Perfect World's (PWRD) CEO Robert Xiao on Q2 2014 Results - Earnings Call Transcript

Aug.19.14 | About: Perfect World (PWRD)

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

Q2 2014 Earnings Conference Call

August 18, 2014 9:00 p.m. ET

Executives

Joanne Deng – Associate IR Director

Robert Xiao – CEO

Kelvin Lau – CFO

Analysts

George Meng – Morgan Stanley

Natalie Wu – CICC

Eddie Leung – Merrill Lynch

Jialong Shi – Credit Suisse

Nick Ning – 86Research

Alicia Yap – Barclays

Thomas Chong – Citigroup

Wendy Huang – Standard Chartered

Operator

Hello, ladies and gentlemen. This is Raymond, and I'll be the operator for this conference call.

I would like to welcome everyone to Perfect World Company Limited's Second Quarter 2014 Earnings Conference Call. [Operator Instructions]

Now I would like to turn the call over to Ms. Joanne Deng, Associate Investor Relations Director at Perfect World. Ms. Deng, please proceed.

Joanne Deng

Thank you, operator, and thank you all for joining us today for Perfect World's second quarter 2014 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 newswires.

Today you will hear from Mr. Robert Xiao, our CEO, who will give us brief overview of the quarter and a brief update on our business. After that, Mr. Kelvin Lau, our CFO, will take us through some of our latest operational developments, and then our financial performance in the second quarter 2014. Following the prepared remarks, Mr. Xiao and Mr. Lau 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 statement as a result of new information, future events or otherwise, except as required under applicable law.

Our earnings release and this call include discussions 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 Robert.

Robert Xiao

Thank you, Joanne. Good morning everyone. Thank you all for joining us today. We are pleased to announce our second quarter result.

Our top-line result were in line with the high end of our expectations. Our PC client-based games such as flagship title Swordsman Online delivered an increase in revenue, and the world-class DOTA2 also contributed to the sequential revenue growth with its growing contribution in the second quarter.

At the same time, we're happy with the achievement we have been making in terms of mobile game development. Towards the end of the second quarter, we launched our 3D mysterious fantasy MMORP mobile game Forsaken World. And more recently, we also launched our 2D turn-based, cartoon-style RPG mobile game CrossGate Mobile, which has become another hit since its debut.

For our existing games, we have always been dedicated to maintain a healthy lifecycle by releasing regular expansion packs and content updates. We are also very devoted to our pipeline of upcoming games across a wide range of genres and types, which I believe will be appealing to varied tastes of different gamers.

Our Legend of the Condor Hero, which is a highly-anticipated 3D MMORPG based on Louis Cha's classic martial art novel is currently under development. Another name, Neverwinter, is an MMORPG developed by our Cryptic Studio. The PC version of this game has been very popular among the gamers following its launch in North America and Europe, and we expect to launch it in China later this year.

Our track record and accumulated experience have paved a solid foundation for us to take our games beyond the PC market. As part of this, we are working on building our console game pipeline. We are particularly happy with the long-term partnership we've established with Microsoft through whose Xbox One platform we are looking forward to introducing several console games in China. Neverwinter will be one of the first titles to launch, along with the debut of the Xbox One in Mainland China.

On the mobile side, we are working on a number of titles, including Touch, Forever Mars and Swordsman Mobile, which should help to further diversify our portfolio in the future.

In addition to our strong portfolio of games that I just touched on, we continue to bolster our well-established global operational network, which is another major competitive advantage for us. Our overseas business now reaches over 100 countries and regions around the world and contributes around one-quarter of our total revenues. We will continue to look for and take advantage of new growth opportunities in the global market as they arise.

As such, we launched our PWIN program to help us capture more investment opportunities in small to medium-sized game studios and R&D teams globally. For example, we recently signed an agreement to invest RMB50 million as a limited partner in a game industry investment fund which will primarily focus our investing in game development teams and early-stage companies in game-related businesses in China.

The fund will be managed by senior members from both a well-known private equity firm in China and Unity China. We look forward to leveraging their broad access to valuable industry resources in our effort to seek more investment opportunities in outstanding R&D teams and companies in the future. We believe our PWIN program will help not only solidify our position in China, but also further strengthen our presence globally.

I will now pass the call to Kelvin for an update on some of our recent operational development and a review of our financials.

Kelvin Lau

Thank you, Robert. First I will start with a quick update of some business developments, then I will go through the financials.

We have had an active quarter in terms of releasing expansion packs and content updates for our PC client-based games. During the second quarter, we released Desert Maze for Swordsman Online, Covenant of the Wolf for Fantasy Zhu Xian, Rage of Hades for Saint Seiya Online, Raider Unleashed for Zhu Xian, and Forsaken World 2.0 for Forsaken World. Towards the second quarter we released the expansion pack, Shaolin Kongfu for Return of the Condor Heroes and Call of Jianghu for Legend of Martial Arts. Later today we will also release the (inaudible) for Battle of the Immortals.

We have also progressed well in our mobile game business. As Robert mentioned, we launched our mobile game Forsaken World in June. In mid-July we launched our CrossGate mobile.

In terms of overseas business, through our own subsidiaries, our fresh title Swordsman Online was introduced to players in various overseas markets. During the quarter, we launched this game in Singapore, Malaysia and Japan. Since the end of the second quarter, we launched the English, French and German versions of this game in North America and Europe. And more recently this game was also launched in Thailand through our overseas subsidiary.

Meanwhile, we remain active in overseas licensing activities through our overseas partners. During the second quarter, we signed an agreement to license Swordsman Online to Indonesia. Moving forward, we will continue dedicate efforts to deliver high-quality entertainment to gamers all over the world.

Now for the second quarter of 2014 financials. Total revenues were RMB928.4 million, compared with RMB891.1 million in the previous quarter and RMB700.1 million in the same quarter last year.

Online game operation revenues, which include both domestic and overseas online game operation, were RMB861.1 million, compared with RMB827.6 million in the previous quarter and RMB650.1 million in the same quarter last year. The sequential increase was due to the combined effects of the increased revenue contribution from some of the PC client-based games that we operate in China, such as Swordsman Online and DOTA2, the continuous strength of mobile games and the decrease in revenues of some other PC client-based games. In addition, the sequential increase was partially associated with a change in estimated player life of certain PC client-based game, which were shortened in 2Q14 as a result of our regular assessment of the player lifecycles of our games.

ACU for PC games under operation in mainland China was approximately 661,000, compared with 662,000 in the previous quarter and 742,000 in the same quarter last year.

Licensing revenues were RMB48.9 million, compared with RMB45.3 million in the previous quarter and RMB31.5 million in the same quarter last year. The sequential increase was largely associated with the mobile games we launched in certain overseas markets in 2Q14.

Other revenues were RMB18.3 million, compared with RMB18.1 million in the previous quarter and RMB18.5 million in the same quarter last year.

Cost of revenues were RMB249.8 million, compared with RMB235 million in the previous quarter and RMB164.6 million in the same quarter last year. The sequential increase was mainly due to an increase in revenue sharing cost in 2Q14 as a result of increased contribution from DOTA2, which we obtained exclusive right to operate in mainland China. Revenue sharing associated with this game increased in 2Q14.

Gross profit was RMB678.6 million, compared with RMB656.1 million in the previous quarter and RMB535.5 million in the same quarter last year. Gross margin was 73.1%, compared with 73.6% in the previous quarter and 76.5% in the same quarter last year.

Operating expenses were RMB550.3 million, compared with RMB478.7 million in the previous quarter and RMB462.9 million in the same quarter last year. The sequential increase in operating expenses was mainly due to increases in sales and marketing expenses, general and administrative expenses, and R&D expenses in 2Q14.

R&D expenses were RMB259.8 million, compared with RMB253.5 million in the previous quarter and RMB198.5 million in the same quarter last year.

Sales and marketing expenses were RMB197.8 million, compared with RMB144 million in the previous quarter and RMB191.9 million in the same quarter last year. The sequential increase was primarily due to an increase in advertising and promotional expenses in 2Q14.

G&A expenses were RMB92.8 million, compared with RMB81.3 million in the previous quarter and RMB72.5 million in the same quarter last year. The sequential increase was mainly due to a provision of receivables from certain overseas partners that no longer operate our games, in some overseas markets.

Operating profit was RMB128.2 million, compared with RMB177.3 million in the previous quarter and RMB72.6 million in the same quarter last year. Non-GAAP operating profit was RMB138.4 million, compared with RMB195.9 million in the previous quarter and RMB89.7 million in the same quarter last year.

Total other income was RMB42.1 million, compared with RMB43.8 million in the previous quarter and RMB33.5 million in the same quarter last year.

Income tax expenses was RMB10.5 million, compared with RMB20.8 million in the previous quarter and RMB20.2 million in the same quarter last year. The sequential decrease was primarily because some of our games are operated by some of the Company's controlled entities that enjoy a greater preferential tax treatment.

Net income attributable to the company's shareholders was RMB161.7 million, compared with RMB201.2 million in the previous quarter and RMB80.7 million in the same quarter last year. Non-GAAP net income attributable to the Company's shareholders was RMB171.9 million, compared with RMB219.8 million in the previous quarter and RMB97.8 million in the same quarter of last year.

Basic and diluted earnings per ADS were RMB3.26 and RMB3.21, respectively, compared with RMB4.07 and RMB3.98, respectively, in the previous quarter, and RMB1.66 and RMB1.65, respectively, in the same quarter last year. Non-GAAP basic and diluted earnings per ADS were RMB3.47 and RMB3.41, respectively, compared with RMB4.45 and RMB4.35, respectively, in the previous quarter, and RMB2.01 and RMB2, respectively, in the same quarter last year.

In terms of financial guidance, based on our current operation, total revenues for the third quarter of 2014 are expected to be between RMB956 million and RMB1,003 million, representing an increase of 3% to 8%, on a sequential basis. This takes into consideration the continuous strength of our mobile games.

This concludes our 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]

And the first question comes from the line of George Meng of Morgan Stanley. Please ask your question.

George Meng – Morgan Stanley

Hi. Good morning everyone. Thank you very much for taking my question. I actually have two questions if I may. The first one is regarding your mobile games. So, can you give us the update on the PWIN project or initiative?

And related to that, can we actually think your mobile game operation as a relatively independent mobile game publisher? And how do you choose from the different categories of games? I know you have like in-house developed mobile games. You have licensed mobile games. You also have like investments in outside game studios. How do you choose from all these different categories? And how do you actually allocate firmware resources, such as like marketing expenses, when you choose to publish these games? That's my first question. Thanks.

Robert Xiao

Thanks, George. I think our PWIN has been making good advancement in terms of finding, not only in China but also global different studios and teams to invest. I mean basically it's going to -- we're going to see the effect of given a little bit longer time. So far we've been investing more than a dozen different studios.

To your question about publishing, we're trying to sort of a balance of different types of games, to form a portfolio that -- which can follow the consumer trend. We're continuously observing what's happening on the market and what the behavior changes or movement of the major body of the consumer. And then we try to cope with this movement, by selecting all kinds of different games.

Of course, we -- in house, we're pretty much in the development of the more hard-core side of the games, both on mobile and on PC, and hopefully on console as well. But eventually we are trying to find more lighter games, not to exclude any harder-core games from outside provider. But eventually we're trying to form a more complete portfolio. That's where publishing is going.

George Meng – Morgan Stanley

Okay, cool. And just quickly want to follow up on that. So if we look at your current mobile game portfolio, the three major revenue contributors I believe all have higher ranking -- or growth in ranking on iPad and on iPhone. Can we assume that also there'll be a higher revenue from the pad than on the phone? And do you think this is mainly due to the MMO nature of your mobile games?

And going forward, to you see this continue to be true, or do you actually expect more revenue contribution from the phones, as your portfolio gets more diversified? Thanks.

Robert Xiao

I think you're -- basically find the key. For harder-core games, it requires bigger screen. And so, so far our major successful games has been all on the hardcore side, so obviously on the iPad, it's much better been received by players. People prefer to spend more time and spend -- their eyeballs need to be attracted to a much bigger screen.

So in balancing that, that's exactly what we're going to do is to either produce or find more all-around type of games to widen the portfolio, rather than just stick with hardcore kind of a mobile MMORPG.

George Meng – Morgan Stanley

Okay, cool. Thanks a lot, Robert. That's very helpful.

Robert Xiao

Thanks, George.

Operator

Thank you. And the next question comes from the line of Natalie Wu of CICC. Please ask your question.

Natalie Wu – CICC

Hi. Thanks for taking the question, and congratulations on a solid quarter. I have a couple of questions here. Do you have plans to turn your other PC games into mobile, beside Touch and Swordsman you have mentioned, such as Saint Seiya, Perfect World, Zhu Xian, et cetera? This is my first question.

Robert Xiao

Well, I think we don't rule out any future possibility of utilizing our existing IPs to turn into mobile. But I'm not confirming anything. We're just saying that's definitely one of our considerations.

Natalie Wu – CICC

Okay. Thank you. And can you give us some color on the sales and marketing expense chain, as well as the effective tax rate? Will it be as low as the first half of 2014 in the coming quarters?

Kelvin Lau

Natalie, thank you. Sales and marketing expenses I think are as what that in Q3 we have participated in China Joy. We also launched the mobile game CrossGate Mobile. So I would expect that in Q3 more sales and marketing expenses because more games are going to be launched, then also because participating in China Joy. But sales and marketing expenses will go up in Q3, definitely.

Regarding the effective tax rate, yes, as what I mentioned in the remarks, I think right now most of our games are revenue generator in all those Chinese entity which still enjoy the great preferential tax rate. That's why my effective tax rate I think dropped a little bit. My estimation for this year, the effective tax rate should be around 10% to 13%, something like this, yes.

Natalie Wu – CICC

That's very helpful.

Kelvin Lau

Yeah.

Operator

Thank you. And the next question comes from the line of Eddie Leung of Merrill Lynch. Please ask your question.

Eddie Leung – Merrill Lynch

Good morning. Thank you for taking my questions. Just two quick questions. The first one, you mentioned that in the quarter there was an impact from perhaps acceleration of deferred revenues given short-tended virtual items' life. So just wondering, if we take that factor away, how much growth you generated in the second quarter. And how would that affect, for example, in the third quarter or for the rest of the year? This is my first question.

And secondly, I'm also wondering if you could give us an update on the overseas operations, especially regarding your mobile game licensing. Thanks.

Kelvin Lau

Thank you, Eddie. Let me answer the first question regarding the change of player life and also the acceleration of the deferred revenue. I have to apologize, Eddie, sorry, we are not going to disclose every single number regarding the sequential increase in revenue. But I think as what I mentioned and remarked, partial of the increase in revenue is coming from the change on the player life.

I think, Eddie, if you look at my 20-F, we disclosed I think very clearly (inaudible) we have an internal policy to review each game's player life regularly. Like gamers with operation datas more than three years, we use the gamer's own data to determine the player life. But I think for all those games less than -- historically less than three years, we refer to the player life of all those old games with similar characteristics.

But internally we do quite a lot of regular assessment and review for each games (inaudible) we also take into consideration of the recent market change and also the gamers' behavior. I think what we observed right now, the gamer market really changed quite a lot. And also the rapid growth of the mobile game business also affect our PC client-based games player life.

For example, what we can see this right now Unc all those players of old games, I think, who played games for a long time, I think right now new-generation players will tend to play games I think -- will spend less time on one game also, some of the gamers will shift out their time to play mobile games.

So I think in Q2, based on our regular assessment, we really, I think, our result really prove our observation. And so we decided to just -- not adjust, but to revisit the player life of all those games, so come up with this type of change of player life. I think this number one.

I think regarding the overseas licensing activity, that's why I mentioned in remark, we also quite actively, I think, trying to license out our mobile games, also PC games to overseas market. That's why I mentioned, Swordsman Online, we recently launched it in quite a lot of various overseas market. And we keep on continuously licensing our mobile games in overseas market, like Korea and also like Malaysia and Singapore. Yes. Thank you, Eddie.

Eddie Leung – Merrill Lynch

Got that. Thanks.

Operator

Thank you. And the next question comes from the line of Jialong Shi of Credit Suisse. Please ask your question.

Jialong Shi – Credit Suisse

Hi. Good morning, Robert and Kevin. Thanks for taking my question. I have a question about your console and TV game business. Can you give us some colors on the size of the market? And when do you think this new business may begin to contribute some meaningful revenue stream to the company?

And also, a follow up on your partnership with Microsoft. I guess Perfect World might share part of the revenue from the sale of Xbox in China. Do you have any idea when that revenue stream might kick in?

And lastly if -- is Perfect World the exclusive Chinese content provider for Microsoft Xbox One? Thank you.

Robert Xiao

Thanks, Jialong. That's a long question. Let me put it this way. The console market is still not very clear, in terms of actual numbers. But we believe that it's going to grow in a sustainable way, in the next three to five years, given the size of the console market over the world. And the console machine itself definitely has its advantages over other platforms, in terms of giving users a pleasant kind of a gaming experience.

So we believe it's relatively longer, in terms of growth. But for recent or current shorter term, it totally depends on how the hardware will be sold, the numbers of hardware and the marketing effort from hardware manufacturers. So I think we are part of the content providing force behind it to -- really to help the -- at the initial stage at least help the hardware to sell more.

So this is where we believe. And it's a relatively longer term thing. We are going to start to see something coming in after Xbox has been launched. The date has been set. According to Microsoft, it's September 23rd. And preordering already started. And I set up my own channel. I have set up my ground experience stores and online ordering processes. So we are part of the distribution team for Microsoft's Xbox One as well.

Basically, we -- sorry, we can't disclose any detail in terms of the contracting with Microsoft, but eventually, we are a part of the ecosystem both distributing the hardware and also providing the software and making sure that we sort of collaborate on the operation of the software as well. Because one of our strengths, and whatever we push out in China, it's a slightly different type of console game than the older type of console games outside of China. We're doing MMORPG.

And so it takes a constant update on the expansion packs and online kind of system to manage and operate the games and users interaction in all this. And so we are prepared in full collaboration with Microsoft and of course, their joint venture in Shanghai to work on that, the purpose obviously is to help the users to get them to the hardware machine and be able to play MMORPG there.

So I think it's a longer-term goal. We're setting up. We are totally partnering with Microsoft and we believe this is going to be a sustainable growth in the next, two or three years.

Jialong Shi – Credit Suisse

Thank you for the detailed answer. May I ask a quick follow up, just to double-check for the JV established with Microsoft? Who is the majority shareholder of this JV? You guys are consolidating this JV?

Robert Xiao

No, I'm not saying the JV between me and Microsoft. It's a JV between Microsoft and Best TV.

Jialong Shi – Credit Suisse

I see, I see. And also, maybe I missed it, I just want to double check, are you guys -- well, for the content providing, are you guys exclusive Chinese game content provider for Xbox One in China?

Robert Xiao

No, I don’t believe so. And I think for the hardware to sell, it takes a lot of partners, in terms of the ecosystem. And for us, to sell our games we're ready to collaborate with other hardware manufacturers as well. And also on the Xbox one, we are not only limiting our self in China, we are trying to sell our games globally. And so the exclusiveness probably will be coming with projects. So in detail, the contract, which I will -- sorry, I will not review in any more detail but eventually, some of the projects, there might be requirements from either side to require exclusiveness of certain period of time or certain kind of hardware.

Jialong Shi – Credit Suisse

Thank you. Sorry, one last follow up. So please correct me if I am wrong, it seems to me that is now what you said, it seems to me this partnership with Microsoft is -- for Perfect World, actually, you guys do not need to bear any additional costs. So at least with this profitable business for the company. Is that right?

Robert Xiao

That's true, that's true. We are not bearing any other costs than building our own games and network or operational capability along with the games.

Jialong Shi – Credit Suisse

Thank you very much.

Operator

Thank you. And the next question comes from the line of Nick Ning of 86Research. Please ask your question.

Hi, thanks for taking my questions. And can management give us some comment on color on the rumor that the company restructuring that involves some of our marketing development and several senior management? And if that is true, will that have any impact on our marketing strategy or marketing approved or how the marketing dollars will be budgeted and allocated between departments and games? Thank you.

Robert Xiao

All right, you heard that, huh? Number one, our policy is we don’t comment on rumors or speculations, number two, I would say is in this industry, as we all know, talent flow is actually normal, and sometimes it is healthy, and so it never stops. Like people moving, people moving jumping around with companies.

Number three, I would state it this way that our senior management has been very stable. So those are -- I think, so far, I can give them to you. Thank you.

Nick Ning – 86Research

Okay. And a quick follow-up is on this marketing side is -- on average, how much does this mobile MMORPG, like CrossGate will cost in terms of the marketing spending during the launch and during their daily operation, and how that compared to the PC MMORPG. Thank you.

Kelvin Lau

So, Nick, our apologies. We are not going to disclose every single game -- every single game's budget, how many sales and marketing expenses is spent on each game. But I mentioned quite a lot of time this, our internal policy is how much we spent on sales and marketing spent on the game depends on the revenue performance of each game. So internally, we offer a certain percentage of our benchmark for the sales and marketing expenses for each game. [Indiscernible] then if the certain percent spent is 8, then we will $8 in terms of advertising on the game. So it all depends on the revenue performance of each game.

Nick Ning – 86Research

Okay, thank you. My last question is on the churn of our major PC MMORPGs and what is management expectation for these legacy games three years down the road?

Robert Xiao

Well, I think, Nick, we all know that the PC MMORPG for older games is going to decline gradually and that is not news. It's like -- for all the years, it has been that way. And the PC MMORPG side, on the PC side, actually, the growth was fueled totally by new games.

And so for now, of course, for the PC market, I openly discussed this may times in the conferences that the threat is the lifecycle for -- even for the good PC MMORPGs are shortened because most people are moving into the mobile side and being experienced and get used to a shorter lifecycle type of game play.

So to get on that challenge, our way of dealing with it is very simple. We are going to try to y maintain as use all the waste and in terms of marketing, in terms of building the game, building expansion packs, and to make sure that the lifecycle can, can stay as long as possible. That is number one.

Number two is basically, we are going to continue to build new games on the PC MMORPG side, but following the trend and the movement of the user behavior, we can't build, the old fashioned PC MMORPG anymore but rather, to follow what users really like in terms of playing games.

So like I said, we are not giving up on PC, PC is still a very major portion of the revenue source and the profit generator and it is going to stay that way for a long time. And like I said, future -- in the infinite future, for example, of five to ten years, the market probably organized like 30% of PC and 30% on mobile and 30% on TV oriented, platforms. That is really the trend or the case, we have to put effort and resources on all three different platforms and build games on those.

And then leverage our -- definitely leverage our capability to expand. And like in the mobile part, we are building a a slightly different type of games rather than just one type of PC MMORPG.

So those are the things we are going to do and we have been doing and hopefully we can keep our PC stabilized for as long as possible. Thank you.

Nick Ning – 86Research

Okay, that is very helpful.

Operator

Thank you. And the next question comes from the line of Alicia Yap of Barclays. Please ask your question.

Alicia Yap – Barclays

Hi, good morning, Robert and Kelvin. Thanks for taking my questions.

I have a follow up question on the mobile games. So can you share with us some -- are you generating more revenue from the IOS platform or the Android, currently on some of your top games, and what are the typical user behavior difference between the two platforms.

And related to that as well, what is your expectation for CrossGate mobile run rate. Would that be further improved for the coming months?

Robert Xiao

I think I probably wouldn’t directly give out the split between different platforms and what I can comment on is user behavior, definitely on the IOS platform, you see more high-end players and then on the Android platform, you see more players, that's basically, the view [ph] we see.

It's very natural, we've been going out to the market and talk to people and getting the marketing-- I mean, consumer information. And Android now, the hardware piece can go as low as like RMB500, a capable Android device to play, our games. And so that is pretty natural and IOS people, more percentage of the people are spending money and then -- but the Android people definitely have larger numbers, total numbers.

And in terms of the -- what was the second part?

Alicia Yap – Barclays

The CrossGate.

Robert Xiao

The CrossGate. CrossGate has been initially, very successful, and I think we started to gradually grow, that is basically your strategy in all of the games we want to see that especially right after the launching. It can have -- enjoy some period of time to grow, not just, up there and gradually decline.

So we are utilizing all our efforts and tools to tune -- even fine-tune the content, that is number one. Number two is targeting the targeted marketing effort. And so, in our mind, we hope every game can grow, enjoy the growth for a period of time rather than just buy right after the [OB].

Alicia Yap – Barclays

I see, I have a couple of very quick follow up questions. One is on the Xbox with Microsoft. So what will be the revenues model so would that mean we generate the revenue from the games that we developed but then there is a certain licensing fee that we have to pay for Microsoft for the license for the using on the console?

Robert Xiao

Well, I think for the Xbox One model, it is similar, so far, it is going to be similar to the PC. It's like, you know, Microsoft is more like a channel for us and then through its Xbox hardware, and then we are the -- basically the publisher and the game producer, we collect our revenue from the item base. It is going to be a free game, okay? It's a free to play game on Xbox and then we collect the revenue from selling the virtual items, it's basically like the PC.

Alicia Yap – Barclays

I see. I see, okay, great. Thank you. Congratulations on a pretty good results.

Robert Xiao

Thank you very much.

Operator

Thank you. And the next question comes from the line of Thomas Chong of Citigroup. Please ask your question.

Thomas Chong – Citigroup

Hi, good morning, Robert and Kelvin. I have two questions. My first question is regarding the third quarter revenue guidance. Can management comment about the sequential growth in the third quarter. Is it mainly coming from you new mobile games?

And my second question is regarding your mobile game, Return of Condor Heroes. Can management about the performance of the games in the second quarter and how we should think about it in the second half? Thanks.

Kelvin Lau

Thank you, Thomas. Regarding our Q3 guidance as well as the sequence of growth for the Q3 revenues mainly come from the increase in revenue from mobile game. So a way to explain this is I think the PC based game will be stabilized in Q3 and then because we are going to launch some expansion for our PC games. So I think not so many of Unc but there is going to do Unc in Q3. So PC-based game will be supervised [ph].

That's what I said I think CrossGate mobile has been well-received by the gamers. So far, the performance is I think up to our satisfaction. So I think largely come from the mobile game for Q3 revenue growth.

Return of Condor Heroes, in Q2, what I will say is it is quite stable in terms of revenue contribution to the whole group. And we are stable, we are happy with Return of Condor Heroes. So we still haven't seen any sign of any decline for Return of Condor Heroes, I think so far so good, the Return of Condor Heroes. Thank you.

Operator

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

Wendy Huang – Standard Chartered

Thank you. Congratulations on the solid results. First of all, I wonder if you can shed some color on the different margin profile of the PC, mobile, and TV games that you just mentioned.

And also, I think the Q2 margin came above the stated expectations, how sustainable that is? Thank you.

Kelvin Lau

Thank you, Wendy. Our apologies, we are not going to disclose separate margin for different type of games. But I imagine before that I think for mobile game, the margin will be lower than P-based games because for mobile game, in terms of revenue, we do the gross revenue.

And then our order, I think 50% to 60% of the revenue sharing to the channel to be put in the cost of revenue. So Unc number you will see that for the mobile game I think the margin will be lower than the PC-based game.

So again, our apologies, not going to give any guidance on the margin. But I will say this, as what I mentioned, sales of marketing expenses will go up in Q3 because of China Joy, because of the CrossGate mobile promotion, and also some of our expansion base is going to launch in Q3, I think more sales and migration expenses are going to be incurred in Q3. So this is what I can give you. Thank you, Wendy.

Wendy Huang – Standard Chartered

How about R&D expense for the coming quarter?

Kelvin Lau

I don’t see any significant increase in the headcount in terms of the R&D people so we obviously finished our annual salary increment in Q2, so I don’t expect there will be any significant increase in R&D expenses in Q3. Yes.

Wendy Huang – Standard Chartered

And also you mentioned, you shared 50% to 60% to China, that seems much higher than what I heard from other --

Kelvin Lau

No, no, I'm sorry, 30% to 50%, yes. 30% to 50%. Sorry.

Wendy Huang – Standard Chartered

Okay. Thanks. Thanks, Kevin.

Operator

Thank you. And the next question is a follow-up question from the line of Jialong Shi of Credit Suisse. Please ask your question.

Jialong Shi – Credit Suisse

Hi. Thank you for taking my follow-up question. I just wonder, for your overseas operation, if we are regard it as independent entity, how is operating margin compared to your China domestic business? Thank you.

Kelvin Lau

Sorry, Jialong, can you repeat? Sorry, Jialong.

Jialong Shi – Credit Suisse

Yes, for your overseas operation center in the U.S. and Europe. How is operating margin compared to your China domestic business? Is it higher or lower?

Kelvin Lau

That is a new question. I would say technically I'm not going to disclose it, but I will give you some color on this. I think in overseas market like in the U.S. and Europe, I think the staff cost will be higher than in China. And so -- and also, in terms of IDC, all these things, I think China and U.S. I believe are similar.

Robert Xiao

The U.S. is slower.

Kelvin Lau

The U.S. is lower a little bit. It is low a little bit.

And so in terms of operating margin, I think it should be -- the U.S. would be low a little bit.

Jialong Shi – Credit Suisse

Lower a little bit. How about Europe?

Kelvin Lau

Europe. Jialong, you're so detailed. Europe I think should be similar to U.S. now. I mean Europe is similar to the U.S., yes.

Jialong Shi – Credit Suisse

So to put it another way, the overseas operating margin is lower than the China domestic business.

Kelvin Lau

A little bit. Yes.

Jialong Shi – Credit Suisse

Yes. And then based on what I know, your overseas operation was very focused on PC-based client games. And now, I understand you guys have shifted your focus from PC to mobile games. And the Chinese game market seems to be your priority at least for now. And so I just wonder what is your thought on the overseas operation down the road. Will you consider downsizing that business a little bit in the future?

Robert Xiao

No, I don’t think downsizing is a way for enterprise to grow, but basically, we are being able to maintain a very healthy overseas operation especially in the U.S. and Europe. And so basically, what we are going to do is to expand into other platforms or e other areas of gaming, especially like the mobile games. We are proactively preparing to get into the U.S. and Europe market as well.

It is just we are going to use a different model and we are still in the way of trying and we are on the way there. So we are not downsizing or giving up on any of the western part of the hemisphere and I think this is very important for us to not only focus on China but also focus on the global different markets. And Europe and U.S., we believe have different characters in terms of different game genres, in terms of PC and in terms of console and in terms of mobile.

What we committed to do is to find the most profitable way or more efficient way to get into this market. And like I said, our Never Winter, first published in China and Never Winter for Xbox One, first published in China on September 23 with Microsoft hardware, and then we are looking proactively looking for publish it in the U.S. and North America, and also in Europe as well. And so we are looking on all three different platforms, the PC and the console, and the mobile around the globe. It is just that China is moving faster and the first.

Jialong Shi – Credit Suisse

Understood. Thank you.

Kelvin Lau

Is that clear enough?

Jialong Shi – Credit Suisse

Yes, yes. Very clear. Thank you.

Operator

Thank you. And the next question is a follow-up question from the line of George Meng of Morgan Stanley. Please ask your question.

George Meng – Morgan Stanley

Hi, thanks for taking my follow up question. I just want to follow up on the talent retention that Robert just mentioned, especially on the mobile side, because previously, I think on PC, the teams have been big and the smaller teams cannot do a lot of PC games, but our mobile, as you can see, the smaller teams are doing -- independently doing or developing mobile games. So how do you align the interest of your development studios or basically your in-house development divisions, and align the interest of the company and also the interest of the employees and how do you retain the key talents? Do you have any plan to try to maybe like introduce more incentive in-house to especially incentivize these key employees? Thanks.

Robert Xiao

That's a great question. Actually the answer is yes, we have been continuously looking for more exciting ways to incentivize our key talent within the entire corporation especially on the mobile side. You are right, it is making a mobile game is much easier than making a PC game and so smaller groups of people can form a group and produce some games but eventually, if you look at the market now, that smaller studios have a harder, even harder time than before and one of the reasons is because they just done have enough resources in terms of the fundamental game support.

In game support, I believe number one is the technology especially if people want to build some harder core games. And build better graphics, it takes a lot of technology and don’t underestimate this importance of the technology and basically, associate with the bigger corporation definitely guarantee that technology side is -- it's a very available resource.

And the second is of course, the IT and the graphic resource. So what I mean is for the talent people, they will evaluate, what they can do and what they can get and the number one thing is they will want to be able to make games and to make games on their dream.

And so they will balance in terms of either via entrepreneur or get the resources and incentivized in a different way. So for us, as a company with relatively longer history in this business, we believe we are continuously changing ourselves and changing our policies and making sure, follow the market trend and be able to incentivize our key talents. And so believe me, we are working on different programs, we are -- we never stopped that actually for the past few years and as the market is moving fast and we are coming out with different incentive plans, all the time.

George Meng – Morgan Stanley

Okay. And just very quickly, I think some other companies, for example, are trying to encourage internal startups so called, or maybe ask the employees to acquire like a minority stake in the company or maybe get more independence from the parent company.

Do you guys also have plans to do so or have similar plans to try to make the development studios more independent from the parent company.

Robert Xiao

We are looking at different options, and whatever you just mentioned is some companies are doing that and it is definitely one of our -- the things we are looking at but what we want to do is to find different ways, maybe not only one way but different ways to cope with whatever the special talent group in this company needs.

And so, so far, I don’t have any more information to reveal but eventually, we have been working on and we have launched several different incentive programs and the incentive program will never stop in terms of changing and in terms of finding new forms to cope with the changes of the market.

George Meng – Morgan Stanley

Okay, great. That is very helpful. Thank you.

Robert Xiao

All right. Thank you.

Operator

Thank you. ladies and gentlemen, due to time constraints, we would now like to conclude this conference call. Now, I would like to turn the call back to Ms. Joanne Deng for closing remarks.

Joanne Deng

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 our IR section.

If you have any additional questions, please feel free to contact us.

Robert Xiao

Thank you.

Kelvin Lau

Thank you.

Operator

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

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