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Executives

Joanne Deng – IR Manager

Michael Chi – Chairman and CEO

Kelvin Lau – CFO

Vivien Wang – VP of IR

Analysts

Timothy Chen – Morgan Stanley

Wendy Huang – Royal Bank of Scotland

Jake Lee – Citigroup

Paul Wuh – Samsung Securities

Adam Krejcik – Roth Capital Partners

Jialong Shi – CLSA Securities

Vincent Sun – Mirae Asset Securities

Andy Young – Oppenheimer

Catherine Cai – Macquarie

Mark Marostica – Piper Jaffray

Perfect World Co., Ltd. (PWRD) Q3 2011 Earnings Call November 21, 2011 8:00 PM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Perfect World Q3 2011 Earnings Conference Call.

At this time, all participants are in a listen-only mode. There’ll be a presentation followed by a question-and-answer session, at which time, if you wish to ask a question, you’ll need to press star 1 on your telephone. I must advise you that this conference is being recorded today, Tuesday, the 22nd of November, 2011.

I would now like to hand the conference over to your first speaker today, Ms. Joanne Deng, Investor Relations Manager. Thank you, ma’am, please go ahead.

Joanne Deng

Thank you, operator, and thank you everyone for joining us today for Perfect World’s third quarter 2011 earnings release conference call. We distributed our audited 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 update on our business. Mr. Kelvin Lau, our CFO, will then provide an overview of the quarter. Ms. Vivien Wang, our Vice President of Investor Relations and Corporate Communications will then take us through some of our latest operational developments. And then she will pass the call back to Mr. Lau to go through our financial performance in the third quarter 2011. Following the prepared remarks, Mr. Chi, Mr. Lau and Ms. Wang would be available to answer your questions.

Before we continue (inaudible) under the Safe Harbor Provisions of the US Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties and can cause actual results to differ materially from our current expectations. Potential risks and uncertainties include or 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 obligations 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 discussions of certain non-GAAP financial measures. Our earnings release contains direct reconciliation of 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, Joanne. Thank you all for joining our call today.

As I’m sure you have all seen by now, our third quarter results, well within our updated guidance. Earlier we adopted a third quarter guidance to account for our decision to slow in-game promotional activities for some of our existing titles. This speed placed some pressure on our revenues for the third quarter on a sequential basis. But we believe it was necessary for lengthening the lifecycle of our games and for our long-term growth. And our third quarter results still represent solid year-over-year revenue growth of 22%.

As we’ve mentioned before, the repeated cycle of content enhancements followed by in-game promotional activities caused a short-term quarterly fluctuations in our earnings. This is simply a normal part of our product cycle and proves to be beneficial to our long-term growth. We’ve continued additions and enhancements to our portfolio. We are quite optimistic about our performance in the long run. We believe investors will more clearly see the strength of our business by looking at our ongoing performance on a long-term basis.

Supported by our diverse portfolio and the strong game pipeline, our prospects over the long term are encouraging. In the third quarter, we launched the unlimited closed beta testing for our first 2D martial arts MMORPG, Heaven Sword and the Dragon Saber, and released a number of expansion tests and content updates for several existing games.

We also have a number of existing projects in our deep and diverse pipeline, including the highly-anticipated Swordsman Online and Saint Seiya Online. These are just part of our strong lineup of games across a wide variety of types, including MMORPGs, web games and social networking games. Our proprietary technology, specialized production studios and global talent pool will enable us to create and launch more hit titles than -- that span different market segments.

Taking our brand out to the world has always been a key strategy for our company, and we continue to make great progress overseas. During the third quarter, we completed the strategic acquisition of Cryptic Studios, a well-known online game company based in the US. This adds more world-class titles such Champions Online, Star Trek Online and Neverwinter, as well as other projects to our strong portfolio and pipeline. It also helps us further penetrate the US and European markets and further strengthen our well-established R&D and operations around the world.

In addition, we recently formed a strategic alliance with Nexon Korea Corporation, a leading global online entertainment company, to jointly establish a new company in Korea. The new company will bring more of our popular games and enhance the services to players in Korea, and it will help us further expand our global user base.

As many of you probably saw, during the quarter, we signed an agreement to invest in a venture capital fund over as a limited partner over a nine-year period. The new fund will be managed by experienced general partners and mainly focus on investing in companies with high-growth potential in the TMT sector. We think our strong industry knowledge and our own growth experience will enable us to better evaluate and capture significant market opportunities. We are also excited about the potential synergies that we can achieve with our portfolio companies through potential investments and cooperation. We believe this will help us further strengthen our online client firm and build up our user base.

With our strong R&D capabilities, extensive global operating network, diversified portfolio and strong pipeline, we believe we are well-positioned to achieve sustainable long-term growth for our company. We remain confident that our performance will continue to create additional value for our shareholders over the long run.

Thank you. Now I will pass the call to Kelvin.

Kelvin Lau

Thank you, Michael.

As Michael mentioned, our third quarter results fell within our adjusted guidance. The pressure on our top line from slowing in-game monetization activities coupled with higher expenses in support of our long-term growth, caused a temporary drop in our margins.

During the quarter, we completed the acquisition of Cryptic Studios. We also launched unlimited closed beta testing for our new game, Heaven Sword and Dragon Saber, and released a series of expansion packs for our existing games in the second half of 3Q11, which resulted in higher advertising and promotional expenses. All these factors caused our expenses to temporarily outgrow revenues. However, we believe they are highly beneficial and help support the healthy growth of our games over the long run.

Despite the third quarter pressure, we continued to excel in our overseas business. We remain the number one online gaming company in overseas market among our peers in China, with over one-fourth of our total revenues generated from our overseas operations and overseas licensing activities. As a truly global company, our geographic coverage reaches over 100 countries and regions worldwide.

To affirm our longstanding commitment to our shareholders, we recently proposed a change in our dividend policy to reflect the company’s intention to distribute a part of the earnings of our wholly-owned PRC subsidiaries to our shareholders from time to time. Such change of dividend policy has been discussed and approved by our board of directors. Therefore, an additional withholding tax was accrued and recorded as deferred tax liabilities as of September 30, 2011 according to US GAAP and a tax arrangement between Mainland China and Hong Kong. The eventual declaration and distribution of dividends are subject to further approval by the board of directors.

Before I go through the financials, I will now pass the call to Vivien for a rundown of some of our operational developments.

Vivien Wang

Thank you, Kelvin.

As Kelvin mentioned, besides launching unlimited closed beta testing for Heaven’s Sword and Dragon Saber, we also had a very active quarter in terms of releasing new content for our existing games as we’ve tried to keep players interested and engaged in our games over the long term.

During the quarter, we released a series of expansion packs, including the (inaudible) MMORPG Legend of Martial Arts, Divine Pearl, our 2D MMORPG Dragon Excalibur, Legend of the Orient, our 2-1/2D MMORPG Battle of the Immortals (inaudible), our 3D MMORPG Perfect World, the Search for Nirvana, our 3D MMORPG Zhu Xian and the Pursuit of Happiness, our 3D online casual game Hot Dance Party. Very recently, we also released expansion packs, Battle of the Gods for our 2-1/2D MMORPG (inaudible) and Perfect Life for our 2D MMORPG Fantasy Zhu Xian. Again, we believe these content enhancements will be beneficial to supporting our games in the longer run.

On the international front, in the third quarter, through our US and European subsidiaries, we successfully launched German and French versions of Perfect World International in Europe, as well as Rusty Hearts in North America and Europe. And since the end of the quarter, we launched Empire of the Immortals in Japan through our Japanese subsidiary.

Meanwhile, we are also active in overseas licensing. During the quarter, through various overseas (inaudible) we launched Empire of the Immortals in Taiwan, Forsaken World in the Philippines, and Zhu Xian in Indonesia. We also signed agreements to license Dragon Excalibur to Taiwan, Hong Kong and Macau, Forsaken World to Brazil and Spanish-speaking countries in Latin America, and Perfect World 2 to Australia and New Zealand. Since the end of the quarter, we also launched Dragon Excalibur in Taiwan, Hong Kong and Macau, and Forsaken World in Russia, through our overseas partners.

With our high-quality content and highly capable global teams, we’re confident that overseas markets will continue to be a solid source of growth for us over the long run.

Now, I’d like to pass the call back over to Kelvin for him to walk through our financials.

Kelvin Lau

Thank you, Vivien.

Before I go through the third quarter financial highlights, I would like to provide some updates regarding the divestiture of our film business. As of September 30, 2011, we have completed the divestiture of our film business and received (inaudible) consolidation in cash. The related gain was recorded in the additional (inaudible) capital account on the consolidated balance sheet, according to US GAAP and applicable to [common control] transactions.

The divestiture of the film business is a strategy to sharpen our focus on our core online game development and operations business and maximize shareholders’ value over time.

Now, for the third quarter 2011 financials. Total revenues were RMB708.9 million in 3Q11, compared to RMB779.6 million in 2Q11 and RMB579.2 million in 3Q10.

Online game operation revenues, which include both domestic and overseas online game operations, were RMB643.2 million in 3Q11, compared with RMB712.1 million in 2Q11 and RMB527.1 million in 3Q10. The sequential decrease was primarily due to our decision to slow down in-game monetization activities for some existing games in the third quarter in order to further enhance the content of our portfolio and lengthen the lifecycle of our games.

ACU for games under operation in mainland China was approximately 828,000 in 3Q11, compared with 890,000 in 2Q11 and 733,000 in 3Q10. The sequential decrease was mainly due to adverse seasonality factors affecting user traffic and our enhanced anti-cheating efforts in 3Q11.

Licensing revenues were RMB55.8 million in 3Q11, compared with RMB61.8 million in 2Q11 and RMB48.6 million in 3Q10. The sequential decline was mainly due to lower usage-based royalty fees because of adverse seasonality in certain overseas markets, and a decrease in initial license fees since we did not have as many new launches in overseas markets as we did in 2Q11.

Other revenues were RMB9.9 million in 3Q11, compared with RMB5.6 million in 2Q11 and RMB3.6 million in 3Q10. The sequential rise was mainly due to revenues generated from our developments of some SNS games.

Cost of revenue was RMB121.2 million, compared with RMB113.7 million in 2Q11 and RMB92.4 million in 3Q10. The sequential increase was mainly a result of the consolidation of Cryptic Studios.

Gross profit was RMB587.7 million in 3Q11, compared with RMB665.9 million in 2Q11 and RMB486.9 million in 3Q10. Gross margin was 82.9% in 3Q11, compared with 85.4% in 2Q11 and 84.0% in 3Q10.

Operating expenses were RMB393.9 million in 3Q11, compared with RMB345.5 million in 2Q11 and RMB293.4 million in 3Q10. The sequential increase was due to higher R&D expenses, sales and marketing expenses, and G&A expenses in 3Q11.

R&D expenses were RMB170.6 million in 3Q11, compared with RMB161.0 million in 2Q11 and RMB113.8 million in 3Q10. The sequential increase was primarily a result of the consolidation of Cryptic Studios.

Sales and marketing expenses were RMB146.7 million in 3Q11, compared with RMB121.4 million in 2Q11 and RMB122.2 million in 3Q10. The sequential increase was largely due to higher advertising and promotional expenses associated with a series of expansion packs mostly released in the second half of 3Q11 for our existing games, as well as the recently launched unlimited closed beta testing for our new game Heaven Sword and Dragon Saber. The increase is also a result of the consolidation of Cryptic Studios and higher expenses related to attending a nationwide industrial exhibition in 3Q11.

G&A expenses were RMB76.5 million in 3Q11, compared with RMB63.1 million in 2Q11 and RMB57.3 million in 3Q10. The sequential increase was mainly the result of the consolidation of Cryptic Studios and an increase in professional service expenses.

Operating profit was RMB193.9 million in 3Q11, compared with RMB320.4 million in 2Q11 and RMB193.5 million in 3Q10. Non-GAAP operating profit was RMB221.3 million in 3Q11, compared with RMB348.0 million in 2Q11 and RMB219.0 million in 3Q10.

Income tax expense was RMB78.8 million in 3Q11, compared with RMB38.6 million in 2Q11 and RMB17.3 million in 3Q10. As I mentioned earlier, the board of directors recently approved a change in our dividend policy to reflect the company's intention to distribute part of the earnings of our PRC subsidiaries to our wholly-owned subsidiary in Hong Kong, from time to time, for eventual dividend payments to our shareholders. Under US GAAP, all undistributed earnings in these PRC subsidiaries are presumed to be transferred to the parent company and are subject to PRC withholding tax, unless certain categories are met. As such, a withholding tax of RMB68.3 million was accrued and recorded as deferred tax liabilities as of September 30, 2011. The eventual declaration and distribution of dividends are subject to further approval by the board of directors.

Net income attributable to the company's shareholders was RMB143.6 million in 3Q11, compared with RMB316.6 million in 2Q11 and RMB213.7 million in 3Q10. Non-GAAP net income attributable to the company's shareholders was RMB171.1 million in 3Q11, compared with RMB344.3 million in 2Q11 and RMB239.2 million in 3Q10.

Basic and diluted earnings per ADS were RMB2.96 and RMB2.83, respectively. This compares with our RMB6.30 and RMB5.98, respectively, in 2Q11, and RMB4.27 and RMB4.05, respectively, in 3Q10. Non-GAAP basic and diluted earnings per ADS were RMB3.53 and RMB3.37, respectively, in 3Q11, compared with RMB6.86 and RMB6.50, respectively, in 2Q11, and RMB4.77 and RMB4.53, respectively, in 3Q10.

In terms of financial guidance, as part of the normal product cycle, we plan to continue to focus on further enhancing the content of our portfolio and decelerate in-game promotional activities for some of our existing games in the fourth quarter, in order to lengthen the lifecycle of our existing games and maintain long-term sustainable growth.

Furthermore, as a result of our efforts to further fine-tune Heaven Sword and Dragon Saber and time promotional activity for the best market condition, we have scheduled the launch of full-scale open beta testing for early next year. As such, Heaven Sword and Dragon Saber is not expected to contribute significantly to revenues in the fourth quarter. And therefore, based on the current operations, total revenue for the fourth quarter of 2011 are expected to be between RMB695 million and RMB737 million, representing a range similar to the third quarter of 2011, but still an increase of 18% to 26% on a year-over-year basis.

Given that we remain highly confident in our outlook, we continue to execute our USD100 million share repurchase program. As of November 21, 2011, we have repurchased an aggregate of 4,366,549 ADS in the open market. We expect to continue to implement this share repurchase program in a manner consistent with market conditions and the interest of our shareholders.

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

Ladies and gentlemen, we will now begin the question-and-answer session. If you wish to ask a question, please press star 1 on your telephone and wait for your name to be announced. Just be advised, there will be only one question from each line at a time, but you will be able to queue again if you wish to ask more questions.

The first question comes from the line of Timothy Chen from Morgan Stanley. Please ask your question.

Timothy Chen – Morgan Stanley

Hi. Michael, Kelvin, Vivien and Joanne, good morning, and thanks for taking my questions. My first question is related to the pipeline. Would you please talk about the pipeline over the next three quarters? In particular, for titles like Heaven Sword and Dragon Saber, Swordsman Online and Saint Seiya? And do you have any plans to launch some of your overseas titles in China? Thank you.

Interpreter

(Chinese Language Spoken)

Kelvin Lau

Good morning, this is Kelvin. Thanks for your question. Regarding our pipeline, as what we have mentioned, we have a very strong pipeline. We have a very strong portfolio in our pipeline. We have already disclosed that Heaven Sword and Dragon Saber, we are going to have a full-scale (inaudible) launch in early next year. And then Swordsman Online, I think, according to our schedule right now, we are going to try to launch in first half of next year, is still our schedule. Saint Seiya Online will be in the second half of next year.

So, there’s a possibility there will be one or two more new games we will launch in the market in the coming year, but I think up to now, all the other games are being – the launch schedule has not been fixed yet.

Regarding the overseas titles, I think up to now we still (inaudible) confirmed project to have any launch of overseas market by Perfect World in China.

Michael Chi

(Chinese Language Spoken)

Kelvin Lau

And also we are putting all our efforts on fine-tuning all the games right now. I think some of the games right now are in the very final development stage. We are again putting all our efforts, including Michael, okay? Michael spends a lot of times on the development of games and modifying the games at the final stage.

Michael Chi

Thank you.

Operator

Your next question comes from the line of Wendy Huang from Royal Bank of Scotland. Please ask your question.

Wendy Huang – Royal Bank of Scotland

Hi. Thanks for taking my questions. It’s very good to hear that Michael is still quite involved in the game operation. But my question is about your dividend policy. Could you elaborate on that? What will be the upcoming dividend payment date? And also, what will be the amount of the next dividend payout? And also, you just said, our policy changed, so what will be the long-term payout ratio target? Thank you.

Kelvin Lau

Thank you, Wendy. Okay, thank you, Wendy. And what I’ve stated, I think the eventual declaration and distribution of our dividend is still subject to another board approval. Right now the board (inaudible) change in the dividend policy. So, regarding your question, I think going forward, how much is going to be paid and (inaudible) and also the long-term plan for the dividend, I think we still haven’t got it finalized and submitted to the board for approval.

I think the major reason for us to change the dividend policy is, I think number one is, if you look at consolidated balance sheet, right now our cash balance is about RMB2.9 billion, represents about USD450 million. So we have a short-term loan (inaudible) of the short-term loan, we still have about USD315 million cash. We already put aside 100 million to (inaudible) for our future M&A project for our future business expansion. So, net-net is we still have about USD215 million cash.

I think this type of amount of cash is I think more than sufficient to support our daily operation, number one. Number two, we are very confident with our future outlook and also our business growth going forward. So, we expect that we still can maintain stable and strong cash inflow from our operation I think going forward. So that means the cash will (inaudible).

I think these are the two key reasons why we decided to change our dividend policy, to pay some dividend to our shareholders. Yeah, thank you.

Wendy Huang – Royal Bank of Scotland

Okay. I understand the detail of the dividend payout is still subject to the board approval, but can you help me understand whether it will be a very dramatic dividend payout like [John] just did, or whether it will be quite like a quite normal dividend payout?

Kelvin Lau

I think, Wendy, I think up to now I still comment – I cannot comment on this because I got to get the board approval before I can disclose that. I hope you can understand, Wendy. Okay? Thank you.

Operator

Your next question comes from the line of Jake Lee from Citigroup. Please ask your question.

Jake Lee – Citigroup

Hi. Good morning everyone. Thank you for taking my question.

Could you please give us color about your overseas licensing investments? It will be great if you could give us some breakdown in terms of regions and also the growth rate in each region, especially your key regions. Okay? Thank you.

Interpreter

(Chinese Language Spoken)

Kelvin Lau

Thanks for the question. As what we mentioned in our remarks, okay, we remain being still number one in terms of exportation of online games to the overseas market amongst our peers in China. But our policy is not to disclose I think (inaudible) the breakdown of revenue from different overseas countries. But I can give you some color. Right now, the major overseas market, in terms of overseas licensing, I would say Taiwan, Russia and also Korea, are the major markets in overseas licensing business.

I think in terms of growth, it all depends on how many games we are going to launch in different markets, okay? As what we mentioned, we are (inaudible) already, in terms of geographical coverage, is already more than 100 countries and regions already. Going forward, I think definitely we are going to – our plan is try to launch more games in more countries. As what we mentioned in the remarks, we already started to launch games in some new markets like Australia and Zealand I think recently.

So, international expansion (inaudible) one of our key strategies. So we will I think continue to put more effort on our international expansion.

Vivien Wang

And of course, besides licensing, we also have [some] operations in some overseas countries, so, certainly, for example, US and Japan, it’s pretty big for us as well, and (inaudible) to the potential in the longer term in these countries. Thank you.

Operator

Your next question comes from the line of Paul Wuh from Samsung Securities. Please ask your question.

Paul Wuh – Samsung Securities

Good morning, everyone. I have a quick question for you regarding, I remember when you discussed your third quarter, you lowered your third quarter guidance, that you were postponing some of the monetization from the third quarter to the fourth quarter. Given that fact, why is it that we are still seeing only flat to down revenues or moderately up revenues on a quarter-for-quarter basis? I would have thought that there would be a significant improvement in revenues, not just another quarter of flat revenues.

Kelvin Lau

Thank you, Paul. Yes, I mentioned, I think (inaudible) guidance, okay, I think the major reason for the revising down of the guidance is because the monetization activity regarding the Immortals series has been postponed I think in August, in order to be transparent to the market (inaudible) I think the major reason is to be transparent to the market, to be transparent to the market. Yes, the Immortal expansion activity has been implemented in early October and I expect Battle of the Immortals will have a good performance in terms of revenue in Q4.

However, I think as you will remember (inaudible) we will launch expansion pack – big expansion pack for our core game like Perfect World 2. So, we got to further slow down our monetization for Perfect World 2 in Q4 and wait for the expansion pack.

Net-net is Battle of the Immortals I think just represents a not quite significant amount of revenue contribution, so it would not impact our revenue quite a lot in Q4. The major is Perfect World 2, we have to slow down a little bit the monetization. And also Zhu Xian, we just launched a big expansion pack in September I think for the Zhu Xian. So we got to wait, okay, because in Chinese New Year I think is the best season to do monetization. So, normally we will slow down a little bit in Q4 and wait for Q1 to do quite a lot of monetization for our core games. So these are the (inaudible) reasons.

Paul Wuh – Samsung Securities

Okay. And one just quick question following, and that is regarding your taxes, do we expect a similar level of – obviously you put – you had some deferred taxes related to your potential dividend payout. Are we going to see a similar level in the fourth quarter as well?

Kelvin Lau

Yes. Once we change our dividend policy according to the GAAP, we got to continue (inaudible) for the dividend tax going forward. That means (inaudible) effective tax rate is about 10 to 12, that means right now you’ve got to add about 4.5% on top of this 10% to 12%. That means about 14.5 to 17.5, I think going forward the effective tax rate.

Thank you.

Operator

Your next question comes from the line of Adam Krejcik from Roth Capital. Please ask your question.

Adam Krejcik – Roth Capital Partners

Yeah, hi, thanks. Two-part question. First, just wondering why you took on some debt in the quarter, short-term bank loan, what that was for, considering your positive net cash balance. And then number two, should we expect operating margins to remain stable in Q4, or is there further downward pressure? Thanks.

Kelvin Lau

Thank you, Adam. Yes, in my consolidated balance sheet in – on – by the end of September we have about USD89 million short-term loan. Okay? This [is seemingly] related to finance our acquisition of Cryptic and also some of our share repurchase program, okay? Because we need US dollar to implement the Cryptic acquisition and share buyback plan. So, we asked for some loans from bank and hedged some of our RMB in China to get the loan. So, it is a short-term loan.

Regarding the margin, Adam, it is our policy not to give guidance in terms of margin I think in the following quarter. Sorry about this. But I think some color on the performance for Q4, as what I said, we are going to have Perfect World 2 expansion pack going to launch, and also we will have to do some more preparation work in terms of promotion for Heaven Sword and Dragon Saber, which will be launched again early next year. So, I would expect certainly marketing expenses to go up a little bit in Q4. And also, as you know, we started to consolidate Cryptic I think in early August. So, in Q4, Cryptic Studios consolidation is full quarter consolidation. There will be some increase in R&D expenses and also the G&A expenses. Yeah.

Michael Chi

Thank you.

Operator

The next question comes from the line of Jialong Shi from CLSA. Please ask your question.

Jialong Shi – CLSA Securities

Hi, good morning, Michael, Kelvin and Vivien, and thanks for taking my question. Just one quick question. Just wondering if you could provide a percentage revenue from your domestic game operations in 3Q. Thank you.

Interpreter

(Chinese Language Spoken)

Vivien Wang

As we mentioned in the prepared remarks, the total overseas revenues, including overseas operation and overseas licensing, already contribute more than 25% off our total revenue. Thank you, Jialong.

Operator

Your next question comes from the line of Vincent Sun from Mirae Asset. Please ask your question.

Vincent Sun – Mirae Asset Securities

Hi, good morning. Thanks for taking my question. Could you talk a little bit more about your social networking games? I noticed there’s a big increase in the other revenue line in this quarter. Thank you.

Interpreter

(Chinese Language Spoken)

Kelvin Lau

As what we mentioned I think in our previous earnings call, I think starting from several quarters ago, we started to more diversify our game portfolio, not just only (inaudible) to MMORPG. In fact, I think several – I think starting last – end of last year, we already started to – some projects on SMS games and also on some web games in Beijing and Shanghai and [Xiangdu]. So, I think our first SMS game has been launched in Q3, so we generated some revenue I think from [one SMS game]. I think we’re happy with the performance of this SMS game, to the revenue they generate (inaudible) in Q3.

So, going forward, definitely we are going to develop more SMS games and also web console, to more diversify our game portfolio and trying to target to more (inaudible) I think is our plan going forward.

Michael Chi

Thank you.

Operator

Your next question comes from the line of Andy Young from Oppenheimer. Please ask your question.

Andy Young – Oppenheimer

Hi, good morning. Thank you for taking my question. This quarter we’d seen quite significant increase in your cost of goods sold and operating expenses. So, I was just wondering if that’s due to should we call issues in your product cycle, or you’ve got – more had to do with structural change in your cost structure due to your domestic (inaudible) conditions or labor conditions, or your overseas operations, including your Cryptic acquisition?

Kelvin Lau

If you look at my gross margin, yes, the gross margin dropped by about 2 percentage points in Q3. I think the major reason is -- there’s no significant changes in the operation in China, in fact. The major reason for the increase in the cost of revenues is simply because of the acquisition – the consolidation of Cryptic.

I think when we acquired Cryptic, there will generally be some intangible assets. I think based on the evaluation of the intangible assets, they’ll create some sort of intangible asset which got to be amortized over a certain period of time. So, this amortization of intangible assets I think will be [recorded] in the cost of revenue and cut down a little bit on the gross margin.

In China, for the domestic operation, yes, as what we mentioned, in Q3, our sales and marketing expenses went up a little bit, because we (inaudible) in Q3 and also we launched Zhu Xian expansion pack, so we got some promotional expenses. And also we started a little bit closed beta testing for Heaven Sword and Dragon Saber and pushed up a little bit on the sales and marketing expenses. So, I think the change in China is quite normal.

And also as what we mentioned in previous earnings call, in China we already controlled our R&D headcount, so in China we don’t have any increase in R&D expenses. I think the increase in R&D expenses is mainly because of the consolidation of Cryptic. So, that’s the answer. Thank you.

Operator

Your next question comes from the line of Catherine Cai from Macquarie. Please ask your question.

Catherine Cai – Macquarie

Hello.

Kelvin Lau

Hello.

Catherine Cai – Macquarie

Hi. This is Catherine Cai calling on behalf of Steve John. I have a question regarding the joint venture. You have recently formed a strategic alliance with Nexon. What kind of expectations do you have for the partnership given that Korea is a very sophisticated and a mature online gaming market with lots of competition? Thank you very much.

Kelvin Lau

Yes. Catherine, thank you for your question. I think, as what I mentioned, I think Korea is one of the key overseas markets we are very interested and also contribute – I think Korea market contributes quite a lot to our revenue portfolio. So, we are interested to participate in – more participate in the Korean market. That’s why recently we established – jointly established a company with Nexon in Korea. The main purpose for this jointly-established companies are – through this jointly-established company are (inaudible) continue to launch more our games I think in this type in Korea. Right now we are still undergoing the company establishment procedures. So I think the first game going to launch through this (inaudible) will be in next year. So, we hope to see the (inaudible) of this jointly-established company we can generate more revenue from Korean market by cooperating with Nexon, because Nexon is really a good partner in Korea and also have a very good and sophisticated platform, gaming platform in Korea. So we are very happy to cooperate with Nexon. Thank you.

Operator

You have a follow-up question from the line of Wendy Huang from RBS. Please ask your question.

Wendy Huang – Royal Bank of Scotland

Thanks for taking my follow-up questions. Your deferred revenue and customer advances increased by 15% sequentially. So, can you help me to understand what’s the implication of this figure for the next quarter’s revenue potential? And also, given that ACU has declined by 6% this quarter, and for the next quarter revenue guidance, you just mentioned that it was actually affected by the timing of several monetization events, but how should we look at ACU trend in Q4? Thank you.

Kelvin Lau

First of all, I think the deferred revenue increases (inaudible) advancing customer also increased in Q3. I think it’s normal for advancing customer because right before the national holidays, most of the distributable (inaudible) so the advancing customer will go up, it’s normal. I think I mentioned this in the previous earnings calls before.

Deferred revenue, I think the major reason is because we launched the unlimited closed beta testing for Heaven Sword and Dragon Saber, so this will contribute some deferred revenue in Q3. That’s number one. Number two is, regarding the ACU, as what we mentioned (inaudible) issue is mainly because of the (inaudible) if you look at my Q3 historical data, last year, my ACU number is [73,000], okay? Two years ago, my Q3 ACU number also dropped.

I think from the point of view of this, Q3, most of the gamers, I think they are on holiday, some of the students may be on holiday, so the time they spend on a game will be short. So I think it’s normal.

Going forward, we are still confident with our existing games. For example, Zhu Xian, we launched a big expansion of our Zhu Xian, you can see a climb-up in the ACU number for Zhu Xian. So I will expect our ACU number will go up a little bit in Q4, because Perfect World 2 expansion is coming, and also (inaudible) also go back to the I think high number of ACU number already. Thank you.

Vivien Wang

And Wendy, this is Vivien, just on top of Kelvin’s point, the deferred revenue, the increase of deferred revenue was also (inaudible) to the acquisition of Cryptic Studios. Thank you.

Kelvin Lau

Yes. Thank you, Vivien.

Operator

We have a question from the line of Mark Marostica from Jaffray Piper. Please ask your question

Mark Marostica – Piper Jaffray

Thanks. Mark Marostica from Piper Jaffray. My question is related to Heaven Sword and Dragon Saber. Since your launch of unlimited closed beta in August, can you give us a sense whether the game is meeting company expectations? And then, as a follow-up, Kelvin, I think you just mentioned Zhu Xian starts ACU climb recently. I’m just trying to get a sense of, on your core games, if you could give us some color on performance, specifically Perfect World 2, Forsaken World and Zhu Xian. Thanks.

Interpreter

(Chinese Language Spoken)

Michael Chi

(Chinese Language Spoken)

Interpreter

Heaven Sword and Dragon Saber is our first 2D real-time MMO that we launched.

Michael Chi

(Chinese Language Spoken)

Interpreter

We (inaudible) in this game, but there are still a lot of areas that we would like to fine-tune more.

Michael Chi

(Chinese Language Spoken)

Interpreter

So, right now, we decided to allocate more resources to further fine-tune this game, and then launch the full-scale open beta testing later.

Michael Chi

(Chinese Language Spoken)

Interpreter

As we are trying to add more creative ideas to implement some creative features into this game, that’s why we decide to reschedule this game to later.

Michael Chi

(Chinese Language Spoken)

Interpreter

We are looking forward to launch this game as soon as possible.

Kelvin Lau

And also, Mark, regarding the Perfect World 2 and Zhu Xian, as what I said, as what I mentioned, I think we just launched a big expansion pack for Zhu Xian. I saw some ramp-up in the ACU number for Zhu Xian. I think it’s normal because, as what I said, normally when – some of the old gamers will wait for the expansion pack when launch a big expansion pack. Some of those old gamers will come back to the game. So, I always Zhu Xian’s ACU number will go back to the attained high level already.

Perfect World 2, right now the ACU numbers are at a low level. Low means normal, I would say. But I think we are going to have a big expansion, which we are confident that adding the ACU number will climb back to a high level in Q4, up to the expansion pack.

Forsaken World, I would say, quite stable right now. In fact, Forsaken World is still ranking number three in terms of revenue contribution in our game portfolio. So, so far we are still quite happy with the performance of Forsaken World, not only in China but also in US or in Europe, I think the performance are also exciting for this game. So, yeah, thank you.

Operator

Your next question comes from the line of Vincent Sun from Mirae Asset. Please ask your question.

Vincent Sun – Mirae Asset Securities

Hi, thanks for taking my follow-up question. For the joint venture with the Korean studio, are you considering licensing any games from the company into China? Thank you.

Kelvin Lau

Up to now, we still haven’t had any plan to license Nexon’s games in China. As what I said, right now the plan is I think we establish our – jointly establish the company to create platform to launch Perfect World’s games in Korea. Thank you.

Vincent Sun – Mirae Asset Securities

Thank you. Thank you, Kelvin.

Operator

We don’t have any questions at this time. I would now like to hand the conference back to today’s presenters. Please continue.

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

Vivien Wang

Thank you.

Michael Chi

Thank you.

Operator

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

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