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

Q3 2010 Earnings Call Transcript

November 15, 2010 8:00 pm ET

Executives

Vivien Wang – IR Officer

Michael Yufeng Chi – Founder, Chairman and CEO

Kelvin Wing Kee Lau – CFO

Analysts

Paul Wuh – Samsung Securities

Timothy Chen [ph] – Morgan Stanley

Alicia Yap – Citigroup

Lisa Yuan – Goldman Sachs

Wendy Huang – RBS

Wallace Cheung – Credit Suisse

Mark Marostica – Piper Jaffray

Tian Hou – Auriga

Eddie Leung – Merrill Lynch

Sam [ph] – Oppenheimer

Mike Hickey – Janco Partners

James Lee – CLSA

Atul Bagga – ThinkPanmure

Nick Ning – Roth Capital

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Perfect World Q3 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 must advise that this conference is being recorded today, Tuesday the 16th of November, 2010. I would now like to hand the conference over to your speaker today, Ms. Vivien Wang of Perfect World. Thank you. Please go ahead.

Vivien Wang

Thank you, operator, and thank you, everyone, for joining us today for Perfect World’s third 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 website 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 third 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 expectations. 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 is available on our website, at www.pwrd.com under the Investor Relations section.

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

Michael Chi

Thank you, Vivien, and thanks to everyone for joining us today. Our third quarter results were mixed as our overall revenues came in ahead of our guidance due to the contribution from our television and movie business. Our performance in the online gaming business was slightly softer than we anticipated. However, our ongoing strategic expansion into film and television business is not only broadening our revenue streams, but also providing access to content and the resources that are expected to create synergies between different segments of our business in the future.

In our online gaming business, we didn’t release any new games or major expansion packs during the quarter as we concentrated on a number of longer-term projects to bring new excitement to our games portfolio. There is much to look forward to in terms of these projects.

As we have stated in the past, in an effort to give new games the best chance of success upon release, we have been extending the development cycle while we enhance our effort in fine-tuning and testing our upcoming releases. We have seen steady progress in terms of such efforts.

In late October, we released 'Forsaken World,' our 3D Western-themed MMORPG. The game has received a pretty positive response from gamers and it’s still ramping up, making for another solid addition to our portfolio.

And even more recently, we also launched 'Dragon Excalibur,' our first 2D real-time MMORPG. This game further diversified our portfolio into a new game segment. And we look forward to further growing this game.

We are making great progress in developing a number of differentiated games to deepen our pipeline. Our collection of new titles will position us well as we target multiple segments and new user groups in the online gaming market. We are also in the final stage of preparation for the upcoming launch of 'Empire of the Immortals,' which will be a sister title to 'Battle of the Immortals,’ under the same 'Immortals' franchise.

‘Empire of the Immortals' has already attracted considerable buzz in the market and we are excited about its prospects. After some early promotions for the game during the quarter, we saw some gamers take a wait-and-see approach with 'Battle of the Immortals,' (inaudible) as they study the new game prior to its launch. But we are confident that, after the launch of 'Empire of the Immortals,' we will be able to broaden the overall user base of both games by targeting slightly different sub-segments of gamers and build the two into an even greater overall franchise.

Additionally, we plan to launch a major new expansion pack for 'Battle of the Immortals' in the coming months. With this, and other expansion packs and updates to our key existing key titles, we expect to draw new gamers and additional interest across our portfolio.

R&D continues to be one of our key competitive advantages to grant a substantial growth of our company. Our investments in technology provide us with ever-improving platform on which we base our investment. As our future rests on the quality of our people, we continue to train and develop key talent that will lead our company forward. While our investments in R&D have caused us to experience some pressure on our margins in the near term, the mild fluctuations in our results are temporary [ph], and we see them as a necessary step for the healthy, long-term growth of our company.

Our growing overseas business continues to develop as a meaningful source of revenue and long term growth. During the third quarter, we signed agreements to license multiple games to a number of overseas markets. We also launched French and German versions of 'Zhu Xian' through our subsidiary in Europe. While we don't expect this to add significant revenue in the near term, we are working hard to acclimate to the European gaming market while building our brand in the region.

And longer-term, we are growing increasingly confident in our capabilities to further strengthen our position as a global player in the online gaming market by leveraging upon our game development studio in the U.S., and our operating subsidiary in the U.S., Japan and Europe.

We believe we are particularly well-positioned to thrive as Internet penetration in China continues to grow at a rapid pace. Our exciting roster of games slated for launch in 2011 and 2012, continued interest of gamers in our existing games, strong R&D and operation capabilities, and the progress in other related supporting businesses, should create a sustainable platform that will drive our enduring success.

With that, I would like to pass the call to Kelvin.

Kelvin Lau

Thank you, Michael. As Michael mentioned, besides launches of two new (inaudible) in the domestic market, we are also making good progress in the overseas market. During the third quarter, we signed agreements to license ‘Battle of the Immortals’ to Thailand, Malaysia, Singapore and the Philippines, ‘Forsaken World’ to Taiwan and ‘Pocketpet Journey West’ and ‘Chi Bi’ to Russian Federation and other Russian speaking territories.

We also launched ‘Fantasy Zhu Xian’ in Taiwan through our overseas partner and ‘Chi Bi’ in North America through our wholly-owned subsidiary under the name ‘Heroes of Three Kingdoms.’ Shortly after the quarter-end, we signed agreements to license Zhu Xian to Indonesia, ‘Fantasy Zhu Xian’ to Russian Federation and other Russian speaking territories, and ‘Legend of Martial Arts,’ ‘Chi Bi’ and ‘Hot Dance Party’ to the Philippines.

We also launched both French and German versions of ‘Zhu Xian’ in Europe under the name ‘Jade Dynasty.’

Now, I would like to take your through our third quarter 2010 financial highlights. Our total revenues were RMB658.2 million in 3Q10, as compared to RMB594.2 million in 2Q10 and RMB590million in 3Q09.

Our online game operation revenues were RMB527.1 million in 3Q10, as compared to RMB533.3 million in 2Q10 and RMB485.9 million in 3Q09. The slight decline in our online game operation revenue from 2Q10 was primarily due to the recent soft performance of ‘Battle of the Immortals,’ partially offset by the better performance of some of our key existing games.

The aggregate average concurrent user, or ACU, for games under operations in mainland China was approximately 733,000 in 3Q10, as compared to 886,000 in 2Q10, and 713,000 in 3Q09. The active paying customer, or APC, for games operated in mainland China under the item-based revenue model was approximately 1,274,000 in 3Q10, as compared to 1,433,000 in 2Q10, and 1,643,000 in 3Q09.

The average revenue per active paying customer, or ARPU, for games operated in mainland China under the item-based revenue model was RMB323 in 3Q10, as compared to RMB292 in 2Q10 and RMB266 in 3Q09. The decline in ACU and APC from 2Q10 was mainly due to the continued underperformance of ‘Fantasy Zhu Xian’ and the recent soft performance of ‘Battle of the Immortals.’

Our overseas licensing revenue were RMB48.6 million in 3Q10, as compared to RMB55.1 million in 2Q10 and RMB58.8 million in 3Q09. The decrease from 2Q10 was mainly attributed to a decrease in initial license fees in 3Q10 as the company had a number of new commercial launches in overseas markets in 2Q10.

Our film, television and other revenues were RMB82.5 million in 3Q10, as compared to RMB5.7 million in 2Q10 and RMB45.3 million in 3Q09. Most of the film, television and other revenue recognized in 3Q10 was related to the release of the TV series ‘Fighting for My Marriage’ produced by Xinbaoyuan and Baohong, in which we recently took majority stakes.

Our gross margin [ph] was 77.3% in 3Q10, as compared to 83.6% in 2Q10 and 83.9% in 3Q09. The decrease in gross margin from 2Q10 was primarily due to larger contribution in 3Q10 from film [ph] and television business, which is a lower-margin business.

Our operating expenses were RMB297 million in 3Q10, as compared to RMB275.1 million in 2Q10 and RMB197.3 million in 3Q09. The increase in operating expenses from 2Q10 was mainly attributed to higher R&D expenses.

Our sales and marketing expenses were RMB123.8 million in 3Q10, as compared to RMB121 million in 2Q10 and RMB88 million in 3Q09.

Our R&D expenses were RMB113.8 million in 3Q10, as compared to RMB90.7 million in 2Q10 and RMB71.5 million in 3Q09. The increase from 2Q10 was primarily due to an increase in staff cost as we continue to expand our R&D talent pool.

Our general and administrative expenses were RMB59.4 million in 3Q10, as compared to RMB63.5 million in 2Q10 and RMB37.8 million in 3Q09.

Our income tax expenses were RMB17.1 million in 3Q10, as compared to RMB29.6 million in 2Q10 and RMB11.1 million in 3Q09.

Net income attributable to the Company's shareholders were RMB213.7 million in 3Q10, as compared to RMB196.6 million in 2Q10 and RMB288.3 million in 3Q09. Non-GAAP net income attributable to the Company's shareholders were RMB239.2 million in 3Q10, as compared to RMB221.7 million in 2Q10 and RMB308.5 million in 3Q09.

The basic and diluted earnings per ADS were RMB4.27 and RMB4.05, respectively, in 3Q10, as compared to RMB3.93 and RMB3.71, respectively, in 2Q10, and RMB5.83 and RMB5.50, respectively, in 3Q09.

Non-GAAP basic and diluted earnings per ADS were RMB4.77 and RMB4.53, respectively, in 3Q10, as compared to RMB4.43 and RMB4.19, respectively, in 2Q10, and RMB6.24 and RMB5.88, respectively, in 3Q09.

In terms of financial guidance, based on our current operations, total revenues for the fourth quarter of 2010 are expected to be between RMB581 million to RMB604 million. This reflects an expected growth of 1% to 5% in revenue from our core gaming business on a sequential basis as we do not expect any major release from the TV and movie business in the fourth quarter of 2010. We also take into consideration the expected growth from the recent launches of ‘Forsaken World’ and ‘Dragon Excalibur.’

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 are ready for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Paul Wuh from Samsung Securities. Please ask your question.

Paul Wuh – Samsung Securities

Good morning. I have a question wondering about your trends for Fantasy Zhu Xian during the fourth quarter, have things improved or not related to that?

Vivien Wang

I am sorry, can you repeat the question, Fantasy Zhu Xian was…?

Paul Wuh – Samsung Securities

How the trends are for the fourth quarter? I mean you had mentioned that one of the reasons why things were weaker in the – with the third was related to this game. And just overall your 1% to 5% growth, how much of that is related to these new games ‘Forsaken World,’ and ‘Dragon Excalibur’?

Vivien Wang

(Foreign Language)

Kelvin Lau

First of all, thank you for your question. I will reply to your first question first regarding the 'Fantasy Zhu Xian,' according to the record we I mean since late this year we are already seeing that 'Fantasy Zhu Xian' (inaudible) has already stabilized. So I expect 'Fantasy Zhu Xian' Q4 compared to Q3 will be stable, in fact some negatives. Regarding our guidance, I think the revenue growth for Q4 is mainly coming from our two new games, ‘Forsaken World,’ and ‘Dragon Excalibur’ and also we expect our existing games like 'Perfect World II' and 'Zhu Xian' can achieve a little bit growth in Q4 as well.

Paul Wuh – Samsung Securities

Thank you very much.

Operator

The next question comes from Timothy Chen [ph] from Morgan Stanley. Please ask your question.

Timothy Chen – Morgan Stanley

Hi, Michael, Kelvin, and Vivien, good morning, and thanks for taking my questions. My first question is possibly related to 'Forsaken World' and 'Dragon Excalibur.' Obviously these games had a good debut in late October. Could you also give us some color of these new games? How did these games perform so far comparing the management’s expectations? And I have a followup question after that. Thanks.

Vivien Wang

(Foreign Language)

Michael Chi

(Foreign Language)

Vivien Wang

So we launched the 'Forsaken World' in late October. It’s performed pretty well even it exceeds our expectations a little back. And as far as 'Dragon Excalibur,' we launched it actually two weeks ago. It’s a new segment for us. It’s 2-D real time gaming, it’s a new segment for us. So, from the very beginning, it was a little bit slow start, but it’s been gradually ramping up and overall we are pretty confident in (inaudible) these two new games. Thanks.

Timothy Chen – Morgan Stanley

Thanks. Thank you. Regarding the overseas licensing revenues, there is a sequential drop in third quarter. And should we expect a rebound in fourth quarter and how should we think of the contribution from overseas licensing revenues next year? Thank you.

Vivien Wang

(Foreign Language)

Kelvin Lau

That’s why I mentioned in the remarks I think the decline in the overseas licensing revenue in Q3 is mainly because we don’t have any titles launched in overseas market. So, we didn’t recognize so much initial license fee in Q3. So, in Q4 I would expect my overseas licensing revenue, we expect to a little bit growth, why it is because it all depends on the exact commercial launch date of our games in the overseas market by our overseas operator.

Up to now (inaudible) my forecast for the overseas license revenue Q4 should be flat to just a little bit growth.

(Inaudible) it is difficult to – I mean again apologies not going to give guidance for – I mean for the coming years. So, yes.

Timothy Chen – Morgan Stanley

Understood. Thanks.

Operator

(Operator instructions) Your next question comes from Alicia Yap from Citigroup. Please ask your question.

Alicia Yap – Citigroup

Hi, good morning, Michael, Kevin, and Vivien. My question is related to your movie strategies. Can you give us some guidance in terms of how we shall look at this business, so for example how many more TV series are you planning to launch in the next three to six months and since this is a little bit lower margin business and how should we be thinking about the longer term margins trend? Thank you.

Vivien Wang

(Foreign Language)

Michael Chi

(Foreign Language)

Vivien Wang

First of all, in terms of the accounting treatment, according to U.S. GAAP, we can only recognize TV or movies revenue upon its receipt [ph], you know recognize the revenue and associated cost in that quarter. So, in other word, yes, we are not launching or releasing any game – anything in the TV or movie in that particular quarter then there is no, basically there are no revenue.

Secondly, as far as long term strategy for our TV and movie [ph] business, we are primarily looking into two areas. One is the synergy with our core gaming business. And the other is that, as you may now, you know TV and movie industry is a cash flowing industry in China and as such has a lot of potential in the long run. Although it’s relatively a lower margin business compared to our online gaming business, but it’s earning accretive and it’s…

Michael Chi

(Foreign Language)

Vivien Wang

Additionally, as we have mentioned in Q4 we didn’t plan any major releases, both TV or film. As far as the release schedule for 2011, it’s too early to comment on (inaudible) are asking, we haven’t confirmed the exact schedule. Yes.

Alicia Yap – Citigroup

Thanks.

Operator

The next question comes from Lisa Yuan from Goldman Sachs. Please ask your question.

Lisa Yuan – Goldman Sachs

Hi, thanks for taking my question. My first question regarding 'Battle of the Immortals', could you share with us the (inaudible) of this game lately? And also when do you plan to launch the new extension to that (inaudible)? My second is regarding guidance. For the guidance, you assume for 4Q, what do you assume for ACU and ARPU and revenue guidance?

Vivien Wang

(Foreign Language)

Kelvin Lau

Lisa, thank you. I think in Q3 we saw that (inaudible) 'Empire of the Immortals' dropped down, it’s true. Again, the major reason with the levels that – in Q3 we announced that we are going to launch our new edition for our ‘Immortals' series and we are going to launch (inaudible) and 'Battle of the Immortals.' So we believe some of the gamers I think opted better Immortals. They are taking a wait-and-see approach as what Michael mentioned in his remarks. So, I think it’s the major reason why the better Immortals is even the drop in Q3. But we are (inaudible) with entire Immortals, so that we launched entire Immortals, we expect well postponed so that you could – so that (inaudible) so that’s why better Immortals dropped in Q3.

Going into Q4 I will expect – because in Q4 – going into Q4 because we launched two new games, the 'Forsaken World' and 'Dragon Excalibur,' I will expect my ACU and PCU and assume my active paying customer will increase in Q4 because of these two new games. But in terms of ARPU, we expect our ARPU will go down in Q4, why because – that’s why I mentioned in the previous earnings call, for this new game launch at the initial stage, the ARPU will be lower. So, this two will (inaudible) the value to my overall ARPU in Q4.

Lisa Yuan – Goldman Sachs

Okay. Thanks.

Operator

Next question comes from Wendy Huang from RBS. Please ask your question.

Wendy Huang – RBS

Thank you. I recall that you mentioned that with the new games launch and the recovery growth in revenue we should expect the operating margin to bottom out. So, given that you are just guiding 1% to 5% sequential growth organic, again, I mean what kind of operating margin should we look at for Q4? And also can you give some color on the sales and marketing and G&A expense in Q4? Thanks.

Kelvin Lau

Q4 – first of all, we are not going to give any guidance on the margin in Q4. Well I can give you some color on the margin is that we still have some pressure in the near terms in our margin. I think there are several reasons behind one just I mentioned before is that when we launched 'Forsaken World' and 'Dragon Excalibur,' especially at the initial launch, we are not going to (inaudible) monetizing these two games. Our immediate purpose is trying to accumulate gamer pace [ph] at this stage. So, that’s why the guidance we give the market now is about 1% to 5% in Q4. So – but having said that, because of these two new games launch we have incurred more – overall sales and marketing expenses to promote our new games and also our existing games. And also in Q4 we have two big expansion packs to be launched for our two big games, 'Perfect World II' and 'Zhu Xian.' So I would expect my sales and marketing expenses to go up in Q4. So this is the key reason.

And another reason is we also mentioned in our remark that we and in Q1 have been increasing our R&D talent pool, so out of the expenses we will have [ph] a little bit in Q4 as well. So, net-net I mean we still have some pressure in the near terms on the operating margin.

Operator

Your question comes from Wallace Cheung from Credit Suisse. Please ask your question.

Wallace Cheung – Credit Suisse

Hi, gross margin, Michael, Michael, and Vivien. Just quick questions on the minority interest. Why there is a big jump in minority interest, is it because of both Xinbaoyuan and Baohong is actually in a loss situation? Thank you.

Michael Chi

In fact, as you know, in fact Xinbaoyuan and Baohong, they are making profit. Again my numbers in this quarter is really because of some of the upcoming (inaudible) under U.S. GAAP, which are clearly to be have a positive number in the (inaudible) it’s all due to adding the (inaudible) the business (inaudible), Wallace.

Wallace Cheung – Credit Suisse

Okay, sorry, can you – you (inaudible) is it a non-cash item or is it a recurring item, so how we are going to see like in the next quarter in the MI [ph] items? Thank you.

Michael Chi

I think this – the one-time item I think in Q3 – I think in Q4 we will see (inaudible) and I am in the – it is not related to non-cash or cash. I think it’s another – a little kind of (inaudible) treatment under U.S. GAAP.

Wallace Cheung – Credit Suisse

Okay, thank you. Just quickly, so it would this special one-off kind of treatment. What should the (inaudible) look like?

Michael Chi

You mean in Q4?

Wallace Cheung – Credit Suisse

Oh, sorry in Q3.

Michael Chi

(inaudible) you assume there is no this one time MI treatment. What is the MI look like in Q3, you mean?

Wallace Cheung – Credit Suisse

Yes, it should be a negative number or positive number?

Michael Chi

(Foreign Language)

Vivien Wang

(Foreign Language)

Wallace Cheung – Credit Suisse

And then what’s the margin on Xinbaoyuan and Baohong in the third quarter?

Kelvin Lau

Hello, Wallace, I think – Wallace, it’s not going to disclose I think our individual subsidiary margin.

Wallace Cheung – Credit Suisse

Okay, thank you.

Kelvin Lau

Thank you.

Operator

Your next question comes from Mark Marostica from Piper Jaffray. Please ask your question.

Mark Marostica – Piper Jaffray

Hi, thank you for taking my question. I’d like to explore your thoughts as to when you expect 'Empire of the Immortals' to begin commercialization. And then tied to that, when do you anticipate 'Empire of the Immortals' will no longer be a drag on 'Battle of the Immortals'?

Vivien Wang

(Foreign Language)

Michael Chi

(Foreign Language)

Vivien Wang

As far as 'Empire of the Immortals' we are actively doing testing for that game now and we target to launch the game in Q1 next year. So, by the time after we launch 'Empire of the Immortals' overall for the ‘Immortals' franchise 'Empire’ and 'Battle of the Immortals', we are expecting a growth of the overall franchise, ‘Immortals' franchise.

Michael Chi

(Foreign Language)

Vivien Wang

In addition actually it took us a little bit longer time for us to get the application approval from related government authorities that’s why we target to launch 'Empire of the Immortals' in Q1.

Michael Chi

(Foreign Language)

Vivien Wang

And a little longer lead time in terms of the approval for new launch from the government authorities is applied to the whole industry, not for us specifically. Yes.

Mark Marostica – Piper Jaffray

Okay, thank you for the color.

Operator

Your next question comes from Tian Hou from Auriga. Please ask your question.

Tian Hou – Auriga

Vivien and Kelvin, I have two questions. One is regarding the tax rate and the game tax rate in Q2 was 4%, so I just wonder what’s going to be the tax rate going forward. That is question number one. Number two is really for Michael. So, I really want to understand what’s your merger and acquisition strategy? And are we – should we expect more acquisitions going forward or you are going to put the break on it, so what’s your plan?

Vivien Wang

(Foreign Language)

Kelvin Lau

Thank you for the question. I think regarding the tax rate, yes, we will see in Q3 my income tax expenses are being decreased as compared to Q2. I think the major reasons for such reasons for such decline is, number one is we newly to established some entities in China, which can enjoy some tax holiday. So we effectively I mean brought down our overall income tax expenses for the whole group. So this is a good news. Number two is I think this something related to our U.S. again taxation situation. Because in U.S. again in U.S. you note again all the tax expenses have been calculated on paid on a positive basis. So there will be some quarterly timing fluctuation in terms of the even type of expenses paid in U.S. But net-net I will still say that for the whole year my – at the same my (inaudible) effective tax rate should be within a range of 10% to 12% of the positive (inaudible) I mean this is what my best estimate for the overall effective tax rate for the whole year. So, I think this is the answer to your question number one.

Question number two is M&A. I think (inaudible) open to looking for some potential M&A candidates I mean which is related to our business, which can contribute growth to our overall gaming and also TV and movie business. So, we – in fact we are actually looking at candidates. (Inaudible) for competitive reason we cannot disclose again what type of target we are looking at or what or to whom we are talking to. So, what I say is we are open to all the M&A opportunities.

Operator

Your next question comes from Eddie Leung from Merrill Lynch. Please ask your question.

Eddie Leung – Merrill Lynch

Good morning, guys. My first question is related to the ARPU trend. Could you shed more colors on the ARPU trend in the third quarter. Is it – is the increase related to any particular game and how should we see the trend going forward of your older games? And then second question is I am wondering, is there any capitalized R&D expense in the third quarter? Thanks.

Vivien Wang

(Foreign Language)

Kelvin Lau

Good morning, Eddie. Okay. Question number one, the ARPU. Yes. in Q3 my ARPU is 320 something I think the about Q2 290 increased a little bit in Q3. I think this is natural and reasonable because in Q3 we don’t have any new game launch. Our belief we are still (inaudible) stream of revenues from coming from 'Zhu Xian' and 'Perfect World II,' (inaudible). So, that’s why I mentioned previously when the game become older the (inaudible) is longer than the ARPU will naturally go up. So, we are still comfortable with this type of ARPU level for these two games. So, going forward, that’s why I mentioned Q4 I will expect my overall ARPU will go down because 'Forsaken World' and 'Dragon Excalibur' (inaudible) launched again will dilute my overall ARPU in Q4. So, whenever we can launch I think my ARPU will dilute. We will dilute ACU, APC or basically APC has to go up that’s what I mentioned before.

Question number two, the capitalization of the R&D expenses, yes, in Q3 we still have some R&D expenses capitalized, but in my balance sheet it’s only related to the 'Forsaken World' and 'Dragon Excalibur' because Q3 again we launched in (inaudible) we are allowed to capitalize the relative R&D expenses in Q3.

Eddie Leung – Merrill Lynch

Got it. Thank you.

Operator

Your next question comes from Sam [ph] from Oppenheimer. Please ask your question.

Sam – Oppenheimer

Hi, good morning. Thanks for taking my call. Quick question on – I understand that overall ARPU and ACU went down in the third quarter, but what games did actually gain sequentially in terms of revenue contribution? Do you have any games that actually gained popularity during the quarter?

Vivien Wang

Sam, (inaudible) we can't hear your clearly.

Sam – Oppenheimer

Okay. Is this better?

Vivien Wang

Yes, no problem now.

Sam – Oppenheimer

It was what games during the third quarter gained in terms of revenue increase sequentially? If you guys saw any of your games gain popularity in the third quarter?

Michael Chi

Sam, it’s actually, in fact in Q3 we achieved revenue growth in our two major games like 'Perfect World' and 'Zhu Xian.'

Sam – Oppenheimer

So, you saw those two games gain sequentially. And overall gaming was down, but those two games still increased on a normal rate?

Vivien Wang

(Foreign Language)

Michael Chi

Yes, the situation is slightly – I mean in Q3 'Zhu Xian' and 'Perfect World II' are still strong (inaudible) as far say 'Perfect World II' and 'Zhu Xian,' 'Zhu Xian' we still achieved some revenue gain in these two games. But any of the major reason for this decline in the online gaming business in Q3 is mainly because of the 'Battle of the Immortals.' That’s why I mentioned in this earning call when we announced 'Zhu Xian' and 'Empire of the Immortals' are being – all those gamers feel like they are taking a wait-and-see approach so there is a drop in the revenue (inaudible). But I mean, as (inaudible) we are optimistic with 'Zhu Xian' and probably more so when we launch – and probably more so when we would not see that (inaudible) going forward.. Yes.

Sam – Oppenheimer

Okay. And my next question goes into – I mean in terms of your films, I am seeing a trend where last year the third quarter you guys also had a big bump on the TV and films investment and this quarter as well. So – and I know you – and in this business you won't be able to recognize any revenue as films are being put out, but in the future will you guys be forecasting any films you put out each quarter and what not to give us a better foresight on film and television revenue contribution?

Vivien Wang

(Foreign Language)

Kelvin Lau

(Foreign Language)

Vivien Wang

As far as film and TV business, because we also want to grow those part of our business (inaudible), so in the long run we do expect to kind of regularly release our films or TVs, but (inaudible) Michael’s comment in the short run on quarterly basis it’s inevitable to have some fluctuations. Thanks.

Sam – Oppenheimer

Okay. I guess my question is really, do you have a pipeline of lines that you ever going to be putting out (inaudible) but (inaudible). Just a question, last question is, so do you anticipate your sales and marketing expenses to be higher in Q4 versus Q3 there with two new games and two (inaudible)?

Vivien Wang

(Foreign Language)

Kelvin Lau

That’s what I was saying, Sam, in Q4 because we have two new game launch 'Forsaken World' and 'Dragon Excalibur' and also we have two big extension there for – one for 'Perfect World II' and one for 'Zhu Xian' in late November or early December. So, I will expect my sales and marketing expenses will go up because we got more games and then we have (inaudible) extensions, so for this reason look for my sales and marketing expenses to go up in Q4.

Sam – Oppenheimer

Okay. Thanks, guys. Appreciate it.

Operator

(Operator instructions) Your next question comes from Mike Hickey from Janco Partners. Please ask your question.

Mike Hickey – Janco Partners

Good morning, thank you for taking my question. Looking at your game portfolio, your APC from Q4 ’09 down 42% and your ARPU to remain at the elevated rate. Q3 it’s 21% above the prior year. And it just doesn’t look like this relationship is something consistent with a healthy game portfolio. What specifically in 2011 do you think will change this relationship?

Vivien Wang

(Foreign Language)

Kelvin Lau

I think according to the formula ARPU is equal to revenue divided by APC, so – yes, my – I think Q3 situation is ARPU go up and there APC go down and my – I think my reference again (inaudible) again very, very (inaudible) managed 1.70% [ph] decline in the (inaudible), so the (inaudible) is like this.

I think the trend going forward I will expect of course we have new game launch in the coming year, so I am quite sure that my gamer base will increase with new game launch and also I feel my APC will go up. And also that’s why I mentioned going forward for all these new games initially the ARPU will be lower so that it will be some time to see it on our overall ARPU, so the trend is ARPU will go down, ACU will go up and APC will go up. I mean this is what my estimation on the trend.

Mike Hickey – Janco Partners

Okay. Thank you.

Operator

Your next question comes from James Lee from CLSA. Please ask your question.

James Lee – CLSA

Thanks for taking my questions. Can you guys may be share your view a little bit about the outlook for 2011? Specifically regarding to revenue growth, what’s the right way to think about it? Should we think about maybe core business being somewhat stable in 2011 whether growth will come in from your new games?

And also in terms of margin, what’s the best way to think about for 2011? Is second half of 2010 margins a good proxy for 2011? And also any update on C&C acquisition and revenue contributions? Thanks.

Vivien Wang

(Foreign Language)

Kelvin Lau

James, I think first of all, is apology not to give you any guidance I think for all those quarters beyond Q4. But again, due to some – my estimation for 2011, 2011 we have – according to our schedule we have four new game launch in coming year. So, I will expect most of the revenue growth in the coming year will be coming from the new games. Okay. So, number one. Number two is for my especially game (inaudible) we are trying to again maintain the – or keep the revenue contribution of this – from our existing game (inaudible) in the coming year. This is what we want to achieve in the coming year. Regarding the margin trend, again, it all depends on the performance of the new game we launch. Okay. Yes, (inaudible) all my games are again can perform up to our expectation, I will say, so my margin will be (inaudible) gradually when you have new revenue coming in. And also, of course again in January we will implement again more effective cost control on my cost so as to try to further improve my margin in the coming year. Yes.

James Lee – CLSA

C&C acquisition?

Kelvin Lau

C&C so far is again operating very smoothly. Again, there is no very big operation or changes in the infrastructure of – since after the acquisition. So, we are where we have to be with (inaudible). In the past two quarters I would say – I was seeing the revenue trend for C&C is stable to little growth. I think as I tell you maximum original budget when we are price sensitive. So, we are happy, but since – and going forward, C&C’s trend is they will like to launch our 'Forsaken World' in Japan in the coming year and also hopefully (inaudible) will be launched in Japan as well. So, I think we are happy with the performance of C&C.

James Lee – CLSA

Okay. (inaudible) can ask for clarification regarding the margin question you were saying that if the new games in 2011 they were in par with your expectation, in combination of with strong cost control, your margin should be improving versus your second half 2010 levels. Did I get that correctly?

Kelvin Lau

This is 2000 what?

Vivien Wang

Versus second half of this year.

Kelvin Lau

Yes, yes, again if my medium launch at least up to our expectation and also of course of our cost control trend, I would like to see again my margin will have to gradually improve in every QonQ.

Operator

Your next question comes from Atul Bagga from ThinkPanmure. Please ask your question.

(Inaudible)

Atul Bagga – ThinkPanmure

Thanks, guys, thanks for taking my call. This is Atul Bagga from ThinkEquity. So, a couple of quick questions. So, on – first of all on ARPU, last two years your ARPU has gone up by 65%. I just wanted to understand what is this (inaudible) and what is your view longer term on the existing games? Do you expect the ARPU to continue to go up or do you think this ARPU at current level is going to stabilized for the existing games?

And, second, I was wondering if you can give us some update on XAGH [ph] when is that – is it still on track for 2011 and shall we see it Q1 or 2Q of 2011? Thank you.

Vivien Wang

(Foreign Language)

Michael Chi

Atul, regarding the ARPU, okay, I will be brief once again, for our existing games like 'Perfect World II' and 'Zhu Xian' I will expect my margin will remain at this type of level or probably going forward because that’s why I said it’s a net increase in ARPU for 'Zhu Xian' probably because these two games are already four years old. So, the longer the period of operation, I think the higher ARPU. We see that as reasonable. So, going forward, we will try to maintain this type of ARPU or try to lower down a little bit or ARPU a little bit fine.

For other existing – for others – new game launches, that’s why I mentioned, okay, all those new games launch, initially the ARPU will be lower. So, in the short run, I would expect my overall ARPU will go down in the near term like (inaudible) is kind of the – in Q4 the ARPU will be lower. Okay. This is question number two.

Question number two is–?

Vivien Wang

(Foreign Language)

Michael Chi

Oh (inaudible) as of this date I think it’s still on schedule on our game development front. So, we expect to launch again – it’s not confirmed – it’s confirmed. But according to our current schedule, we expect it to launch (inaudible) in the second half of next year.

Atul Bagga – ThinkPanmure

Thank you, guys.

Operator

Your next question comes from Hui Dong from HSBC. Please ask your question.

Your next question comes from Nick Ning – Roth Capital. Please ask your question.

Nick Ning – Roth Capital

Well, hi, thank you for taking my question. So, because (inaudible) far off in (inaudible) and you just said you have just clarified you have four games to be launched in 2011, is that right?

Kelvin Lau

Yes, yes, including 'Empire of the Immortals.'

Nick Ning – Roth Capital

So what about 2012?

Kelvin Lau

2012, Nick, it’s too early to comment on our product line launch in 2012. Two reasons, one is for competitive reason, okay. It’s not better – again, better for us not to disclose so much at the sort of profit at in right now for 2012. Secondly is I think generally as you know at least it’s typical to predict I mean the progress or the build status of all the games. So, what I can tell you is that we have seven games to be launched I mean seven games is under development, which is planned to be launched in 2012.

Nick Ning – Roth Capital

Okay. So, another group of question is perhaps for Michael. So, what do you think is the biggest change in gamers’ preference in the past few years? (inaudible) marketing exactly?

Vivien Wang

(Foreign Language)

Michael Chi

(Foreign Language)

Vivien Wang

In terms of gamer preference one of the experience that we noticed is that we think the gamers are more inclined to more user friendly type of games or functions within games.

Nick Ning – Roth Capital

So, does that mean that is this the reason why this game right now is more short-lived because gamers prefer this convenience, so they are trying to get their time spent on this game?

Vivien Wang

(Foreign Language)

Michael Chi

(Foreign Language)

Vivien Wang

(Foreign Language)

Nick Ning – Roth Capital

So (inaudible) taking more and more difficult for MMORPG to grow since the players prefer these games that are easy to play, so casual games will be more popular, is this the trend? Thank you.

Michael Chi

(Foreign Language)

Vivien Wang

For the audience if you allow I would like to repeat – the next question was about first of all about the gamers’ preference if there was any changes that were noted? And our answer is that we think the gamers preferred more user-friendly types of games or more convenient functions within the games.

And then next followup question was does that lead to a shorter life of our games? Our answer is, no, we don’t necessarily think so. What we mean is that the user prefer more convenient features, user-friendly features within the games. It doesn’t necessarily give a shorter life of games and we are actually pretty confident in terms of maintaining pretty long lifecycle of our games.

And then the other followup question is about I mean – does this gamer preference trend mean that more gamers will prefer casual game as opposed MMORPG? And our answer is that we think these two are fundamentally two segment servicing different type of users. For MMORPG, there are still a lot of users prefer MMORPG because there a lot of interaction, active interactions within the game, which casual game cannot offer. And what it means is that we are currently paying more attention to the two synergy [ph] areas in terms of design to make sure that gamers are getting more comfortable playing the game. Yes, that’s it. Thanks.

Michael Chi

(Foreign Language)

Vivien Wang

(Foreign Language)

Nick Ning – Roth Capital

So, my last question is regarding the innovation. So, what do you think is the major direction for future innovation in the industry since so many games here? So, secondly, do you think with this – it is game plays actually improve at all, but we (inaudible) necessary some effects that is the major direction future innovation. Thanks.

Michael Chi

(Foreign Language)

Vivien Wang

Our answer is that in our industry speak of initially typically there will be a lot of massive innovation in terms of technology, but after kind of a lethargy [ph] kind of mature level that at this stage we are – we think that industry is undergoing kind of micro innovation, which means that it’s not a massive innovation in terms of technology, but there are a lot of subtle detailed areas that we need to pay more attention in terms of design to make sure that gamers are happy with those tiny [ph], subtle areas. In other words, there are a lot of very minor, but important at the same (inaudible) program innovation at the macro level of our games in terms of design, which should lead to better gamer experience within the games. That’s the areas that we are working on. Thanks.

Operator

The next question comes from Paul Wuh from Samsung Securities. Please ask your question.

Paul Wuh – Samsung Securities

Yes, very quick two followup questions. First on why was your interest income up so much on the quarter-over-quarter basis? And secondly, you had mentioned you spent a lot more on R&D expenses due to employees. Could you tell us how many employees you have now and what the incremental increase during the third quarter was? Thank you.

Kelvin Lau

Paul, thank you for your questions. The number one, is my interest income increase is because go back to my balance sheet, okay, you see the total sum of our cash in the current deposit, okay, longer term of deposits, so earned a high interest rate. So, this is the major reason why our interest income (inaudible) increase. In terms of headcount, we have – I think for the whole group, we have about right now – hold on.

Vivien Wang

We have right now about 4000.

Kelvin Lau

About 4000 people whole group, including U.S., including Japan, including

Europe, including China, about 4000 people for the whole group.

Paul Wuh – Samsung Securities

And how many did you add during the quarter?

Kelvin Lau

700 in Q3. Yes.

Paul Wuh – Samsung Securities

Thank you.

Operator

Ladies and gentlemen, that’s all the time we have for today. That does conclude our conference. Thank you for participating. You may all disconnect.

Vivien Wang

Thank you. This is the end of the conference call. The webcast 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.

Michael Chi

Thank you.

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