core focus of our business is to develop engaging content that meets the needs, taste, and preferences of online game players, and then foster active user communities that further bolster their passion for our games.

In the second quarter, we released new expansion packs and new games, while we pushed ahead with building a central platform for distributing and promoting games. I’ll discuss each of these starting with the new expansion pack that we released for TLBB in the second quarter.

TLBB is the biggest driver of our revenues, accounted for around 63% of total revenues in 2013. When designing and then managing our games, our philosophy is that we meet user needs best through the continuous development and launch of new content in the form of regular expansion packs.

When gamers’ needs are met, they will stay with the game longer and become more committed to playing the game, which in turn lengthens the lifespan of the game. The longer the game’s lifespan, the more revenues and profit our company can earn from the game over time. This approach has been proved effective with TLBB.

TLBB’s revenues have increased over the past several years. To date, TLBB is one of the most popular MMO games in China and one of the most profitable MMO games globally. Following this strategy, we released the latest expansion pack for TLBB on April 25.

In the latest expansion pack, we reduced the level of difficulty and battle time per session of its popular game play and made other adjustments to encourage more non-spending and low spending players to engage in battles in the game.

The purpose of these adjustments was to enhance the in-game environment, making game-play fairer for all users. Such changes brought about our desired result in terms of user numbers.

In the second quarter, TLBB’s monthly active accounts increased sequentially. In terms of revenues, however, because we reduced the level of difficulty, high spending players were less incentivized to spend money on the game during the quarter. This impact was larger than originally anticipated, and revenues of TLBB came in below our expectations in the second quarter. The revenue shortfall of TLBB in the second quarter was the main reason for the company missing its revenue expectations.

Looking ahead, we plan to make further changes to the game-play and functions of TLBB to enhance players’ experience of the game. In particular, we intend to add new in-game features to stimulate community activities and make the social environment more lively.

These changes will be part of the next expansion pack for TLBB to be released this Friday and the annual major expansion pack released later this year in October. As a result of these changes, TLBB’s lifecycle is expected to be effectively extended, and the revenue from TLBB remains stable at around the current level.

Our objective with TLBB is to build a sustainable product that will continue to generate cash for a long-time. With the cash, we can invest in new product development and in sales and marketing to support growth and the expansion of our business. We are currently targeting investment in new MMO, web, and mobile games.

We have a good line-up of new games for the second half of the year. On the MMO game side, two weeks ago on July 18, we launched a new fantasy MMORPG called Fantasy Frontier Online, which is licensed from a game studio in Taiwan. The game features Japanese anime-style graphics and has attracted many players who are Japanese comic fans. On the opening weekend of its launch, PCU for the game exceeded 100,000.

Later in the year, we plan to launch a 3D Fantasy MMORPG called Echo of Soul. The game is licensed from Korea, and we’ve nearly completed localization of the game. Echo of Soul is a fantasy action MMORPG featuring fast-paced combat and dungeons created especially for new players. The game features four classes of characters and focuses on tactics, strategy, and positioning. The game is undergoing closed beta testing and launch is planned for the fourth quarter of 2014.

Recently, Changyou also secured exclusive rights to adapt Qin Shi Ming Yue, a martial arts novel that is popular with generation born in the 2000s into a number of online games or the [oughts] I should say. Over the next few years, we plan to release a series of MMO, web, and mobile games based on this widely recognized IP.

Next month, coinciding with the August release of the movie also based on this novel, we will be launching three Qin Shi Ming Yue games, a license role-playing web game called Qin Shi Ming Yue and two trading card mobile games called Qin Shi Ming Yue 2 and Qin Shi Ming Yue [Q-Drone] (ph), which were developed – which were co-developed with third parties.

Other games we plan to launch this year are Deity’s Crown, a self-developed web game focused on multi-online battle arena game-play, and another three to four mobile games including a mobile version of DDTank.

In the second half of the year, we expect the additional revenues generated from these new games to offset the decline in revenues from our existing web games, DDTank and Wartune, which have both entered a mature phase in China.

Overseas, both games revenues were stable. Meanwhile, TLBB is expected to continue to generate a steady stream of revenues to support our business.

Changyou’s overarching strategy is to continue to launch new expansion packs and new games while supporting our emerging platform business, including the launch of broad range mobile apps to capture the business opportunities that we’re seeing in the mobile space.

We’re using profit from the online games to support R&D and sales and marketing for the platform we’re building. This strategy is based our view of market evolution and takes advantage of our core competencies. It’s clear from a number of metrics and trends that internet users and services are shifting gradually from PC to mobile.

What we’re seeing is that because of the nature of the mobile game business and the screen size of mobile devices, social messaging apps in alternative app stores are taking time share and mind share of mobile internet users. They are becoming more and more of a hub for various internet or mobile services from entertainment to eCommerce to recruitment and social messaging.

For us as a leading game company, while we can continue to be greater developing games, we see a much more massive opportunity in expanding our business beyond the game segment, particularly while the mobile internet market is still up for grabs.

This is the strategic context of our aggressive investment in building out our platform center. Three to five years down the road, we believe the biggest business model on mobile will be similar to the PC business, essentially online games and advertising.

We expect that our mobile platform will use capital generated from the game business to promote games through mobile apps and other software applications on our platform.

In the second quarter, our progress has been as follows: In the second quarter, we had 252 million average monthly active users of platform channels, up 196% year-over-year. Of that number, roughly 15 million were monthly active users of mobile apps.

Monthly unique visitors to the 17173 website increased by roughly 20% year-over-year due to the introduction of new video content. As of now, we have videos and live broadcasts of E-sports events for over 1,000 games, including exclusive content for popular games like Dota 2.

The increase in user traffic of 17173 media translated into higher online advertising revenues in the second quarter, up 46% year-over-year. On July 1, we raised advertising prices on the 17173 website by 10% in light of the strong advertising demand.

The 17173 browser designed for web game players is currently the top ranked – top ranking game browser in China for PCs. On the mobile side, we would be investing in MoboTap, the creator of Dolphin Browser, one of the top alternative mobile browsers globally.

The internet browser, whether on PCs or mobile is a gateway to the internet and a channel for distributing content like news, videos, apps, and games. With this investment in MoboTap, we will gain immediate presence in the U.S. and Europe, where the vast majority of Dolphin browsers users lie.

We plan to leverage Dolphin browser to cross-market other mobile apps that we own. We believe that the MoboTap team’s extensive experience with the global browser market will also aid us in developing our own products.

On the other hand, we plan to help the commercialization of the Dolphin browser. MoboTap will continue to be run by its existing management team, and we will provide support if needed for its global expansion.

To wrap up, I would like to say that we have a very profitable online games business and many promising new games in our pipeline. We are seeing good results from the investment in our emerging platform business, and I believe the combination of online games and platform is a solid business model that will give us high returns in the long run. Thank you.

This concludes Tao’s prepared remarks. Now, let me turn the call over to Changyou’s Acting CFO, Ms. Rucia Ren to walk you through the operational and financial highlights for the quarter.

Rucia Ren

Thank you Tip. Hello everyone. I will now take you through our operating results for the second quarter.

Total average monthly active accounts of our games were $24 million, a decrease of 14% quarter-over-quarter and 33% year-over-year. The quarter-over-quarter decrease was mainly due to a decline in active accounts of the web games, Wartune and the DDTank in China, as both games have entered into a relatively mature phase.

The year-over-year decrease was mainly due to a decline in active accounts of Wartune and DDTank and the decline in active accounts of TLBB after the company closed certain game accounts in 2013 to enhance the balance of the in-game economic system.

Total average monthly active accounts of our platform channel were 252 million, an increase of 5% quarter-over-quarter and 196% year-over-year. The quarter-over-quarter and year-over-year increases were mainly due to an increase in monthly logged-in accounts of various software applications for PCs and mobile devices and an increase in the monthly unique visitors to the 17173 website as more video content and live broadcast of E-sports events were added to the website.

Let me move go on to discuss our financial results for the second quarter. As for revenues, total revenues were $177.8 million, down 2% quarter-over-quarter and 3% year-over-year and below our guidance by $4.2 million.

Online game revenues were up $153.9 million, down 6% quarter-over-quarter and 9% year-over-year, and below our guidance by $7.1 million. The quarter-over-quarter and year-over-year decrease were mainly due to decreased revenues from Wartune and DDTank in China, and the decreased revenue from TLBB because fewer players spent on the games in the second quarter of 2014 after we released a new expansion pack that made some of the game play easier for players to play.

Online advertising revenues were $14.7 million, up 59% quarter-over-quarter and 46% year-over-year, in line with our guidance. The quarter-over-quarter increase was mainly due to the seasonal pickup typical for advertising in China in the second quarter. The year-over-year increase was mainly due to an increase in the utilization rate of advertising on the 17173 website after the company introduced improvements to help advertising sales in 2013 and 2014.

Internet value-added services revenues were $4.8 million, up 34% quarter-over-quarter and 251% year-over-year. The quarter-over-quarter increase were mainly due to the inclusion of revenues of web games operated by (inaudible) in the second quarter of 2014 after the company centralized it’s web game operations.

The year-over-year increase was mainly due to the reasons I have just mentioned as well as increased revenues from self operated web games and the consolidation of the financials of RaidCall Business into Changyou’s financial statement from December 31, 2013.

Other revenues, which consist of cinema advertising revenues, were $4.3 million, down 4% quarter-over-quarter and up 66% year-over-year. The year-over-year increase was mainly due to better advertising sales resulting from improvements in the advertising sales function during 2013.

Now, let me provide some more details about other financials. From now on, most of the figures discussed will be non-GAAP. As a reminder, you can find a reconciliation of these non-GAAP measures in our official earnings release.

As for gross margins, the non-GAAP gross margin was 76% compared with 78% last quarter and 83% in the same period last year.

As for operating expenses, non-GAAP operating expenses were $140.8 million, 18% lower than last quarter and 144% higher than the same period last year. The quarter-over-quarter decrease was mainly because of compensation expenses related to employee incentive plans announced in early 2014 and recorded in the second quarter were lower than the last quarter.

The year-over-year increase was mainly due to higher advertising costs for promotion of software applications of the platform business for PCs and the mobile devices, and an increase in salary and benefit expenses.

As for operating loss, non-GAAP operating loss was $6.6 million. This compares to non-GAAP operating loss of $29.7 million last quarter and a non-GAAP operating profit of $93.6 million in the same period last year.

As for income tax benefit, income tax benefit was $2.2 million. This compares with income tax benefit of $2.7 million last quarter and income tax expense of $13.9 million in the same period last year.

We recorded an income tax benefit, because we recognized deferred tax assets for the loss carry-forward. Income tax benefit in the second quarter exceeded loss before income tax expense in the same period because income tax benefit from some operating entities which are loss-making exceeded the income tax expense incurred by our profitable operating entities.

And as for net income, non-tax net income attributable to Changyou.com Limited was $2.4 million and exceeded our guidance by $16.4 million, mainly because the company scaled back its advertising and promotion of its PC based and the mobile based software applications in the second quarter of 2014.

On a fully diluted basis, non-GAAP earnings per ADS attributable to Changyou.com Limited, were US$0.04.

Next, moving on to the balance sheet and cash flow statements. As of June 30, 2014, we had cash and cash equivalents of $393.2 million, down from $409.5 million at the end of last quarter.

As of June 30, 2014, we had short-term bank loans of $257 million and current restricted time deposits of $372.1 million, unchanged from last quarter. For the second quarter, we had net operating inflow of $2.9 million.

Finally, our outlook for the third quarter of 2014 is as follows: We expect total revenues to be between $186 million and $192 million, of which online game revenues are expected to be between $158 million and $163 million and online advertising revenues are expected to be between $16 million and $17 million.

Non-GAAP net loss attributable to Changyou.com Limited to be between $0 million and $6 million. We expect non-GAAP net loss attributable to Changyou.com Limited mainly because we plan to continue our marketing campaign for software applications and our platform initiatives, as well as because of the anticipated consolidation of MoboTap, a loss-making business into our financials in the third quarter.

Non-GAAP fully diluted loss per ADS attributable to Changyou.com Limited between $0.00 and $0.11.

Assuming no new grants of share-based awards, we estimate share-based compensation expenses between $0.5 million and $1 million, increasing our fully diluted loss per ADS attributable to Changyou.com Limited under U.S. GAAP by $0.01 to $0.02.

Our online games and online advertising businesses are generating more than enough cash flow to allow us to make investments in opportunities to expand our business. In the long-term, we believe that you will appreciate our foresight and the strategic assessment of how best to position Changyou in the evolving online games and the mobile market.

This concludes our prepared remarks. Thank you for joining the call today. Operator, we would now like to open the call to questions.

Question-and-Answer Session

Operator

Thank you ma’am. We will now begin the question and answer session. (Operator Instructions). Our first question comes from Eddie Leung from Merrill Lynch. Your line is open. Please go ahead.

Eddie Leung – Bank of America Merrill Lynch

Good evening. Thank you for taking my questions. I have two questions. The first one is about your margin outlook. I understand that you usually don’t have specific margin guidance for the full year, but given some of the games to be launched in the second half of the year, how should we think about your marketing expenses in the upcoming couple of quarters after they declined in the second quarter?

And then my second question is about your headcount. Could you give us an update of your number of headcounts by the end of second quarter? And how many of them are related to R&D? Thank you.

Tao Wang

(Interpreted). Okay. Actually for us in the second half of the year, we do have some plan to launch several web games and PC-based games, and we will also spend some marketing -- we’ll do some promotion and do spend marketing expenditure to promote these games. But most of our marketing expenditure will be for our platform products.

And actually for us, the gaming business is kind of grows very healthy. And in second quarter, we actually generate about $90 million net profit in our gaming business and most of our expense actually putting on to our platform business.

And we actually make like a full marketing plan in our platform business, we make plan for three months. And we kind of use the marketing money in a conservative way and effective way. We’ll try to find a balance between future growth development and also making profit. So, actually it depends on how we – how our platform business perform.

And for the headcount number, at the end of second quarter 2014 our headcount is around 6,200. And headcount in the R&D section would be nearly 3,000.

We put in a lot of resource in R&D. And in second quarter, we roughly would put like 28% of our revenue was put in R&D expense.

Operator

Your next question comes from Tian Long from Credit Suisse. Your line is open. Please go ahead.

Tian Long – Credit Suisse

Management share any kind of data plans on this product like its MAU or DAU and also the latest and also the latest trend for these user metrics and also how big of a impact of this investment on your margins and the bottom line down the road? And how are you going to integrate this new product into your existing platform and game operation? And finally, is it fair to say advertising, mobile advertising, is the primary revenue source for this product? Thank you.

Tip Fleming

Sorry, we kind of missed the beginning part of your question. Could you repeat your question?

Tian Long – Credit Suisse

If management can share like MAU or DAU, such like user metrics for Dolphin Browser?

Rucia Ren

We are not inclined to describe the MAU and the DAU of the Dolphin Browser. And it’s a business secret now, yeah. Thank you.

Tian Long – Credit Suisse

Then how is the trend like from what you can see for the MAU and the DAU, how is the trend for those user metrics of this?

Tao Wang

(Interpreted). Okay. And right now actually the daily active user account for like 33% of the monthly active user. And for the monthly active user, we are going to include consolidate the number into our next quarter’s guidelines.

Tian Long – Credit Suisse

Thank you.

Operator

The next question comes from George Meng from Morgan Stanley. Your line is open. Please go ahead.

George Meng – Morgan Stanley

Hi, good morning. Good evening everyone. Thank you very much for taking my question. So, my question is related to your platform strategy. I just wonder when do you expect that your platform can become a self-sustained platform and when should we expect the benefit of the platforms to kick in?

Tao Wang

(Interpreted). Yes, we did put in a lot of like marketing money also put a lot of money on R&D to develop our platform business. And in second half of the year we’re going to try to commercialize our platform business by like provide like internet value added service.

Domestic wise, video broadcasting service, it’s actually kind of growing very fast. But it’s a fundamental service to users. And we don’t have a plan to kind of start commercialization of this service.

Probably next in 2015 we will give expectation on the revenue front like broadcasting video service. For overseas business, we now don’t have like a very specific plan about this part. Actually it depends on the game development. And right now we’re still kind of in the planning process to kind of develop game, suitable for overseas market.

We are not planning to reduce marketing expenditure we used to promote our platform business in overseas market, like marketing campaign would remain at least till the end of 2015. And even if we make money from our platform business in overseas market we’ll still kind of reinvest the money we earn into the promotion, into promotion the platform product in overseas market.

George Meng – Morgan Stanley

Thank you. Can I have a very quick follow-up on the platform? You mentioned the MAU of the platform is 250 million out of which about 15 million, is that 15 million is for mobile, because if I recall correctly, last quarter it was already 16 million, so is that really a quarter-on-quarter decline on the mobile platform user numbers?

Tao Wang

(Interpreted). Yes, so the MAU of our – from our mobile side, 50 million. So it is [inaudible] by monthly active user, it’s not quarterly.

George Meng – Morgan Stanley

Okay, got it. And also on the – can you give us any color on the PC front, on the breakdown of this MAU because you’re providing quarter-after-quarter in a higher MAU but what kind of – out of this 252 million how much of that was actually the login account versus just the [inaudible] without login?

Tao Wang

(Interpreted). Okay. So, from the PC side actually we don’t really – actually the login account, the user generally don’t have a login account because most of the users are using the [once a month] [ph] media service. And we kind of – the mobile user tend to have a login account. And our focus is on mobile side.

Operator

Okay. The next question comes from Natalie Wu from CICC. Your line is open. Please go ahead.

Natalie Wu – CICC

Hi, good evening. Thanks for taking my questions. Could you please [inaudible] on your revenue sharing details with [inaudible] Network and [inaudible] for Fantasy Frontier Online and Echo of Souls? And about your mobile game, [inaudible], what would be your major distribution platform in android, the android platform. And would it enter into exclusive licensing with certain third party actors like Ba Bu?

And there is another question we can see that you’ve guided 5% to 8% sequential growth in the third quarter. I’m just wondering how much would be attributable to MoboTap [ph]. Thanks.

Tip Fleming

Sorry, could you repeat the first part of your question because the voice is really low?

Natalie Wu – CICC

Yes, the revenue sharing details with [inaudible] network had a big share for Fantasy Frontier Online and Echo of Souls?

Tip Fleming

I’m sorry. Your voice is getting [inaudible] like MAU you’re saying?

Natalie Wu – CICC

No, no.

Tao Wang

(Interpreted). And actually it’s kind of quite confidential for us to disclose kind of this information. But we can tell you that it’s within industry standards. It’s about 20% to 30%.

Natalie Wu – CICC

(Foreign Language).

Tao Wang

(Interpreted). Okay, and actually it depends on the quality of the game. If the gaming quality, the quality of the game is very good, it’s [S] [ph] level then we’ll use some branding, brand marketing. And we’ll also work with kind of partner with channel 2 promoter game.

And for the games not reach the [S] [ph] level then we will not do brand marketing on. But we’d do what with platform channel to promote a game.

So, I mean, the strategy we’re used to promoting [inaudible] would depend, highly depend on the performance we after launch then we’ll decide [strategy] [ph], yes. Thank you.

Natalie Wu – CICC

If you enter into tax [ph] period in this summer right?

Tip Fleming

Sorry.

Natalie Wu – CICC

[Inaudible] if you enter into [tax] [ph] period this summer right?

Tao Wang

(Interpreted). Yes.

Operator

The next question comes from Thomas Chong from Citigroup. Your line is open. Please go ahead.

Thomas Chong – Citigroup

Hi, good evening. I have two questions. The first question is I want to ask about management how we should think about the China client base and web game market? How should we think about the industry growth going forward?

And my second question is regarding TLBB. For the second quarter, can management give us some guidance about whether there is a sequential growth in active paying accounts or are we seeing the ARPU, this keep on declining trend going forward. And when should we expect the revenue to rebound? Thanks.

Tip Fleming

Sorry, what’s your first question?

Thomas Chong – Citigroup

The first question is regarding the China client based games and web games market. Are we seeing - very difficult to get new users if we are very difficult to get new users, how we should think about your PC games revenue going forward?

Tao Wang

(Interpreted). Right now, PC kind of game, already kind of enter into declining stage. For the past two quarter we observed the user who played PC game and the user play web game, they kind of, they’ve become, gradually become the same group of people.

Okay. So, we think that PC gamer will gradually become a mobile gamer. But we don’t know yet like in the end like how much PC gamer will stay on playing PC games.

And we also noticed that for mobile game, the game-play is actually also evolving. And we see there is a strong demand for mobile gaming usage, the demand for MMORPG type of games.

So, forward-looking we think in the future, mobile gamer they tend to choose to play MMORPG type of games. And a lot of mobile gamer, they actually switch from PC gamer, they are originally play PC games.

So, right now we are actually given the trend we observe, we are now developing TLBB mobile version but it’s a MMORPG game-play. And we should kind of release more information at the end of the year or at the beginning of next year.

So, actually for TLBB it’s over – account for over 60% of our revenue. And given the market is right now kind of in the strength the overall PC client based game market. So, we actually have kind of up to kind of target milestone for TLBB.

So, our target is actually to remain – the revenue to remain flat year-over-year in 2014. And so that our development team had more energy to kind of develop game for long-term growth, for long-term health. So, we will be more conservative on TLBB. Yes, so we hope TLBB for its gamer base and also the revenue can sustain for a very long time.

Operator

The next question will be the last question. The next question is from Alex Yao from JPMorgan. Your line is open. Please go ahead. Just to inform you Alex has just disconnected his line. There are no more questions in the queue. (Operator Instructions). I would now like to hand the call back over to Mr. Fleming for further remarks or closing comments.

Tip Fleming

Thank you everyone for joining our call today. That’s all the time we have for today. If you have any follow-up questions, please don’t hesitate to contact us directly. Thank you.

Operator

And that does conclude today’s conference. Thank you for your participation. You may now disconnect.

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Changyou.com (NASDAQ:CYOU): Q2 ADS of $0.04 beats by $0.31. Revenue of $177.8M (-2.5% Y/Y) misses by $9.2M.