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Executives

Rich Chiang – IR Director

Jazy Zhang – CFO

Wei Liu – President

Xuefeng Ji – VP of R&D

Analysts

Timothy Chan – Morgan Stanley

Gary Ngan – UBS

Mark Marostica – Piper Jaffray

Steve Zhang – Macquarie

Jialong Shi – CLSA

Vicky Lin – Merrill Lynch

[Shayan Yang] – Nomura

Adam Krejcik – Roth Capital Partners

Andy Yeung – Oppenheimer

[William Wong] – Barclays Capital

Martin Bao – CICC

Chao Wang – Merrill Lynch

Giant Interactive Group, Inc. (GA) Q4 2011 Earnings Call March 5, 2012 8:00 PM ET

Operator

Good morning and good evening, ladies and gentlemen. I would like to welcome everyone to Giant Interactive Group’s fourth quarter and fiscal year 2011 earnings conference call. (Operator Instructions).

Now I would like to transfer the call to the moderator, Mr. Rich Chiang, Investor Relations Director of Giant Interactive.

Rich Chiang

Good morning, ladies and gentlemen. Welcome to the fourth quarter and fiscal year 2011 earnings conference call for Giant Interactive Group. With me today are Wei Liu, President; Ms. Jazy Zhang, Chief Financial Officer; and Mr. Xuefeng Ji, Vice President of Research and Development.

As we proceed through our prepared remarks, we will refer to our results presentation which can be downloaded from our website at www.ga-me.com. Following the remarks, Ms. Liu, Ms. Zhang and Mr. Ji will be happy to take your questions.

Before we continue, I would like to remind you that statements on this call that are not strictly historical in nature constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended, and as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by terminologies such as will, expect, anticipates, future, intends, plans, believes, estimates, and other similar statements, and include, among others, statements regarding our expectation of sequential top-line growth for the first quarter 2012, continued improvement of our operating metrics, the continued growth of ZT Online 2, the effects of our studio reorganization, and the timetable for engineering testing, closed beta testing, open beta testing, introduction, and commercial launch of various products in the company’s game pipeline.

Such forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results of Giant to be materially different from the historical results or from any results expressed or implied by such forward-looking statements. These factors include but are not limited to the risks discussed in filings with the Securities and Exchange Commission, including our annual report on Form 20-F filed on June 17, 2011. All forward-looking statements are qualified in their entirety by this cautionary statement and Giant undertakes no obligation to revise or update this information to reflect events or circumstances the date hereof.

Operator

Ladies and gentlemen, your speaker is currently experiencing some technical difficulties with their line. Please stand by while we address this situation. Your lines will be placed on music hold until the conference resumes. Thank you for your patience.

Rich Chiang

Hi, everyone. Sorry about that.

Continuing from where I left off, all forward-looking statements are qualified in their entirety by this cautionary statement and Giant undertakes no obligation to revise or update this information to reflect events or circumstances after the date hereof. In addition, please note that references in the presentation to dollars refer to US dollars.

Now, I would like to turn the call over to our CFO, Jazy Zhang. Jazy?

Jazy Zhang

Thank you, Rich. Good morning and good evening everyone. First, I would like to read the prepared remarks from our President, Ms. Wei Liu, and then I will walk you through our financial highlights and update you on our game development efforts.

We concluded 2011 with solid fourth-quarter results and delivered another year of consistent growth from both the financial and operational perspective. Our progress throughout 2011 was made possible by our long-term strategy of focusing on developing games with passion and creativity, games that are of the highest quality and games that are fun to play and that engage and broaden paying user base.

ZT Online 2, our new flagship game, has been the main growth driver over the past year, supporting the steady increase in paying accounts and average user -- sorry, average revenue per user. The success of ZT Online 2 has proved the merits of our game segmentation strategy and our strong internal development capability. We’re very proud of ourselves, that even in this increasingly competitive MMORPG market in China, we were able to produce another hit MMO game. We’re highly confident that with its first expansion pack expected to be released in April 2012, ZT Online 2 will continue to grow and achieve greater success in 2012.

With respect to our growth strategy, first, we will continue to focus on MMORPG as we believe it’s still the most profitable segment of the online game market in China, and this is our core competence. Meanwhile, we’re actively working to enter new game genres and new growth areas in China’s online game market. For example, Elsword, our first action casual game which we licensed from South Korea, entered into new open beta testing in December, and our first-person shooter game continues to progress through our development pipeline. Both games represent new genres that are complementary to our core MMORPG competence.

Secondly, as we indicated on our last quarter earnings call, we have a new strategic focus, and this is web game development. As social media and web-based gaming platform usage rapidly expands in China, we are aggressively working to position Giant as a future leader in this segment. We recently hired a senior industry expert in web game development and have allocated significant internal RMB resources to web game development this year and beyond. Given our years of extensive experience in developing and operating MMO games, our deep understanding of web game characteristics and user preferences and our progress made in web game graphics and technology, we believe we are well-positioned to deliver a few hit games in the near future.

Thirdly, we will introduce micro-client versions of our popular games to attract a wider range of players by operating the micro-client versions of our games jointly with various platforms. We believe we will reach out to a much broader user base and bring the additional revenue growth. We’re also targeting some longer-term development opportunities such as the mobile game segment. We are closely monitoring developments in this area and exploring ways in which we either internally or with partners can leverage our experience and capabilities to further expand our game portfolio and game platform.

And finally, we continue to focus on opportunities in game licensing and partnerships in overseas markets. We have already had success with games such as the Golden Land in multiple jurisdictions, and we successfully licensed ZT Online 2 in Taiwan in the first quarter 2012. We have a dedicated internal team focused on international business development opportunities, and our position as a leading game developer and operator in China makes us a compelling choice for international partners.

To maintain the growth momentum and to further bolster our internal development capabilities, we have reorganized our game development teams into various subsidiaries that are 51% owned by Giant and 49% owned by members of the development teams. The game studios will focus on producing and supporting internally developed games and will have a direct stake in the success of those games through a revenue-sharing plan as well as individual P&L responsibilities.

We strongly believe such a reorganization plan will incentivize our game developers, improve productivity, and effectively control expenses. From a financial perspective, our game studio reorganization may cause our net margin to decrease by a few percentage points, but we believe this approach will help increase top-line revenue as well as bottom-line net income growth. We are confident that this strategy will help us success in this competitive market.

Looking to the year ahead, we’re confident in our ability to deliver continued steady growth with many new value-driving events slated for 2012. Our financial position and balance sheet remains strong. And as a result, our Board of Directors has declared a cash dividend of $0.30 per ADS or ordinary share. The total cash payment will be approximately $70.6 million. Our increased dividend payout demonstrates our commitment to maximizing shareholder return and confidence in our business outlook. We will continue to focus on generating positive returns for our investors in the year ahead.

This concludes the opening remarks from President Liu. And now I will walk you through our financials. Let me now turn to our key operational metrics for the fourth quarter on slide six. The Active Paying Accounts or APA grew 3.9% sequentially and 28% year over year to $2.167 million. Average Revenue Per User or ARPU was RMB221, up 1.8% over last quarter and up 2.8% over the fourth quarter 2010. Average Concurrent Users or ACU was 667,000, a 0.9% sequential increase and a 14.3% increase year over year. Peak Concurrent Users or PCU was up 1.8% sequentially and up 36.5% year over year to 2.339 million.

The increases in our operating metrics were largely driven by the success of ZT Online 2 which has attracted a large and diverse audience who are increasing their in-game spending as they become more accustomed and comfortable with the game and its third-generation in-game economy. Meanwhile, the operating performance of ZT Online 1 remains stable, with the first expansion pack for ZT Online 2 expected in April and continued progress in our development pipeline, we expect to see continued improvement in our operating metrics in the year ahead. The success of ZT Online 2 and the continued stable performance from our other games allowed us to deliver solid financial results for the fourth quarter and full year, as seen starting on slide seven.

Net revenue for the quarter was $78.6 million, an 8.1% increase from the third quarter 2011 and 34.4% increase from the fourth quarter 2010. Our core business, online game revenue grew 5.8% sequentially. For the full year, net revenue was $284.8 million, an increase of 34.5% over the full year 2010.

Gross profit for the fourth quarter 2011 was $67.9 million, representing an 8.3% sequential increase and a 37.3% year-over-year increase. Gross margin of 86.3% was up from 86.2% in the previous quarter and 84.5% in the fourth quarter 2010. Full-year growth profit was $243.9 million, an increase of 34.5% -- 35.4% over 2010. Gross margin for 2011 was 84.6%, up from 85.1% in 2010.

Total operating expenses for the fourth quarter 2011 were $21.3 million, an 18% sequential increase and a 20.3% decrease year over year. The sequential increase was mainly due to higher R&D expenses and sales and marketing expenses in the fourth quarter 2011. For the full year, total operating expenses increased 4.2% year over year to $72.5 million. This increase was mainly due to increased R&D spending, marketing campaigns for new games launched in 2011, and less government financial incentives throughout the year.

R&D expenses increased 41.5% sequentially and 3.9% year over year to $11 million in the fourth quarter. The sequential increase was due to yearend bonuses and expenses related to newly-granted restricted shares. For 2011, R&D expenses were $36.6 million, a year-over-year increase of 23.7%, resulting from the expansion of the R&D department as we developed new products and enhanced our existing games.

Sales and marketing expenses were up 11.3% sequentially and 80.8% year over year in the fourth quarter to $8.8 million. The sequential and year-over-year increases were due to marketing campaigns launched in support of the open beta testing of ZT Online 2 and Elsword during the fourth quarter. Fiscal year sales and marketing expenses were $27 million, an 18.9% increase over 2010, due to new marketing campaigns for new games including ZT Online 2, XT Online and Elsword.

General and administrative expenses increased 9% sequentially and decreased 20.7% from the fourth quarter 2010 to $4.4 million. The sequential increase was mainly due to yearend bonuses, while the year-over-year decrease resulted from an increase in reimbursements related to our ADR program in 2011. For the full year, G&A expenses decreased year over year by 13.2% to $16.5 million due to stricter cost controls and increased reimbursements related to our ADR program.

Net income attributable to the company’s shareholders in the fourth quarter was $39.2 million, a 31.8% sequential decrease and a 6.6% year-over-year quarterly increase. The sequential decrease in net income was due to four factors. First, a sequential decrease in interest income due to our lower cash balance after payment of our one-time special cash dividend of $3 a share or ADS in September 2011. Second, a sequential decrease in other income which mainly included the foreign exchange gains in the third quarter 2011 as we obtained a more favorable exchange rate for the repatriation of cash for the special cash dividends, whereas in the fourth quarter there were no such gains.

Third, the sequential increase in income tax which reflected an income tax benefit in the third quarter 2011 due to the one-time recognition of RMB33 million in deferred tax assets, whereas in the fourth quarter 2011 there was no such one-time adjustment. And finally, a sequential increase in net income attributable to non-controlling interest, which reflected the reorganization of our game development studios as described in our earnings release. Now please allow me to further elaborate the financial impact of this reorganization plan.

Third reorganization plan is applicable to all of our internally developed games, except for the four games in our ZT Online 1 series. The ongoing development and support work for our other internally developed games will now be conducted by our reorganized game studios that are 51% owned by Giant and 49% owned by members of the relevant development teams. Giant or its designated wholly-owned subsidiary, [Sha], continues to be the sole owner of the game software copyrights for these internally developed games.

From a financial perspective, the company and the reorganized studios have agreed to monthly revenue-sharing plan where the studio receives 24% of its games revenue after deducting channel cost and business taxes. In certain cases, the company agreed to pay an upfront fee to a reorganized studio. From expense perspective, each reorganized studio is responsible for its own costs including game development and support expenses which mainly consist of labor costs.

Giant consolidates its financial results with those of the reorganized studios and then present a net income or loss attributable to the minority shareholders as a separate minority interest line item under the heading Net Income or Loss Attributable to Non-Controlling Interest. The company’s consolidated income attributable to its shareholders is arrived at after deducting the minority interest. Total minority interest related to our reorganized studios was RMB24.7 million and RMB26.4 million for the fourth quarter 2011 and fiscal year 2011 respectively. If games that are supported by our reorganized studios such as ZT Online 2 become more popular and profitable in the future, this minority interest amount will increase, which may result in a lower net income attributable to company shareholders.

The year-over-year increase in net income attributable to the company’s shareholders was due to the increase in game operations throughout 2011. Net margin for the fourth quarter was 49.8% compared to 78.9% in the preceding quarter and 62.8% in the fourth quarter 2010. Full-year net income was $139.8 million, an 8.5% increase over 2010. Net margin for 2011 was 49.1% compared to 60.9% in 2010.

On a non-GAAP basis, excluding non-cash share-based compensation, net income attributable to the company shareholders for the fourth quarter 2011 was $40.9 million, a 9.6% decrease sequentially and a 7% increase year over year. Non-GAAP net margin was 52.1%. For fiscal year 2011, non-GAAP net income attributable to the company’s shareholders was $172.6 million, an increase of 28.6% over 2010. Non-GAAP net margin for fiscal year 2011 was 60.6% compared to 63.4% in 2010.

Basic and diluted earnings per ADS for the fourth quarter 2011 were $0.17 on a GAAP basis and $0.17 on a non-GAAP basis. For fiscal year 2011, basic and diluted earnings per ADS were $0.60 on a GAAP basis and $0.74 and $0.75 respectively on a non-GAAP basis.

Moving on to our balance sheet on slide 10, as of December 31, 2011, cash, cash equivalents and short-term investments totaled $297.1 million compared to $300.2 million as of September 30, 2011. This decrease is mainly due to our $50 million investment in the Yunfeng e-Commerce Funds for the purpose of purchasing shares in Alibaba Group, and repurchases of our ADS according to a share repurchase plan approved by our Board of Directors in September 2011, which authorized the repurchase of up to $50 million worth of ADRs, partially offset by our free cash flow generated in the fourth quarter 2011.

We are pleased with the steady improvement in our financial performance throughout 2011 and we expect to maintain our steady momentum as we enter 2012. We will continue to focus on growing ZT Online 2 while investing in our game pipeline as we work to bring new hit games to the market. In addition, we will continue to focus on cost controls to deliver profitable growth going forward.

Now, let me give you an update on our game development efforts starting on slide 12. As a key element of our strategy, we continue to enhance our games with ongoing upgrades and the addition of new features. For ZT Online 1 series games, in the fourth quarter we launched a new ZT Online expansion pack introducing a new in-game profession, in addition to several customized in-game activities which helped to keep existing players engaged while attracting former players back to the game. We also introduced new game play features to ZT Online Classic Edition and released a new expansion pack for ZT Online Green Edition in the fourth quarter, which received a high level of attention and positive feedback from gamers.

As we have discussed, ZT Online 2 continues to perform well, attracting new users and new paying accounts. During the fourth quarter we launched a special holiday edition of the game for the Chinese New Year.

Concurrently, a large-scale cross-shard PK tournament attracted a high degree of player interest and involvement. So far in the first quarter 2012, we have licensed ZT Online 2 to the Taiwanese market and are continuously adding new features to keep players engaged. We have begun to prepare for the launch of the micro-client version of the game as well as the first expansion pack scheduled to be release in April 2012. We also released a new expansion pack for Giant Online in the fourth quarter with new equipment upgrading features and increased user [stitchiness]. We are continuing to enhance newly-added functions based on user feedback in the first quarter 2012.

We also released the first expansion pack for XT Online in the fourth quarter since its open beta testing in September 2011, with an emphasis on enhancing core PK-oriented game plays, increasing interaction and competition among players. We intend to roll out a second expansion pack in the current quarter.

Moving on to the Golden Land, which has become our most broadly-licensed international game, we continue to optimize across previously released functions. The Korean version enjoyed great popularity among Korean gamers and remains popular in Taiwan and Japan. The US and European versions entered open beta testing in October 2011 as scheduled. The Spanish version completed closed beta testing in the fourth quarter 2011 and the commercial launch is expected in the first quarter 2012.

Turning to our two licensed games, Elsword and Allods Online. Elsword, a 3D, side-scrolling advanced casual game entered into closed beta testing in November and open beta testing in December, which have received positive feedback from gamers and trying to introduce new characters and release an expansion pack in the first half of 2012. Allods Online, a 3D, free-to-play fantasy MMORPG developed by Mail.Ru is currently under optimization and design customization to align it with local market preferences. We intend to conduct the second engineering testing in April 2012.

In conclusion, we are extremely pleased with our progress throughout 2011. We believe we have generated positive momentum supported by our consistent strategy and strong market response to ZT Online 2. With a robust development pipeline and a strong financial position, we expect to deliver continued sequential top-line growth in the first quarter of 2012.

This concludes our prepared remarks. Once again, thank you for joining us today. We are happy to take your questions now.

Question-and-Answer Session

Operator

(Operator Instructions).

Your first question today comes from the line of Timothy Chan from Morgan Stanley. Timothy, please go ahead.

Timothy Chan – Morgan Stanley

Good morning, President Liu, Jazy, Mr. Ji and Rich. Thanks for taking my questions, and congratulations on a very solid quarter.

Jazy Zhang

Thank you, Tim.

Timothy Chan – Morgan Stanley

Regarding ZT Online 2, could you give us some highlights of the expansion pack in April, if you can share with us your expectation as well as any feedback you received on the expansion pack? That would be very helpful. And I have a follow-up question after that.

Jazy Zhang

Sure. Thanks, Tim. Let me first translate your question.

(Chinese language spoken)

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

Hi, Tim. In April of this year, we’ll try to release the first large expansion pack for ZT Online 2, as its open beta testing started a couple of months ago. And in terms of new content, new game play for the game as well as marketing campaign, we are allocating a lot of resources towards these two areas. It’s going to be a pretty exciting event and hopefully we can achieve a new peak in terms of user numbers, hopefully surpassing 500,000 PCUs.

Timothy Chan – Morgan Stanley

Thank you very much. And my second question is about web game. Obviously web game has become an important area for Giant. You mentioned that there are six web games in the pipeline. May I know how many of them will be launched this year? And do they fall into the more like social games or PK style of games? And what are your expectation as to their financial contribution? Thank you very much.

Jazy Zhang

Thank you, Tim.

(Chinese language spoken)

Wei Liu

(Chinese language spoken)

Rich Chiang

As for our web game strategy, this has become a very important strategy for us for the remainder of this year, both in terms of building out our team, our developers and building out our web game pipeline. We have six games, six projects in development right now, and they’re various, different genres. But mostly are in the -- with more focus on the RPG segment, leveraging our experience and core competence in MMO, and also because RPGs are still the most profitable type of web games that we’ve noticed out there. But besides this, we also have social web games, 2D, 3D web games. So, it encompasses a lot of different genres.

All six of these web games will achieve certain milestones this year, and a few of them hopefully will be -- well, they’ll all be in various stages of testing throughout this year. Hopefully a few of them can come out this year.

Jazy Zhang

And Tim, this is Jazy. I know you asked about the financial contribution from the six web games. As of now, we have not built the revenue contribution into our model yet. As we go through various stages of testing, we will be able to update you on that.

Operator

Your next question today comes from the line of Gary Ngan from UBS. Gary, please go ahead.

Gary Ngan – UBS

Good morning everyone. Thanks for taking my question. Firstly, I would ask a little bit about the minority interest regarding the studios. So, could you help us understand, so, what is the revenue split of the revenues that’s attributable to these minority studios, so that we can sort of understand the actual contribution?

Jazy Zhang

Sure. Thanks, Gary, for asking that question. I’ll take your question.

So, there’s a minority interest carve-out on our consolidated income statement. So, basically, with each reorganized game studio, we will have a top-line revenue, you know, game revenue sharing. Twenty-four percent of the net game revenue goes to the studio. And the studio is responsible for their own development costs, namely labor costs. So they have a net income or loss. And that net number, Giant takes 51% of that net. They take 49% of that net.

So, 49%, basically 49% of their bottom-line net income or loss is the ultimate minority interest carve-out.

Gary Ngan – UBS

Right, thanks. But I think -- I want to ask is like, for example, within the 417 million revenue for online games, so, roughly speaking how much of that is related to these studios and how much of that is not?

Jazy Zhang

So, with the exception of ZT Online 1 series, the rest of the game are placed into various studios that we follow the revenue-sharing plan. And as of now, the two profitable game studios are ZT Online 2 and Giant Online. Those are the two main ones. But then you also have a pipeline of other game studios that are currently incurring losses because those games are still under development.

Gary Ngan – UBS

Right, I see. Thanks for that. And my second question is related to also web games. So, could you share with us -- I guess the first part is, how much of the R&D currently is accounted for by web games, roughly speaking? And is the company happy with the current cost base in terms of web games R&D personnel? And then the second part is, what exactly -- do we have, especially innovative angle in looking at the web game segment, for example, you know, ZT 2 has been very successful due to a -- new economic systems. So, in web games development, has the company -- what sort of the special features or surprises that we can look for?

Jazy Zhang

Sure. That’s a great question, Gary. Let me first translate your question.

(Chinese language spoken)

Wei Liu

(Chinese language spoken)

Rich Chiang

For our current web game teams, so far there are about 20 or 30 persons, people for each project. And for web games in general, this genre or this type has been growing -- or just starting (audio gap) two years or so. So there’s constant innovation, constant new things and new content, ideas, coming out.

For us, we’re definitely going to improve or increase our resources into this regard and continue -- or try to come out with new innovations in terms of content, game plays, ideas or expanding different genres by games that we offer to cater or capture gamers who have never played games before.

Operator

Your next question comes from the line of Mark Marostica from Piper Jaffray. Mark, please go ahead.

Mark Marostica – Piper Jaffray

Thank you. Nice job on the quarter. My first question is in regards to ZT 2 monetization, and I'm curious if you could relate the levels of ZT 2 monetization as of the current state to the overall business at this point. Other more core stable games, that is.

Jazy Zhang

Okay, thanks, Mark.

(Chinese language spoken)

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

For ZT Online 2, for this game, which we’ve been operating for about a year now. We’re very happy with the overall paying amount or monetization within the game for our users, exceeding or met our expectations. Because of this revolutionary third-generation in-game economy, the paying, monetization may lag a little bit compared to more traditional MMO -- free-to-play MMORPG, but we’re seeing that as time goes on, the monetization is definitely going to improve or keep growing as time goes on.

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

But overall, for the growth of ZT Online 2 as a whole, we definitely hope that the growth is coming from new users or growth in number of years. And we’re very confident in our performance in this space.

Mark Marostica – Piper Jaffray

Okay, thanks for the color there. And just as a follow-up, if you could comment on your pipeline of new MMO games that you're planning to launch this year, and specifically the timing for the launches. I know, for example, Spirits of Warriors and Guangrong Shiming, the first-person shooter game are on deck, and I think a couple of other games as well. But if you could just give us some more color there, that’d be helpful. Thanks.

Jazy Zhang

Sure. Thanks, Mark.

(Chinese language spoken)

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

For 2012, we still have a heavy MMO lineup that’s scheduled to come out (inaudible) we announced Spirits of the Warriors and Allods Online. We also have a few in-house developed games that are upcoming, including (inaudible) of course previously mentioned, our online first-person shooter game, 2D martial arts MMORPG. They’re all in the works. And starting from about the second quarter, these will enter into various stages of testing. And depending on how that goes, we’ll hopefully do a very comprehensive testing schedules for these games, and we’ll keep updating you on the progress throughout the year.

Operator

Your next question today comes from the line of Steve Zhang from Macquarie. Steve, please go ahead.

Steve Zhang – Macquarie

Hi. Thanks for taking my questions. I have a question in regards to the user currently ZT 2 and possibly the other games, the ZT 1 series. Can you talk about how stable the user base for ZT 2 is? Have you see any cannibalization for ZT 1?

Jazy Zhang

Sure. Thanks, Steve.

(Chinese language spoken)

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

(inaudible) ZT Online, for the past couple of months, quarters, at least the second half of 2011, it’s been extremely stable, mostly comprised -- the user base is mostly comprised of very loyal players who’ve been playing games for many years and have a lot of relationships or close ties with other gamers within the game, other users.

Now, ZT Online 2, when we did launch it about a year ago, in the very beginning it did impact ZT Original a little bit. But currently all the user numbers and revenue from all these metrics, it’s not having much impact in the original game anymore.

Steve Zhang – Macquarie

Okay. Thank you. My second question is, can you talk about how much cash flow you generated in the quarter? And where are you in terms of the share buyback program.

Jazy Zhang

Sure. I’ll take your question, Steve. So, in Q4 2011, we generated approximately $50 million of free cash flow. And so far, since we started the share buyback program not too long ago, in the middle of October, we started to buy back our shares at various levels of prices. So far we have bought back about 940,000 shares, so, a total of a little under $4 million.

Operator

Your next question comes from the line of Jialong Shi from CLSA. Jia, please go ahead.

Jialong Shi – CLSA

Hi. Thanks. Good morning to new President, Ji, Jazy and Rich. Thanks for taking my question.

My first question is about the annual dividend. I guess this is probably one of the most interesting questions among investors. As Jazy mentioned in the prepared remarks, you raised the payout ratio for this past year. So, going forward, are you going to stick with the same payout ratio as this past year?

Jazy Zhang

Sure. Thanks, Jialong.

(Chinese language spoken)

Wei Liu

(Chinese language spoken)

Rich Chiang

Yes, for our dividend policy, definitely we work hard towards this, to give value back to our loyal shareholders. And for future payout ratio, this will actually depend on future developments of the company, our future financial performance, future top line and bottom line growth, future market conditions as well. And definitely at the proper time, our Board of Directors and us will make announcements in this regard.

Jialong Shi – CLSA

Thank you. My second question is about the other revenue and other income on your P&L. Other revenue, in 4Q, other revenue saw a strong sequential growth while other income saw a big quarter-quarter decline. Could you give us some color for this sort of big sequential change of these two items? Thank you.

Jazy Zhang

Yes, sure. Jialong, I’ll answer your question. So, in the fourth quarter, other revenue is about RMB11 million. There is a substantial increase compared to the prior quarter. This is because we received about -- sorry, RMB9.6 million of a payment from a government agency for us to develop GPS game model.

Rich Chiang

Third-person shooter, which is related to the initial first-person shooter game. [Gloria] mentioned that we did for the government last year.

Jazy Zhang

And the -- sorry. Okay. The decrease in other income, that was because in the third quarter we received some government incentives for the purchase of our office building. We received in Q3, there was no such incentive in Q4. That’s why the [account] decreased.

Operator

Your next question comes from the line of Vicky Lin from Merrill Lynch. Vicky, please go ahead.

Vicky Lin – Merrill Lynch

Hi. Thank you for taking my questions. Could you please let us know why ACU trend has been -- has not been up margin 4Q? How should we expect it in the first quarter?

Jazy Zhang

Sure. Thanks, Vicky.

(Chinese language spoken)

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

Hi, Vicky. For the past few years, we’ve noticed that gamers’ habits have been changing in China. People have less time, they’re more busy. Their time has become more fragmented. So we’ve noticed that for each duration of each log-in, has become more compact and more shorter, but some gamers that may be logging in more, more often. And also weekends, people used to log in during what we call primetime on weekends, but more and more people are probably going out, outside more, and away from their computers. And in order to compensate for changes in people’s habits, for example, in ZT 2, we’ve adjusted some of our game play and content where we don’t make game play as tedious or as time-consuming as before. We make up for that by having people spend logging back in frequently. And we’re still seeing a surge or increase in number of users, as can be seen from growth in PCU and APA. So that’s why ACU, which is the average time spent over a much longer period of time has stayed flat over the past couple of quarters.

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

As for the first quarter, because of Chinese New Year, Spring Festival occurred in January, people were probably away or on holiday. So, for hard core users, older gamers, they’re probably offline. And so, for the first quarter, we’re hoping that ACU will continue to remain flat.

Vicky Lin – Merrill Lynch

Okay, great. Thank you.

Operator

Your next question comes from the line of [Shayan Yang] from Nomura. [Shayan], please go ahead.

[Shayan Yang] – Nomura

Hi, this is [Shayan] sitting in for Jin Yoon. Just a quick question on your income statement this year of loss of an equity investee. I noticed that the number compared to previous quarters and years is significantly higher. I'm just wondering if you can provide some color around that.

Jazy Zhang

I'm sorry, [Shayan], can you repeat your question? You mentioned an item in the income statement, the equity loss?

[Shayan Yang] – Nomura

Yeah, your share of loss of an equity investee. I think this figure is around negative 5.5 --

Jazy Zhang

Oh, okay. I see, I see. Okay, okay. I’ll answer your question.

So, this, included in this number, it mainly includes an overall share of structuring fees from our investments in Yunfeng e-Commerce Fund which we’ve disclosed that the purpose of which is to purchase Alibaba Group shares. So there the allocation of structuring fee of about $1 million. That is the main item.

This is a one-time. One-time item.

[Shayan Yang] – Nomura

Okay. All right. Thank you.

Jazy Zhang

Yeah, sure.

Operator

Your next question comes from the line of Adam Krejcik from Roth Capital Partners. Adam, please go ahead.

Adam Krejcik – Roth Capital Partners

Yeah, hi. First question was on ZT 2, the micro-client version. I was wondering if you could give us some more color about when this title might launch. And then, will the margin be lower for this game because you have to share revenue with the platform operators? And maybe kind of discuss how big you expect this version to be.

Jazy Zhang

Sure. Thanks, Adam.

(Chinese language spoken)

Xuefeng Ji

(Chinese language spoken)

Rich Chiang

For the micro-client version of ZT 2, we’re planning to initiate this in April alongside with the expansion pack for the game. Micro-clients is smaller download executable and much more convenient and new trend for downloadable games in the industry. And hopefully we can capture new gamers due to this convenience.

As we’re putting it on game platforms, only if this micro-client becomes hugely successful on these platforms would it impact our margin. But even if so, it would be offset by the huge benefits in terms of top line or revenue that would bring about.

Adam Krejcik – Roth Capital Partners

Got it, that’s helpful. And then, Jazy, I just had some housekeeping questions. The tax rate for 2012, and then should we expect the same level of government financial incentives for this year? And also, should we expect any more other revenue in the first quarter like you did in Q4? Thank you very much.

Jazy Zhang

Sure. Thanks, Adam. So, for 2012, the expected tax rate that we use is about 9%. The reason being several of our subsidiaries obtained software company status which gives us first two years of tax exemption, followed by three years of 50% tax exemption. So, overall, on a consolidated basis, we would use 9% expected tax rate. And we’re currently in the process of applying for National Prominent Software Company status. If we do qualify for that status, this will further reduce our effective tax rate.

In terms of government financial incentives, we expect the number to be similar to 2011 -- 2011, yes.

Sorry, what’s your third question? Other income? Expectation of other income in Q1.

Adam Krejcik – Roth Capital Partners

Yes.

Jazy Zhang

Other revenue. Other revenue, there will be about RMB3 million of additional payment from this third-person shooter project. Other than that, we don’t have -- we don’t expect to receive any other non-recurring payment.

Operator

Your next question comes from the line of Andy Yeung from Oppenheimer. Andy, please go ahead.

Andy Yeung – Oppenheimer

Hi, good morning. Thank you for taking my questions. My first question is about your R&D investment which we have seen a pretty significant increase in 4Q. But given the step-up effort in web games and mobile games, what’s your investment plan or hiring plan for R&D in 2012? And how should we think about R&D ramp-up through the year?

Jazy Zhang

Thank you, Tim, for the question.

(Chinese language spoken)

Wei Liu

(Chinese language spoken)

Rich Chiang

For R&D expenses or costs through the remainder of this year, each web game team is comprised of smaller amount of developers compared to our MMO developers. Each web game team is probably 20 to 30 people versus around 100 for one of our typical MMO teams. So, with six web game projects in development now, the total number of people allocated to these web game projects is not that much, especially because these teams are composed of both external developers we’ve recruited with web game experience and also our existing old developers who have worked on our MMO or other online games previously.

So, total new recruits is not going to increase too drastically. So, throughout this year, R&D expenses will increase, but it will be controlled -- at a controlled pace compared to our total financial numbers.

Andy Yeung – Oppenheimer

Got it. My final question is about your net income attributable to non-controlling interest (inaudible) to your minority interest in game development studio. There was a significant jump in income attributable to non-controlling interest. Why was the jump in 4Q? And should we expect that going forward?

Jazy Zhang

Okay. Hi, Tim. I’ll answer your question.

So, the number increased significantly in Q4, that was because we finalized the reorg plans with our subsidiaries and we started revenue sharing at that time. And going forward, we would expect to -- so, in terms of 2012, as a whole year, the impact to our bottom line will be about 5% net margin erosion. So that’s the current forecast. So without that impact and without [SBC] expenses, our net margin would be -- would have been 60%. That’s the normalized rate. But again, as we mentioned before, we’re willing to share our profits with our key developers to incentivize them, and this will bring us much greater success top line, bottom line in the longer term.

Operator

Your next question comes from the line of [William Wong] from Barclays Capital. [William], please go ahead.

[William Wong] – Barclays Capital

Hi, good morning. Congratulations on a great quarter. I just want to follow up a question about R&D. So, in long run, due to your studio reorganization, should we expect R&D to moderate or even decrease given that maybe because these studio have to respond for their costs independently? And also, can you show with your expectation on marketing dollars when you launch expansion pack for ZT 2? Thank you.

Jazy Zhang

Sure. That’s a great question, [William]. So, yeah, definitely with the reorganization, each studio has their own P&L responsibility, and definitely they are able to more effectively control their expenses. In terms of headcount, we don’t expect any drastic or significant increase in our headcount.

In terms of marketing expenses for Q2 in connection with the launch of the first expansion pack for ZT Online 2, we expect, you know, overall we have a very strict guideline for sales and marketing expenses. Usually it’s under 10% of the game revenue. So we expect in Q2 the overall marketing spending to be in line with maybe Q3 last year. I mean, should be, in terms of percentage of revenue, it should be definitely under 10%.

[William Wong] – Barclays Capital

Just second question about your mobile game strategy. Can you just share with us a bit more color about your mobile game strategy? Or it’ll be great if any game on the pipeline could be shared as well.

Jazy Zhang

Sure, [William].

(Chinese language spoken)

Wei Liu

(Chinese language spoken)

Rich Chiang

For our mobile strategy, first we would like to allocate investment in M&A resources to find good mobile companies or teams, such as mobile embedded, mobile platform company that we’ve invested in before.

Second, internally, we hope to utilize mobile platforms as just another platform or growth area so that our games can be accessed through many different platforms, through PC or mobile, web, and so forth.

Operator

Your next question comes from the line of Martin Bao from CICC. Martin, please go ahead.

Martin Bao – CICC

Thank you for taking my question. I have a quick question regarding the web game, and it seems that the company is aggressively going to the R&D area of web game. Does the company also have a plan to go into the operational area of the web game? Thank you.

Jazy Zhang

Sure. Thanks, Martin.

(Chinese language spoken)

Wei Liu

(Chinese language spoken)

Rich Chiang

Yes. So, our platform for upcoming mobile games, our own internal investment departments and teams have always been looking for platform opportunities for web games. But when we have something announced, we’ll keep you updated.

Martin Bao – CICC

Appreciate it. Thank you very much.

Operator

Your next question comes from the line of Chao Wang from Merrill Lynch. Chao, please go ahead.

Chao Wang – Merrill Lynch

Hi. My question has been asked. I withdraw it.

Operator

There are no further questions today at this time. I would now like to hand the conference back to today’s moderator, Mr. Chiang. Please continue.

Rich Chiang

Thank you for joining us today. And we look forward to updating you on our progress in the near future.

Operator

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

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