Here’s the entire text of the prepared remarks from Shanda Interactive’s (ticker: SNDA) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Donglei Zhou, Director of Business Development and Investor Relations
Tianqiao Chen, Chief Executive Officer
Jun Tang, President
Shujun Li, Chief Financial Officer
Safa Rashtchy, Piper Jaffray
Wallace Cheung, Credit Suisse First Boston
Antonio Tambunan, Bear Stearns
James Mitchell, Goldman Sachs
Chang Qiu, Forerun Technology
Welcome to today’s Shanda Interactive Entertainment Third Quarter 2005 Earnings Conference Call. At this time all lines have been placed on a listen-only mode and the floor will be open for questions following today’s presentation. It is now my pleasure to turn the floor over to your host Donglei Zhou, Shanda’s Director of Business Development and Investor Relations. Donglei, you may begin.
Donglei Zhou, Director of Business Development and Investor Relations
Thank you and welcome everyone to Shanda’s Third Quarter 2005 Conference Call. I would also like to give a special thanks to our friends in the US who joined this call at a later hour. As always, we appreciate your participation. With us today on the call are Tianqiao Chen, our CEO; Jun Tang, our President; and Shujun Li, our CFO. After the close of the US market today, Shanda issued its Third Quarter Earnings Release. Copies of this Release have been sent to you for your information and reference during this call. A copy of the release is also available on Shanda’s corporate website at www.snda.com.
The purpose of this call is to provide investors with some further details regarding our financial results and to provide a general update on the company. Following our formal remarks, we’ll be happy to take any questions you might have. Before we begin, I would also like to remind you that during today’s call, we will make certain forward-looking statements that are intended to qualify for the Safe Harbor from liability. For such statements established in the US Private Securities Litigation Reform Act of 1995. All statements during the conference call other than statements of the historical facts are forward-looking statements. Although we believe that our expectations expressed in our forward-looking statements are reasonable, we cannot assure you that our expectations will be correct. Risks and uncertainties would cause our actual results to be materially different from our expectations, including the risks set forth in our filings in the US Security and Exchange Commission. Now, with that, I would like to turn the call over to our CEO, Tianqiao Chen.
Tianqiao Chen, Chief executive Officer
Thank you, Donglei, and welcome everyone. Overall our third quarter results were solid on an earnings benefit and in the revenue performance of many of our games, as well as online net pricings. We posted strong year-over-year revenue growth of 41.4%, but a potential revenue decline of 7.4%, mainly affected by the revenue decline in Mir II, which was down 33.5% over the second quarter of 2005. Excluding Mir II revenues from all of our other games increased 21% quarter-over-quarter. Shujun, will talk about the second terms with Mir II in more detailed discussion of our online game operations.
While our older game titles start to decline, we are pleased to see our other current game titles generate solid growing during the summer holidays in third quarters. At the same time, we continued to focus our investment in game development and in our home strategy making that generating sustainable growth in the future.
As part of the investment in strengthening our foundation, we have increased headcounts in R&D in the sales and marketing department and also raised salary levels at various positions to be more competitive in hiring and retaining talents in the dynamic industry. Our sales and marketing expense also increased as we invest more in building Shanda’s brand name. As a result, our operation margin was lower this quarter. Shujun will discuss this development in more detail.
Now, turning to discussion to some exciting new development in our home strategy and growing prospects. First of all, on the content side, we continue to build on our expertise in online game. We have built the most diversified portfolio of games in this industry and a very strong pipeline for the next 18 months.
In addition to our core online game business, we have continued to broaden our entertainment ph payment content offerings. Through cooperating with various leading content providers and the service providers, we have prepared three major categories of the content offerings. The first is entertainment, which includes movie, music, TV and games. Second, living which includes finance, e-commerce and the communication programs and third, info-learning which includes news and education programs. Working closely, with our partners we are committed to bring more diversified content to our users.
Secondly, we also made some notable progress on efforts to further improve and streamline our operation platform. For example, with the execution of unified user account and payments, we saw revenues contribute by direct online sales via credit or debit card payment increased to 17.4% of total revenue in Q3 up from 8.6% in Q2 2004, in 2005, sorry. This is a result of our active promotion of these payment methods and a very encouraging sign of how we could grow the easy payment methods into home user market.
Another example is that QuanQuan, our integrated instant messenger in service, which starts to open testing at the end of August. Already, reached some 10 ph users; nearly up 126,000 by now without any advertisement. QuanQuan has multiple features built in that allow game users to interact, search and chat with other members within the game community. QuanQuan also has a 3D advertising system building in.
As we transition from a pure online game operators to an interactive entertainment media platform and a service provider, we introduce EZ Center software solution as the unified software on top of the service platform. EZ Center software solution is an integral part of our home strategy. It integrates rich interactive contents from Internet and display them through our new user interface that has info intuitive menus with large tabs and clear graphics. It’s clearly the way people navigate media content from information base, which is the old internet portal model to an accreditation based new entertainment portal. I believe this would be the second generation portal.
Our new EZ Series product, which includes EZ Station, EZ Pod and EZ Mini are all based on the same EZ Center software and are supported by Shanda’s unified service platform, including user accounts and security, billing and payment systems and customer service.
Before I introduce our EZ Series products, I would like to reiterate that Shanda’s core competency is in operation of platform that provides interactive entertainment content and service. Our goal is to expand our service platform and ultimately grow user base by providing them with the best entertainment experience in the most convenient way. We believe the EZ Series products will help us to set the standards for perfecting user experience and initially consolidated different process along the value chain. Once the market starts to generate momentum we expect to focus on our core competency.
First is EZ Pod, which is targeted at the PC users. It includes an EZ Center software and a remote control that together upgrade a normal PC platform to an interactive entertainment platform that let’s the user browse applications on the full screen as easily as operating a TV. Now, user can relax and sit back in their chair while enjoying entertainment on their PC.
Recently Intel has entered into a partnership with us to jointly promote EZ Center or EZ Pod products and expect to distribute a half a million sets over the next 12 months. EZ Pod has already been rolled out in the market and in the price at RMB 458, about US$557. Users are then expected to subscribe to our various services on an a-la-carte basis for monthly package.
Secondly, the EZ Station, also known as the set-top box, which is target at mainstreaming home new TV users. It is an entertainment PC based on Intel architecture with EZ Center software in package and operate on Windows XP or Linux. EZ Station comes with a remote control and connects to and displays via a normal TV set of all sorts.
EZ Station brings rich editorial entertainment into living rooms through an Internet connection. We believe the EZ Station will appeal to a wider range of users in China because of its higher degree of user friendliness compared to a PC. While the products have not been commercially launched yet, we are currently conducting marketing trials. We expect we will allow users to choose between the monthly subscription fee that entitle them to unlimited access to content and service or pay per use fee for content and the service.
Third is EZ Mini, which is targeted at user on the go. EZ Mini is a handheld online entertainment device that connects through WiFi or via PC to the internet and access Shanda’s content and service platform the same way PC or TV users in EZ Station would.
The product is jointly being launched by Shanda and Mitac, a leading Taiwanese IT product developer and manufacturer. Mitac will be responsible for the design, manufacturing, marketing and the distribution of the product, whereas Shanda will include EZ Mini in its agenda, EZ brand series of product and product and provide content and services.
EZ Mini users will pay for ongoing services through Shanda’s unified payment system via prepaid card instead of through mobile operators. In total, we expect cost incurred on or capital tied up to our EZ initiative to be less than US$20 million over the next year. However, as the market momentum picks up we intend to partner with other hardware manufacturers and then license to them the right to produce and then distribute the product independently.
Again, our ultimate goal is to enlarge our user base and to promote content consumption. Because once users buy any of the EZ series products they are very likely to become loyal users to Shanda’s broad portfolio of content offering and contribute recurring revenue streams.
In closing, Shanda has strategically grown and diversified its revenue base by building one of the largest portfolio of online entertainment content in China. We have a deep portfolio of offering and services as we have one of the broadest platforms over which to distribute them. A big part of our future is expanding both as advantage through the home strategy, as we challenging the way Chinese consumers entertain with our EZ series. Shanda is planning for the long-term and we are excited about the development that lies ahead. I will now turn the call over to Jun Tang, our President.
Jun Tang, President
Thank you, Tianqiao. I will discuss our online game business in more detail. Despite of declines in Mir II revenues in the user base, user ph numbers for this quarter. The majority of the games in our game portfolio have performed well in the third quarter. Total online game revenues were US$51 million, an increase of 35.5% year-over-year and a 6.1% decline quarter-over-quarter due to the decline of the Mir II revenues. Our total key concurrent users for the third quarter was 2.55 million, representing a small increase from the prior quarter while our total average concurrent users reached 1.4 million, representing 1.8% growth over Q2.
As many of you know, Mir II is in its fourth year of operation, majority of which was without any technical support from the game developer. While, we have been extremely satisfied with Mir II’s performance over the past several years, it has now entered into the later stage of its life cycle. Along with the aging, the revenue decline was also attributable to the increase of competition in the online gaming markets, the effort of the hacking incidents, cheating programs and the parity to servers. Furthermore, the 33.5% in sequential decline was exaggerated because of the success of the expansion pack and related in game events in the second quarter.
If you look at the Q1 2005 as a comparison without the temporary spike caused by the expansion pack, the revenue decrease of the Mir II in this quarter is as a much smaller percentage of 11.7%. Despite of Mir II’s decline, the underlying strength of our diversified game portfolio was clearly demonstrated through the fact of that War ph have become the leaders, posting strong revenue growth in the third quarter. It’s now our largest game in terms of revenues. In addition, Magical Land and RO are off to good starts in the game market as their user base grows. Overall, peak concurrent MMORPG users grow 1.5% to 1.03 million in the third quarter while the Mir II saw a 19.5 decline in peak concurrent user numbers.
The decline in Mir II PC was mainly offset by the user interest in War, in our other concurrent current titles, including the newly commercial launch of the games. Average concurrent MMORPG users in the third quarter declined 17.4% from Q2 to 630,000. That also includes a 38.9 decline in average concurrent users for Mir II.
Casual games revenue for the third quarter including revenue from Bianfeng and Haofang was $13.2 million US dollars, an increase of 95.5% year-over-year and an increase of 1.9 quarter-over-quarter. Peak concurrent users for casual games declined 3.7% quarter-over-quarter to 1.5 million, while average concurrent users for casual games increased 24.4% to 807,000, as compared to the second quarter 2005.
In September we launched The Three Kingdoms, an in-house developed casual game. Going forward, we remain very confident in our pipeline of upcoming games. We plan to launch three other in-house developed casual games, Shanda Rich Man, NAB Card and the Kung Fu Kids ph through the remainder of the 2005. We also have a few more development projects of the various type of casual games that have recently been established.
On the MMORPG side, Dungeons & Dragons is on track to begin beta testing in first half 2006. We are pleased with the early test of versions we have seen. In addition, Actoz has recently unveiled three exciting new games that will be added to our game portfolio and launched over the next year.
The first is a side screen 2D casual games with cute characters and a charming decoration. The second is a 3D MMORPG with a fighting in the sky story line and a cutting edge graphics and scenery. The third is an adventurous 3D casual game. All three of these three games will broaden our content portfolio and allow us to reach the fastest growing youngest market in China. With that, I will now turn the call to Shujun.
Shujun Li, Chief Financial Officer
Thank you, Jun, and welcome everyone. Q3 total net revenue was US$61.7 million representing a 41.4% increase year-over-year and a 74% decrease quarter-over-quarter. Our core online game business delivered revenue of US$54.1 million up 35.5% year-over-year and down 6.1% from the previous quarter.
Revenues from MMORPGs increased 23.3% year-over-year, but decreased 8.4% quarter-over-quarter to US$40.9 million due to the softness in Mir II revenues as discussed. Average concurrent users for MMORPGs was 630,000 in Q3 compared to 763,000 in Q2.
ARPU, which is based on net revenues, was $0.24 in this quarter compared with $0.22 in the second quarter 2005.
Our casual games revenue increased 95.5% year-over-year and 1.9% quarter-over-quarter to US$30.2 million.
Active paying accounts declined 9% to 3.2 million where average monthly revenue per paying account grew 12% quarter-over-quarter to Reminbi 11. We are pleased to see ARPU growth in both, our casual and MMORPG games as well as good performance from our other games excluding Mir II. We believe that our expanding roster of games will gradually help diversify our revenue base.
Other revenues from Q3 was US$7.6 million, an increase of 105.3% year-over-year and a 15.4% quarter-over-quarter decrease. While online advertisement revenues continue to grow D.O.’s slowing sales have caused other revenue to decline sequentially. Other revenues accounted for 12.3% of our total net revenue.
Our gross margin was 68.9% of net revenue this quarter, up from 62.7% in the third quarter of 2004 and 68.4% in the second quarter of 2005. The increase is related to the decline of ongoing license royalties from the decreasing revenue of Mir II and the increasing revenue from in-house the other games.
As Tianqiao talked about earlier, in the third quarter we continue to invest in the areas that we have to generate future growth. This has resulted in operating margins decreasing to 30.4% year-over-year from 40.2% and quarter-over-quarter from 45.2%. The decline of operating margin was attributable to increment of payroll costs and sales and marketing expenses.
Payroll costs increased because of the increase of headcount, as well as a 20% on average wage increases granted to existing employees in various positions to be more competitive in this industry. The total headcount increased 6.5% quarter-over-quarter to 2,363, mostly due to the increase of employees related to new game projects and other initiatives.
Sales and marketing expenses in Q3 was 15.7% of our net revenue compared with 7.1% in the previous quarter. The increase is mainly because of continued investment in Shanda’s brand name, as well as marketing activities relating to the launch of the new games during this quarter and the upcoming launch of the Shanda EZ series. In addition, Shanda has made some contributions to social causes to improve public perception of the gaming industry.
We reported income before taxation and minority interests of Reminbi 243.3 million, representing a 38.8% increase compared to Reminbi 175.3 million in the third quarter of 2004 and 80% decrease compared to Reminbi 264.6 million in the second quarter of 2005.
Income before taxation and minority interest for the third quarter of 2005 include other income was Reminbi 89.1 million, which mainly comprised government financial incentives of Reminbi 50.4 million and the foreign exchange gain of Reminbi 43.5 million. The foreign exchange gain aroused from the revaluation of monetary and assets and liabilities denominated in US dollars following the appreciation of Reminbi in July 2005.
We have posted net income during the third quarter of Reminbi 251.1 million, up 58.1% year-over-year and 17.1% quarter-over-quarter. The income tax benefits in the third quarter of 2005 is still to receive government approval by one of our operating companies irrespective the preferential tax incentive, but has income tax liabilities totaling Reminbi 34.2 million for the first two quarters of 2005 and credit as a benefit in the third quarter of 2005.
Shanda’s effective income tax rate for the first three quarters of 2005 after receipt of the tax benefit is 9.3%. This rate is expected to be maintained for the next several quarters.
On per share basis, third quarter net income per diluted ADS increased to US$0.44 year-over-year from US$0.26 and quarter-over-quarter from $0.36 per diluted ADS. The number of related average ADS outstanding for the third quarter was 73.5 million, compared to 75.1 million a year earlier and 72.6 million for the previous quarter. That concludes my formal comments. Thank you everyone. I would now like to turn the call back to Donglei.
Donglei Zhou, Director of Business Development and Investor Relations
Thanks you, Shujun. Before I turn the call over to the operator I would just like to note that shortly after today’s call we will post a slide presentation on our investor’s relations website that takes a further look at the strategy around our EZ series and also displays some of the exciting features of the EZ series products. The presentation can be found on the investor’s relations portion of our corporate website at www.snda.com under presentation.
Now, I’d like to turn the call over to the operator for Q&A.
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