Shanda Interactive Entertainment Ltd. (NASDAQ:SNDA)
Q2 2007 Earnings Call
August 27, 2007 9:00 pm ET
Maggie Zhou – Manager, IR
Jun Tang - President, Director
Daniel Zhang - Chief Financial Officer, Vice President, Director
Tianqiao Chen - Chairman of the Board, Chief Executive Officer
Tony Gikas - Piper Jaffray
Dick Wei - JP Morgan
Ming Lu- Riedel Research
James Mitchell - Goldman Sachs
C. Ming Zhao - Susquehanna Financial Group
Richard Ji - Morgan Stanley
Richard Chau - Alliance Bernstein
Tian X. Hou - Pali Research
Wallace Cheung - Credit Suisse
John Chen - Owl Creek
Welcome to today’s Shanda Interactive Entertainment’s second quarter 2007 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Maggie Zhou, Shanda's Investor Relations Manager. Maggie, you may begin.
Thank you, operator, and welcome everyone to Shanda's second quarter 2007 conference call. I would also like to give a special thanks to our friends in the U.S. 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 Daniel Zhang, our CFO.
After the close of the U.S. market today, Shanda issued its second quarter earnings release. Copies of the 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 will 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 U.S. Private Securities Litigation Reform Act of 1995. All statements during the conference call other than statements of historical fact 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 could cause our actual results to be materially different from our expectations, including the risks set forth in our filings with the U.S. Securities and Exchange Commission.
Now with that, I would like to turn the call over to our President, Jun Tang.
Thank you, Maggie, and welcome everyone to Shanda’s second quarter 2007 conference call. In my presentation, I am going to talk about our Q2 performance and our future goals. In Q2 2007, despite seasonal weakness, Shanda achieved another quarter of solid growth. Total revenue grew 6% quarter over quarter and 39.1% year over year to a record high of $74.1 million, beating the company’s up guidance.
Operating margin rose to 43.3% compared with 42.2% in the previous quarter. Adjusted net income rose 16.9% quarter over quarter to $31.3 million and non-GAAP diluted earnings per ADS was $0.42 compared with $0.36 in Q1.
Online gaming revenues in Q2 grew 7.6% quarter over quarter and 45.3% year over year to $71.4 million, driven by the solid performance of our MMORPG business. In Q2, revenues from MMORPG games rose 14.2% quarter over quarter to $62.1 million. Due to the continuous improvement of existing titles, including MIR 2 and Woool, and commercialization in April of our new game, LaTale, which has already made a meaningful revenue contribution in Q2.
During the second quarter we released additional expansion packs for our existing MMORPG including Heroes for MIR 2, Confinement for Woool and God of Fire for RO. We also held in-game promotions during the holidays. In addition, we commercialized MMORPG LaTale, which was developed by Axis and was warmly welcomed by our female users. The initial success of LaTale validates our strategy regarding Axis, which we believe will be an increasing portion as we further solidify our pipeline in the future.
The positive performance of our existing title and the newly launched game, LaTale, active paying accounts for our MMORPGs in Q2 increased 16.3% to $2.72 million. On the other hand, ARPU for MMORPGs decreased 1.8% quarter over quarter to RMB57.9, mainly due to the dilution caused by the lower ARPU of our newly added paying users.
Turning to the casual games, revenues for the second quarter, including revenue from Bianfeng, Howfun and GameTea declined 22.3% quarter over quarter to $9.3 million. The sequential decline in revenues was due to the weak seasonality related to the school examinations and aging of BNB. Seasonality-related issues have impacted our casual games active paying accounts, which declined 29.3% quarter over quarter to 1.68 million in Q2. While we saw the decline of the active paying accounts, ARPU for casual games increased 9.9% quarter over quarter to RMB 14 mainly due to the continued launch of expansion packs and the hosting of in-game promotions during the period. In Q3, we expect our casual games business to pick up again as a result of strong seasonal efforts.
Looking to the third quarter, we expect continued growth in our existing titles generally from the planned launch of expansion packs and the introduction of the new service. Expansion packs to be released in Q3 include Cat House for Mir II, The Burning Hill ph for Woool, Fairly Tale World for LaTale, Return of the Heroes and new expansion packs for Maple Story and Crazy Kart. We have also held a series of marketing activities for our game content and will continue to do so in Q3 in order to capitalize on the strong seasonal effect brought by the summer holiday period and at the China Joy exhibition.
Turning to the new games, in addition to LaTale, we have also commercialized our fighting series for casual game, Kung-Fu Kid in late-June and the casual game, Tales Runner, in mid-July. So far, the results have been very encouraging. We look forward to a series of high-quality MMORPG titles to be released in the coming quarters including Changchun Online and Majesta. We will also introduce The Legend Online which we obtained through our acquisition of Aurora Technology.
Furthermore, we have already begun building our pipeline for 2008 and beyond. We recently announced agreement to co-develop an online version of Heroes with THQ and Dead or Alive with Tecmo. We are confident that our constant innovation strategy will allow us to introduce these proven titles into the Chinese market with great success.
We also have several sports-oriented casual games including an in-house developed skateboard game and the table tennis game, XR which we believe will attract greater interest due to the excitement surrounding the upcoming 2008 Beijing Olympic games.
In summary, our online game portfolio concluded another quarter of solid growth and has continued to perform well. Our newly launched titles have shown encouraging results so far. We look forward to an active period of new game launches in the coming quarters and we have already added several high quality titles to our pipeline in preparation of 2008 and 2009.
We will continue to focus on providing users with high quality content that provides a fun and exciting games experience, which we believe is the key to our success in the future.
With that I will turn the call to Daniel.
Thank you and welcome everyone. I am pleased to announce another consecutive quarter of revenue growth with total net revenues of 74.1 million, up 6% quarter over quarter and up 39.1% year over year, hitting the upper range of our guidance of a quarter-over-quarter growth of between 3% and 6%.
Gross margin was 67.2% of net revenues this quarter, up from 65.2% in Q1 '07 and up from 56.5% in Q2 '06. The sequential increase in gross margin was mainly due to the more efficient absorption of the fixed cost of services as a result of continuous revenue growth and reduction in cost of EZ products reflected in the decline of other in the cost of services.
Income from operations was 32.1 million in Q2, up 8.8% quarter over quarter. Operating margin increased from 42.2% in Q1 to 43.3% in Q2. The sequential increment in operating margin was primarily due to the higher gross margin, partially offset by the increase of operating expenses as a percentage of revenues. Operating expenses increased 10.4% quarter over quarter in Q2, mainly due to merit-based salary increases for our employees starting from June '07, as well as increases in marketing and promotion expenses resulting from the launch of new games during the quarter.
Other income increased 47.3% quarter over quarter to 1.5 million, primarily due to a reduction in foreign exchange loss, partially offset by the decrease in government financial incentives. Net income in Q2 was 54.6 million, compared to net income of 58 million in Q1 and a net income of 16.7 million in Q2 '06.
Diluted earnings per ADS was 0.74 in Q2, compared to diluted earnings per ADS of 0.80 in Q1 and diluted earnings per ADS of 0.24 in Q2 '06. Non-GAAP net income in Q2 '07, which excludes net gain from disposal of SINA’s stake, increased 16.9% quarter over quarter to 31.3 million. No adjustments were made to net income in Q2 '06.
Non-GAAP diluted earnings per ADS was 0.42 in Q2 '07 compared to Non-GAAP diluted earnings for ADS of 0.36 in Q1. We adjusted the effective tax rate after excluding pre-tax gains from disposal of SINA shares, which is free of income tax due to Shanda being incorporated in the Cayman Islands was 13.8% in Q2 '07 compared to 9.8% in Q1.
Turning to our balance sheet, prepayments and other current assets decreased to 7.7 million in Q2 from 24.6 million in Q1, mainly due to the returned guaranteed deposit for upfront licensing fees paid. Investment in equity securities increased from 45.6 million in Q1 to 50.2 million in Q2 mainly because we additionally acquired a stake in Actoz in the open market in Q2.
Long-term assets increased from 26 million in Q1 to 31.4 million in Q2, mainly due to the prepayment for the acquisition of Aurora Technology in Q2. Upon the settlement of the acquisition in Q3 we will consolidate Aurora's financials into our financial statements. In Q2, deferred revenue declined 15.7% quarter over quarter to 33.1 million, primarily due to seasonality following the Chinese New Year holiday purchasing of prepaid cards by our distributors in Q1.
As of June 30, 2007 Shanda's cash and cash equivalents, short-term investments and marketable securities totaled 516.2 million, and are adequate to satisfy the redemption of 275 million in convertible bonds, which are listed as a current liability and are due October 15, 2007. At this point, we plan to pay it off. On July 4 our stake in Actoz increased to 50.1%. As a result, Shanda will consolidate Actoz' financial statements starting from that day.
I will now provide our business outlook for the next quarter. We currently anticipate total net revenues for the third quarter of 2007 to be in the range of 80 million and 82.3 million, representing an increase of 8% to 11% from the second quarter. Given more marketing activities during the summer holidays in Q3, we expect operating margin in the third quarter of 2007 to reduce, but be no less than 35%. This guidance includes the impact of consolidating the operations of Actoz into our third quarter financials. Excluding the impact from Actoz, we anticipate total net revenue for the third quarter of '07 to be in the range of 79.3 million and 81.5 million, representing an increase of 7% to 10% from the second quarter. Operating margin target for the third quarter is expected to be no less than 35%.
In giving our financial targets, we caution that we cannot predict the future exchange rate of the RMB against the U.S. dollar and therefore cannot accurately and with any degree of certainty estimate the impact of any change in the exchange rates on our financial results. Accordingly, in giving our financial target above, we assume no change in exchange rate in the third quarter of '07 and have adopted the same exchange rate as of June 30, 2007 which is $1 equals to RMB 7.6155. Our actual results could differ, however, from the above mentioned financial targets as a result of fluctuations in exchange rate.
That concludes my formal comments. Since this is my last earnings call with Shanda, I want to thank all of you for your support. It has been a great pleasure working with all of you and I look forward to continuing to support Shanda as a director.
Thank you everyone for joining us today. I would now like to turn the call to Tianqiao.
Thank you, Daniel and thanks for your valuable contribution to Shanda during the last two years. I also wish you great success in the future.
For the second quarter of 2007, we achieved solid success with revenue close to a record high of just over 74.1 million. This year also another quarter of continued growth during the last six quarters since we initiated the transition in late 2005. Actually, looking back to our past 14 quarters, we experienced positive quarter-over-quarter growth in all quarters but Q4 of 2005 when we were in a period of transition.
Going forward, Shanda will continue to focus on its three C’s strategy: content, community and commerce. First today on the content side we will continue to focus on reinforcing our online game content to our diversified, balanced strategy. Shanda is dedicated to maintain a strong portfolio of high-quality games. In the past, we have accomplished this through a combination of in-house development, licensing and investment in good content.
We recently took this approach to a higher level by partnering with top-tier game companies to co-develop online versions of popular PC and console games. We began by collaborating with THQ and Tecmo and we were pursuing a similar relationship with other companies. This model allowed us to quickly replicate our successful experience with back end networking infrastructure, anti-hacking systems and profitable revenue models, compared to in-house content development and licensing. It normally requires much less in the way of financial resources and time. Secondly, through the co-development model, we will be able to share the global revenues of these titles with our partners, which will not only provide us a new revenue stream but also help us to introduce our content to the overseas market as well.
In addition to the creative co-development model, we also increased our commitment to in-house development, licensing and investment in past quarters. On the in-house development side, we provided additional funding and a bonus as an incentive to high performing teams and individuals. At the same time, we have also increased our stake in Actoz to over 50% in July. Actoz will become a consolidated subsidiary on our financial statement beginning in the third quarter of 2007 and will be our key R&D center in South Korea.
On the licensing side, so far into this year we have licensed several high quality MMORPG such as LaTale as well as casual games such as Tales Runner. We are also actively negotiating to license two other well-known titles and we plan to introduce more sports-themed casual games in 2008.
On the subject of investment, we have purchased the domestic online game developers Aurora Technology and we are in the process to establishing the Feng Yun forum. The Feng Yun forum will be the first online game forum of its kind in China, focused on the investment in proven game titles. We believe our abundant casual reserves are sufficient to support our investment in high quality game content in the future. In summary, in house development, licensing, investment, and code development will remain important to our strategy of enhancing our content portfolio as we look forward.
In addition to content enhancements, we will continue reinforcing our platform and build up a Shanda online community for users. In the past four years, our platform has contributed substantially to the company growth. Currently, about 20 of our games are operated under our unified platform which is supported by a unified account authorizations system, a unified billing system, unified customer service, unified distribution channels and unified technical support. All of our titles have been successful and our sales and marketing expense have grown less than those of our competitors, which explains the continued improvement to our operating margins we have achieved.
Another advantage of our unified platform is it provides us with a large community of users who continually enjoy our high quality service and content. As we introduce new content to our platforms, we will be able to attract an increasing number of new users. In addition, based on a unified platform, interaction between users could not only appear in WAP or inside of games, but also between different games on our platform. We believe the interaction will help Shanda gradually form a powerful virtual community.
Thirdly, on the commerce side, we will continue introducing new growth drivers focusing on our users. First of all, we remain better use of our existing users. Currently our paying accounts only amount to approximately 60% of our actual accounts while we continue to enlarge the paid user program and enhance the ARPU, we also have encountered better opportunity to generate profits from in-game enterprising than any other peer company since we begin full operation on these models. Currently we have completed the development of IGE technologies and we have formed the talent team to work on our IGE strategy. We are also making considerable effort to introduce casual games to users in order to capture the substantial market opportunity brought by the 2008 Beijing Olympic Games. We believe our IGE strategy will become a new driver for revenue growth in the future and we plan to fully unveil Shanda's IGE strategy soon.
In closing, I would like to reiterate that content, community and commerce are the key areas of Shanda's development strategies over the next five years. We plan to use our high quality entertainment content to attract more users; our large online communities to retain these users; and our creative business model to generate large profits from them. We are confident in the tremendous potential of China's online game market and we believe that Shanda will be able to maintain its leadership position in this industry and continue building premium value for our shareholders.
That concludes our formal comments. Thank you everyone for joining us today. I would now like to turn the call back to Maggie.
Thank you, Tianqiao. We are now ready for questions. Operator, we can begin the Q&A session now.
(Operator Instructions) Your first question comes from Tony Gikas - Piper Jaffray.
Tony Gikas - Piper Jaffray
Good morning, everyone and congratulations on a good quarter. You talked about for the third quarter that the operating margin during the quarter would be no less than 35%. Could you provide a little bit more color on what line items? It sounds like sales and marketing is most heavily impacted, but maybe just a little bit of help on weighting those operating expenses in the third and fourth quarter, please?
I will elaborate in more detail. Actually, looking forward in the third quarter we expect our sales and marketing expenses will increase due to more marketing activities during the summer holiday. In addition, as we said in our earnings release and presentation, we increased the base salaries in June, and so in Q3 which will be the first full quarter after we increased the salaries, so the impact will be in the whole quarter.
I think, generally speaking, we believe that we are confident to achieve a margin no less than 35%. Thank you.
Your next question comes from Dick Wei - JP Morgan.
Dick Wei - JP Morgan
Congratulations on a very good quarter, and thank you for taking my questions. I have two questions. The first question is it looks like in the second quarter your active paying accounts were up around 380,000. I wonder, are those active paying accounts coming from the new games, or is it more from the old games?
If you can, maybe give us some color on the guidance that for the next quarter’s growth of 7% to 10%, is it mainly coming from the active paying accounts or is it from the ARPU? That would be great.
Thank you, Dick. We did see growth in the active paying accounts, which contributed from two parts. One is the organic growth which is from the existing games, and secondly it is from the new title released, LaTale. We think the organic growth will continue to grow over the next quarters, that is why in Q3 and Q4 we will continue to see the growth in the active paying accounts side.
Dick Wei - JP Morgan
Is it possible to get some color in terms of the 380,000 increasing active paying accounts, how much is from the old games and how much is from the new games?
Well actually, we are not going to disclose the details coming from new games or old games, but the trend is very clear that we have emphasized, we tried to increase more on the active paying accounts rather than grow the ARPU side, which is the strategy which has worked so far. We will continue to grow that because, as Tianqiao mentioned, today our portfolio, only 6% of total users are paying users, so I think we do have a lot of room to increase from the 6% to double-digit kind of numbers there.
Dick Wei - JP Morgan
After Daniel joined Shanda, I think Daniel put in some cost initiatives that helped to improve the operating margin for the company. I wonder with Daniel’s departure, how should we look at more of the cost-conscious culture in Shanda going forward?
Daniel did a great job in the cost controls, and also the efforts from the management as well, so both Tianqiao and I and Daniel worked together to do a lot of things to reduce the costs. That will continue, the company’s strategy will continue to be to control the costs, in line with growing the revenue side. You shouldn’t have any worries. We will do a better job later too.
Your next question comes from Ming Lu- Riedel Research.
Ming Lu- Riedel Research
Good morning, great quarter. Two questions. First, is there any MMORPG games under development, or any schedule to develop in-house MMORPG in the near future?
The second question, can you tell us, Aurora Tech’s revenue in the first half of ’07 or ’06? Thank you.
Thank you, Ming. In terms of development of MMORPG, we do have a couple in line, one from Actoz which we have 51% control of the company, they are developing a title called Majesta, we hope to have a release in the next couple of quarters. Also internally, we are also developing the version 2 of the Woool which is a good way. That is the answer to your first question.
The second question, in general we do not disclose the details of each of the games and as we mentioned, Aurora Technologies, we acquired it, I think it has generated the revenue and it is profitable with strong cash so I think in general, we are very happy with the performance. I think once we take over that, we have been taking over the company so I think the trend will continue to be better yet.
Your next question comes from James Mitchell - Goldman Sachs.
James Mitchell - Goldman Sachs
Good morning, and good luck to Daniel with his future projects. On the consolidation of Actoz, looking into the third quarter, will your license fee payment decline by the full amount of your license fees on Mir 2, or will there still be license fee payments from Mir 2? That is my first question.
My second question is, will Actoz’ own expenses show up mostly in R&D or in cost of services or in general and admin expenses?
A third question, which is really a follow-on from the previous question, when I look at your guidance for high single-digit revenue growth in the third quarter versus the second quarter, is the consolidation of Aurora material to that revenue growth guidance? Thank you.
Thank you, James. I would like to answer this question. For the first one, actually we pay, even after we consolidate Actoz’ financials, we still as a business we still pay license fees to Actoz on a monthly basis. Then, Actoz will further pay a part of the license fee to Wemade and so on a consolidated basis, we will of course between Actoz and Shanda, we will eliminate the intra-company revenue, but as Actoz, for sure they make a great margin from the license income from Shanda, so after consolidation, I believe the gross margin will be substantially improved.
In terms of operating expenses, as you said, actually Actoz is an R&D center, so the major cost incurred for Actoz will be the R&D expenses, so it will have an impact on our operating expenses, which will eventually reflect in our operating margin.
Our next question comes from Ming Zhao from SFG. Please go ahead.
C. Ming Zhao - Susquehanna Financial Group
Thank you. Good morning. I have two questions. The first question, I just want to get an update on your pipeline because when we look at the first half of this year, it seems like you added the Latale but if we look back half-a-year ago, basically you are saying there might be five to six games to be launched this year. Are we still on track to that projection, meaning in the second half how many games are we going to see in the market? Does that include Changchun Online’s open beta testing? That’s the first question.
The second question, on the casual games side, you mentioned that BNB has declined, has been aging, so you launched the TalesRunner. Is that good enough to offset the decline of that old game? Thank you.
Thank you, Ming. Let me answer this question in terms of the pipeline. Earlier we have announced, we are waiting to release several MMORPGs and casual games. We did make some of the casual games as TalesRunner and some of the related casual games. And also, we had launched Latale and also some others. In the coming quarters, we plan to have more MMORPGs, such as DDO, which will be commercialized later this year, and Changchun Online and also the [logistic] pipeline as well, so we are pretty much in line with the previously announced pipeline.
Actually, we are looking for more big partners as well, so hopefully we can have more titles for 2008 and 2009.
And the second question in terms of the aging of the BNB, actually BNB has been doing a great job in the past four years for the revenue contribution and actually it is still contributing to our revenue side, thought it is reaching the end of the cycle. But we do see BNB is generating revenue as well. And we have several casual games in line, as I said, TalesRunner, the Crazy Kart kind of things in our casual game pipeline.
We had some of the decline in the second quarter, which was purely due to the seasonality issue and you will see we are picking up the casual games in the third quarter. Thank you.
Our next question comes from Richard Ji from Morgan Stanley. Please go ahead.
Richard Ji - Morgan Stanley
Hi, guys, great quarter and I have two questions, and the first question is regarding the ARPU for your MMORPG, and clearly we see a very strong volume pick-up for your premium users. On the other hand, the ARPU seemed to be a little soft during the quarter. Maybe you can help us to understand that a little bit better. Is that mainly due to the rollout of lower-paying, the special of the lower-paying new users? And what will be the trend for the ARPU going forward? And then I have a follow-up.
Okay, great. In the second quarter, we did see a double-digit growth in active paying accounts and we did see 1.8% decrease in the ARPU side, which as we said was mainly due to the newly added active paying accounts paying less in the early days. I think it will pick up later on. That is why you will see we have a greater improvement on the active paying accounts and we did see some of the decline in average in terms of ARPU.
Going forward, we would like to see more growth on the active paying account side rather than seeing big growth on the ARPU side. But I think we do see great room for improvement in ARPU as well, though we like to see a big improvement in the active paying account side. Thank you, Richard.
Our next question comes from Richard [Chau] from Alliance Bernstein. Please go ahead.
Richard Chau - Alliance Bernstein
Thank you. Congratulations on a good quarter. I have two questions. The first question is regarding the other revenue. As cited here, the decline in other revenue is mainly due to the decline in EZ Pod sales. I wonder, what’s your company’s strategy going forward for that?
My second question is regarding the in-game sales. I wonder what type of customers have you lined up, when are we going to see a start in revenue booking? Thanks.
In terms of other revenue, in Q2, we have seen a reduction in EZ Pod sales, but on a per article basis, we still receive orders from our customers and we made our shipment to the users, so basically we will still deliver the EZ Pod products to our customer.
I would like to answer the second question in terms of the -- actually, we have been doing technical testing for our IGA technology and it has proved to be very positive and actually, we are planning to have the formal announcement of our IGA business strategy later this year, probably next quarter. We have been talking to the customers and so far we had the event, we are inviting a lot of the customers and also the companies. They showed a very, very interest and actually we have been talking to them actively. Thank you.
Our next question comes from Tian X. Hou from Pali Capital. Please go ahead.
Tian X. Hou - Pali Research
Thank you. I have a question regarding the community strategy. As Tianqiao said, you have a three-C strategy -- content, community and commerce. I’m just trying to understand how this community contributes to your game revenues. For example, let’s just say Latale; how many gamers are generated from your platform, your community, how many gamers are out of the community? I don’t need a specific number, just a percentage will be fine.
I can give you the percentage, just to take as an example, Latale or any new titles. According to our experience, when we launch a new game without any promotion, nearly 40% of the users they are Shanda’s platform users. That means they have already unified accounts and they just logon without any registration. They can play the games by the money in their account. I think the contribution from the community is very huge to new titles.
In terms of how to build up our own communities, you know, it’s a big topic so maybe we can -- we will let you know not only -- we will try to encourage the interaction between the users and not only just in games but also between the different games. It is a big topic so maybe we can talk in more detail later. Thank you.
Our next question comes from Wallace Cheung from CSFB. Please go ahead.
Wallace Cheung - Credit Suisse
Good morning. Thank you for, Daniel, the great job in the last two years. I just have two quick questions. I think first of all, can you go through on the Actoz consolidation impact into the balance sheet in terms of marketable securities or invest in affiliate items?
And also I think the second question will be regarding the [inaudible] investment fund, can you explain that a little bit, like the M&A criteria or any other terms and objectives of this fund? Thank you.
Let me answer the first question. In terms of the impact of consolidation of Actoz, actually now you can see in our financial statement, in Shanda’s balance sheet, that we have an investment in equity securities, which is mainly composed of investment in Actoz, so after consolidation, these investments will disappear and instead the whole balance sheet and P&L will be consolidated into Shanda’s financials.
As I said before, as Actoz is mainly an R&D center, so the major cost incurred would be the R&D expenses. On the other hand, the labor cost in Korea is much higher than that in China, so what I can project is that the operating expenses after consolidation will increase. That is why we give a target of, a financial target that the operating margin will be no less than 35% in Q3. This is after consideration of this impact.
So in terms of the gross margin actually, Actoz will pay 70%, around 70% of license costs we make, so the gross margin of the license income from year two in Actoz is pretty high. I think after consolidation, this will help us to improve our gross margin. Thank you.
[inaudible] our focus on online game and again, Shanda is a gaming company and we have announced a funding project which we would like to leverage our existing cash to acquire exciting game titles. And we do have our criteria, which means number one, it has to be an online game studio and focusing on the online game development; secondly is commercialized with good performance and with a longer term growth potential; and thirdly, the company has to be profitable and with a strong cash flow. So that is our criteria.
(Operator Instructions) Our next question comes from John Chen from Owl Creek. Please go ahead.
John Chen - Owl Creek
I apologize if you guys have this -- if this question was asked before, but can you tell me what were the circumstances behind Daniel leaving as CFO?
Actually now, as you can see, Shanda reported a very amazing quarterly results in Q2 and I think it is maybe good timing for me to consider to leave Shanda and pursue my personal interests. That is I think the main reason at this point I consider to leave. Thank you.
Ladies and gentlemen, there appear to be no more questions at this time. I would like to turn the floor back over to our speakers for any closing comments.
Thank you, everyone. That concludes our formal remarks. Thank you again for joining us on the call.
Thank you, everyone. This concludes today’s conference call. You may disconnect your lines at this time and please have a wonderful day.
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