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NetEase.com, Inc. (NASDAQ:NTES)

Q3 2007 Earnings Call

November 7, 2007 9:00 pm ET

Executives

Brandi Piacente - The Piacente Group

Michael Tong - Co-Chief Operating Officer, Director

Onward Choi - Acting Chief Financial Officer

William Ding - Chief Executive Officer, Director

Analysts

Richard Ji - Morgan Stanley

Wallace Cheung - Credit Suisse

Analyst for Paul Keung – CIBC

Dick Wei - JP Morgan

Analyst for Ming Zhao - SIG

Tony Gikas - Piper Jaffray

Alicia Yapp - Citi Investment Research

James Mitchell - Goldman Sachs

Evan Wilson - Pacific Crest

Tian Hou - C.E. Unterberg

Operator

Good evening, ladies and gentlemen. Thank you very much for standing by andwelcome to the NetEase third quarter financial results conference call. (Operator Instructions) At this time I wouldlike to turn the conference over to Brandi Piacente, Investor Relations forNetEase. Please go ahead ma’am.

Brandi Piacente

Thank you, operator. Please note that the discussions today will contain forward-lookingstatements relating to future performance of the company that we are intendingto qualify under the Safe Harborfrom liability as established by the USPrivate Securities Litigation Reform Act. Such statements are not guarantees offuture performance and are subject to certain risks, uncertainties, assumptionsand other factors. Some of these risks are beyond the company’s control andcould cause actual results to differ materially from those mentioned in today’spress release and this discussion.

A general discussion of the risk factors that could affectNetEase’s business and financial results is included in the certain filings ofthe company with the Securities and Exchange Commission, including its annualreport on Form 20-F. The company does not undertake any obligation to updatethis forward-looking information, except as required by law.

As a reminder this conference is being recorded. In addition, a webcast replay of thisconference call will be available on the NetEase corporate website atcorp.NetEase.com.

I will now turn the conference over to Michael Tong, co-Chief Operating Officer, who will read prepared remarks on behalf of Mr.William Ding, Chief Executive Officer of NetEase.

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Michael Tong

Thank you, Brandi. Thanks everyone for joining us. Total revenues for the third quarter were $76.2 million compared to $74.5million for the second quarter of 2007 and $76.3 million for the third quarterof 2006. Online game revenues were $62.5million for the third quarter compared to $63.4 million for the second quarterof 2007 and $62.4 million for the third quarter of 2006.

During the third quarter, we continued to expand ourresearch and development for new games, including fee-based and item-basedgames. Westward Journey Online III, theupgraded version of Westward Journey Online II, was commercialized on September12th. Based on the results of a market survey we conducted withgamers during the third quarter, we decided Westward Journey Online II would continueto operate along with Westward Journey Online III. We also plan to launch one and two expansionpacks for both games respectively on an annual basis. This will enable the company to develop a newgame market that will appeal to those players who prefer Westward JourneyOnline III. In addition, this willenable us to retain players of Westward Journey Online II, who have expressedtheir continuous support and preference on this game.

For the third quarter, PCUs (peak concurrent users) and ACUs(average concurrent users) for Westward Journey Online II were 305,000 and124,000 respectively, compared with 505,000 and 162,000 respectively for thesecond quarter. Our newest expansionpack for Fantasy Westward Journey was launched on September 25th andwe will continue to issue expansion packs and patches on a regular basis tosupport and expand the product life cycle of this game.

For the third quarter, PCUs and ACUs for Fantasy WestwardJourney were 1.44 million and 517,000 respectively, compared with 1.47 millionand 491,000 respectively for the second quarter. In other games, we are on track for ourupcoming closed beta testing for Tianxia II and we are continuing our developmentson free to play item-based games including Tianxia II and Fly for Fun.

Turning to our portal business, increased traffic fromportal, email, and blogs have provided an additional platform for generatingadvertising revenues. Our enhanced blog servicesincluded the consolidation of similar blog content as well as better qualityand quantity of graphics.

We are also pleased with our progress in creating andcommercializing new services through our free email services, which continuesto lead the Chinese e-mail markets. Overall we achieved solid growth in ouradvertising services during the third quarter, which brought in a total revenueof $11.4 million for the third quarter of 2007, compared to $8.7 million forthe second quarter of 2007, and $11.1 million for the third quarter of 2006.

We are committed to building our capacity and market sharein the high growth domestic markets, with improved content and integrating withour different products as the Beijing 2008 Olympic Games draw closer.

Finally, since our last quarter conference call, we have addedsignificant enhancements to our search engine. This includes more highlycompetitive features, such as tool bars, desktop pictionary, audio dictionaryand enhanced intelligence in returning search results based on diverse usersearch criteria.

With that, I would like to turn the call over to Onward Choifor his review of our third quarter financial results.

Onward Choi

Thank you, Michael. I will now provide an overview of ourfinancial highlights using numbers and percentages based on US dollars. In ordernot to repeat what has just been explained by Michael on the revenue side, Iwill focus on explaining margins and expense fluctuations along with netprofits.

Third quarter gross profit was $59 million, compared to $58.4million in the preceding quarter, and $59.8 million for the same period in2006. The quarter-over-quarter increase in gross profit was primarily due tohigh advertising services revenue in the third quarter of 2007. Theyear-over-year decrease was mainly due to the decrease in wireless value-addedservices revenue.

Gross margin for the online game business for the thirdquarter of 2007 was 89.4%, compared to 90.2% and 89.4% for the precedingquarter and the third quarter of 2006, respectively. The quarter-over-quarterdecrease was primarily due to lower game revenues resulting from increasedcompetition coupled with high cost of revenues. High cost of revenues wasmainly the result of increased headcount and high operational costs incurredduring the third quarter of 2007.

The year-over-year gross margin remained relatively stable.Gross margin for the advertising business for the third quarter of 2007 was 54%compared to 47.2% and 36.1% for the preceding quarter and the third quarter of2006 respectively. Thequarter-over-quarter increase in gross margin was primarily driven by theincrease in advertising services revenue coupled with a lesser extent ofincrease in content costs in the third quarter of 2007. The year-over-yeardecline in gross margin was primarily driven by increased content costsincurred during the third quarter of 2007.

Gross loss margin for the wireless value-added services andothers business for the third quarter of 2007 was 33.3%, compared to gross lossmargin of 28.1% and gross profit margin of 3.4% for the preceding quarter andthe third quarter of 2006, respectively. Both the quarter-over-quarter andyear-over-year deepening in gross loss margin was primarily due to decreasedrevenue from wireless value-added services while operating expenses remainedrelatively fixed.

Total operating expenses for the third quarter of 2007 were$23.9 million, compared to $19.1 million and $17.5 million for the precedingquarter and the third quarter of 2006, respectively. Both thequarter-over-quarter and year-over-year increase was primarily driven byincreased spending on the advertising and marketing promotion of WestwardJourney Online III and Fantasy Westward Journey, and higher staff-related costas a result of an increase in research and development headcount.

Net profit for the third quarter of 2007 totaled $34.7million, compared to $41.7 million $42.0 million for the preceding quarter andthe third quarter of 2006, respectively.

In June 2007, we received a reinvestment incentive taxrefund of $3.2 million, which significantly reduced the company's income taxexpense for the second quarter of 2007. We reported basic and diluted earningsper ADS of $0.28 and $0.27 for the third quarter of 2007, respectively. Thiscompares to basic and diluted earnings per ADS of $0.34 and $0.31 for thepreceding quarter and $0.33 and $0.30 for the third quarter of 2006,respectively.

As of September 30, 2007, our total cash andtime deposit balance was $410.9 million, compared to $525.6 million and $505.0million as of December 31, 2006and September 30, 2006,respectively.

In addition, there was a restricted cash balance of $100.1million as of September 30, 2007primarily related to the our committed revolving loan facility, which iseffective for a period from May 17, 2007 to July 31, 2008.The loan facility can be used at our discretion to fund any redemption requestsmade by the holders of its zero coupon convertible subordinated notes inaccordance with the terms of those notes. As of September 30, 2007,we reclassified the callable obligations of the convertible notes as short-termpayable in accordance with the terms of issue.

Cash flow generated from operating activities wasapproximately $45.3 million for the third quarter of 2007, compared to $44.2million and $46.0 million for the preceding quarter and the third quarter of2006, respectively.

On July 2, 2007,the board authorized a share repurchase program of up to $120 million of theNetEase’s outstanding ADS. As of September 30, 2007 we had spent in aggregate a total purchase considerationof approximately $30.8 million including transaction costs. The sharerepurchase program will end on July 1, 2008.

Thank you for your attention. We would now be happy to takeyour questions. Operator, please go ahead.

Question-and-AnswerSession

Operator

(Operator Instructions) Our first question comes fromRichard Ji - Morgan Stanley.

Richard Ji - MorganStanley

I have two questions. Starting with your Westward Journey II migration, at the end of lastquarter you guided us that you planned to migrate Westward Journey II toWestward Journey III. I just want to clarify that the migration willno longer happen and your latest status.

Also relating to the question is that during the quarterhave you seen Westward Journey II user volume stabilize or recover after youstopped the migration process?

Michael Tong

What happened is when we launched Westward Journey III webelieved that with the new features and the new graphics and engines that wewould be able to draw a lot of the uses from Westward Journey II and migrateall of them to Westward Journey III. Butit happens that Westward Journey II players are so loyal to the game that evenwith the new features and all these new graphics that the Westward Journey IIplayers continue to like to stay in Westward Journey II and the majority of thosegamers stay in Westward Journey II.

Effectively, what happened is we actually draw a lot of newusers into Westward Journey III rather than from migrating from WestwardJourney II. As we said in the scriptthat we have done a lot of surveys to see what happens, how the players thinkabout the games and most of the Westward Journey II players, even with the newengine and the new features they still decided to stay on the Westward JourneyII.

There is a slight drop with the Westward Journey II playerswhen Westward Journey III was in open beta that drop has been stabilized rightnow and within the Westward Journey III players we have found that majority,over 50% of the accounts are newly opened accounts, rather than WestwardJourney II players.

Richard Ji - MorganStanley

Regarding advertising revenue, indeed it climbed nicelyquarter over quarter and I just want to find out, what is the price increase thathappened during the quarter? Going forward, do you see further price increase inanticipation of the Olympics?

Onward Choi

Well of course our price increase is effective on the firstof July basically the beginning of this quarter. The price increase is very complicated. On an overall basis, I would say the priceincrease is around 10% compared to before. But that is not really the main reason for the increase in advertisingbusiness. It really is the increase ofour traffic, especially on the content channels and our other productsincluding the email and the blogs. Most of that we are able to commercializethe email better than before.

I would say these are really the reasons for the increaserather than purely for the price increase. Our policy has always been that we increase our price during the middleof the year and the beginning of the year. So the next price increase is going to be in January of 2008, and ofcourse most likely during the Olympic time then there will be another price increasewhich happens to be just the right time where we usually do it with our policy,that happens on first of July.

That’s the plan, but the price in the market is alsoswinging up because of the Olympics. Wemight actually change the policy next year and see what happens in the market.

Operator

Your next question comes from Wallace Cheung - CreditSuisse.

Wallace Cheung -Credit Suisse

A question on the Westward Journey III. I think we found thatin September before the commercial launch, I think that whole user base ispretty high and then after commercial launch the PCU, it actually was downquite a bit. Can you talk a bit moreabout this, the situation after the commercial launch? Any plans to drive theuser levels up again?

My second question will be related to the advertising. Canyou talk a little bit more also about 2008 Olympics? I think recently William had talked aboutstrategies and what the expectation on the advertising growth on any kind ofnew content strategies going forward? Thank you.

Michael Tong

For Westward Journey III, during the open beta of WestwardJourney III I think we saw the PCU of a bit over 210,000 during the open beta andafter the commercialization of it the PCU of the game reached about 150,000 andthat actually happens around the national holiday, but I can only give you thePCU numbers, and I wasn’t able to give you the ACU numbers because the game onlyhas been commercialized for 18 days during the past quarter. I’mnot able to give you 18-day numbers for a non-reported financial period. That’s the flavor for the Westward JourneyIII, anyway.

The second question, is on the Olympics. The main point for the Olympic is that forthe content strategy we have been working with different business partnersincluding the likes of Reuters and so on. Also we are consolidating our different products including the email, blogs,and different content channels to really have an integrated and consolidatedproducts where we can allow our users to be involved in the Olympics on all ofour products, so that they can experience our products, all of them, throughthe Olympics.

I think it’s a very great opportunity for us to promoteNetEase as a portal with a good breadth of all the products where the users canexperience it in one single portal. I think on the advertising side, of course duringthe Olympics a lot of the advertisers will be very interested to ride on thisopportunity. We have just had a pressrelease to explain our strategy for the portal during the Olympic time and alot of the media has covered that, and a lot of them are very excited about itand so are we.

Wallace Cheung -Credit Suisse

How is the percentage of revenue, online game revenue, comingfrom Westward Journey III in the third quarter?

Onward Choi

I will take these questions, Wallace. We’ve gone through the distribution of therevenue from the game side. Basicallythe Fantasy Westward Journey contributed about [78]% of the total revenuesarising from the online games, whereas about [90]% being contributed from the WestwardJourney II and the rest for the Westward Journey III.

Wallace Cheung -Credit Suisse

Oh, the rest is Westward Journey III?

Onward Choi

Yes. It’s actuallycontributed to about 1.5% on the overall games revenue for the third quarter.

Wallace Cheung -Credit Suisse

Can you comment on Datang as well?

Onward Choi

For Datang, the percentage contribution is more or less thesame as Westward III. It is about 1.3%.

Operator

Thank you for you question, sir. Your next question comes from Dick Wei with JPMorgan. Please go ahead with yourquestion sir.

Mr. Dick Wei, please go ahead with your question.

He must have stepped out. Our next question come from theline of Paul Keung with CIBC. Please go ahead with your question.

Brandi Piacente

Operator, it seems that we are having some audio issues, itdoesn’t sound like it’s on our end. So maybe if you can check?

Operator

I’m sorry. Please go ahead.

Analyst for PaulKeung – CIBC

I just have a question on your general strategy. Except Datang and Tianxia II do you have anynew game development plan either from M&A licensing or from your in-housedevelopment?

Michael Tong

On the licensing we have been talking to a lot of differentpotential partners, but again right now we don’t have anything that we are ableto disclose. All I can say is that we have been working very hard to findbusiness partners for the possibility of licensing games and so on.

Analyst for PaulKeung – CIBC

If any plan is on the way, would it be on ’08 so we can knowbetter? What’s the timeframe of you willhave a plan you can announce?

Michael Tong

We don’t know. It’sonly when we can announce then we will announce, then we will tell you, butwhen we cannot announce...

Analyst for PaulKeung – CIBC

I understand, I just want to ask from more of a growthstrategy... Also wireless value-addedservice, seeing as it is not profitable, are you going or get rid of it in thefuture?

Michael Tong

I think with regard to our segments of the business, I thinkwe currently have no plan of closing this segment and we are still keepingexpertise and this is what we can update you for the time being.

Onward Choi

The business itself is profitable. When you see the grossloss margin in that particular business line of revenue and business, it isactually wireless and other. That otheractually includes a lot of depreciation costs of the email services that weprovide as a free business so that is in the other. Independently, the wirelessbusiness itself is actually profitable.

Analyst for PaulKeung – CIBC

That’s great. Also, what’sthe process right now on the CFO search in process?

Michael Tong

Onward is our Acting CFO right now, and I think it’s up to theboard to decide, is it Onward to continue to be the Acting CFO or become theCFO?

Analyst for PaulKeung – CIBC

In the future in all those expenses as a percentage of revenue,would you expect if there’s no new games added, just like the current status, wouldyou expect them to be stable? Includingmargins.

Michael Tong

All I can say is I will give you a very simple analysis on this,is that Fantasy Westward Journey III actually increased it’s revenue by 4.3% ona quarter-to-quarter basis. So on anoverall basis, I would say that this game itself is still on an increasingtrend. Of course, given that we havedone a very successful summer promotion during the third quarter and that is alsopart of the increase and also seasonally is part of the increase, but overall,the game increased by 4.3% from Q3 over Q2.

When we look at Westward Journey II or Westward Journey IIIaltogether, given that Westward Journey III only upgraded for 18 days duringthe third quarter and if I use the word “quarterize” that revenue contributedduring the third quarter, then I would say then at least Westward Journey IIIand II added together is very stabilized compared to the total revenue ofWestward Journey II in Q2.

Also we have, of course, Datang and some other popogames andso on. So I think I would say that the game business is stabilized and there isa bit of good and bad. The good is sincewe have decided that we separate Westward Journey II and Westward Journey IIIinto two games we are looking forward to be able to attract more new users forWestward Journey III and the game design will go on to try to attract newusers. Whereas for Westward Journey II,we will try to design the games satisfy all the current users of WestwardJourney II. It is a very clear strategygoing forward.

In this way, I think Westward Journey III will be a gamethat we are trying to grow further rather than maybe some of the investors andanalysts may understand before that Westward Journey III is only a replacementof Westward Journey II; but it is not, because now we have decided thatWestward Journey III is trying to grow and trying to attract new users.

So that’s the game business, and obviously we are alsolooking at the possibility of licensing new games and we are also developingother new games as well. So that’s how Iwould describe our games business going forward.

Operator

Your next question comes from Dick Wei - JP Morgan.

Dick Wei - JP Morgan

Can you characterize what happened in the third quarter forWestward Journey II? It looks like theACU was down 20% plus quarter over quarter and I don’t know if it is due tosome users trying out Westward Journey III. But some comments that you have is thatthe users are not really overlapping. Canyou describe that?

Michael Tong

I think on explaining the drop in Westward Journey II isthat during the open beta of Westward Journey III a lot of the Westward JourneyII players decided to trial Westward Journey III during this one-month periodof time, and that’s why there is a decrease of ACUs in Westward Journey II.

I would say that since we have now decided and announced toall the players that the two games will be totally separate and there willcontinue to be expansion packs and further development for Westward Journey IIthat we are seeing that the decrease has been stabilized for Westward JourneyII. That’s how we feel about it right now.

Dick Wei - JP Morgan

So going forward, would you feel that Westward Journey IIplus Westward Journey III together will see revenue growth for the next coupleof quarters?

Michael Tong

That’s our target.

Dick Wei - JP Morgan

I don’t know if someone asked about sales and marketingexpenses, but fundamentally is there any change in philosophy in terms of NTES’marketing spending? I think historically the company has been quiteconservative in spending against some other games companies out there now.Maybe you are spending 12% or 20% of the top line in sales and marketing, Idon’t know. Any fundamental change in your view in that respect?

Michael Tong

I would say there is no change in the philosophy. I wouldsay yes, during the third quarter that we see an increase in the marketingexpense. That is purely because for one that we have launched on the WestwardJourney III, and at the same time we also have done some summer promotions forthe Fantasy Westward Journey, so there is a hike in the marketing expense.

But our general philosophy has never changed, and we’llcontinue to as you mentioned, we are more conservative in marketing expense,and we will continue to be very conservative. I think that this hike is partlyan exceptional expense. That is purely because of the launch of the WestwardJourney III, and so that’s the reason why.

Dick Wei - JP Morgan

You mentioned you see more monetization from your emailservice. Could you further describe that, please?

Michael Tong

Sure. On the e-mail service, I think one of the hardestthings is email in the media has been very difficult for the advertisers tounderstand before. We have been doing a lot of education to our agencies and tothe advertisers, and this seems to bear some fruits right now.

Secondly, we have also developed more spaces and in the emailservices. Innovative services where we forexample, that we put customized stock lists right beside the email landing pagewhere the users can choose the stocks that they monitor or they purchase andprovide financial information, which is obviously very hot in China right now. So that becomes some spaces where we are ableto provide to the users and which the users are satisfied and happy with, butat the same time we are able to generate more advertising revenue.

So the strategy really is not just to pick a space withinthe email page, but rather to provide more services and content to the emailusers and at the same time increase our advertising space for that.

Operator

Your next question comes from Ming Zhao - SIG.

Analyst for Ming Zhao- SIG

As you mentioned, you launched new advertisements to placeinventory in your free email services, so in your third quarter advertisingrevenue, how much was contributed by this new inventory?

Michael Tong

I don’t have the particular statistics on that, especiallybecause it is hard to calculate this way because you know a lot advertisementsare placed as a package and because of this inventory we are able to draw somenew advertisers, especially including those financial institutions and fundcompanies.

We are able to use that particular inventory to draw a lotof new advertisers from that financial industry and the particular place thatthey put the advertising includes that inventory, but also includes some otherinventory as well.

It would be not fair to just say how much that we generatedfrom that one space, but rather how this one space will be able attract newadvertisers, especially from the financial industry and so that’s how I’llanswer it.

Analyst for Ming Zhao- Susquehanna

After you postponed the conversion between Westward Journey IIand III we saw both games resumegrowth. So will you operate them as twoseparate games going forward? Or youwill convert these two games and if so, when?

Michael Tong

We will operate the two games separately. This is what the users want and like.

Analyst for Ming Zhao- Susquehanna

When do you plan to launch closed beta testing and open betatesting for Tianxia R and Datang?

William Ding

We have plans to launch our closed beta testing of Tianxia Rin the first quarter of 2008. This isour plan.

Analyst for Ming Zhao- Susquehanna

I’m asking for Datang. How about Datang?

Michael Tong

For Datang it’s before the end of the second quarter of nextyear.

Operator

Your next question comes from Tony Gikas - PiperJaffray.

Tony Gikas - Piper Jaffray

I justwant to go back to the sales and marketing costs. So you ran some promotions during thequarter. Is that going to continue intothe December quarter at all, or will the sales and marketing expense go back toa normalized level?

Can you tell us the percentage of users that migrated fromWestward Journey II over to Westward Journey III?

With the Olympics coming next year do you expect user trendson the gaming side of the business to change? Do you expect any slow down or interruptions in that business?

Michael Tong

On the first question, is again, the marketing expense ispurely on the launch of Westward Journey III. So I would expect going forward it the overall marketing expense shouldbe lower than the third quarter and it would go to normalized, more or lesslike before. So that’s theexpectation.

For the second question for the Westward Journey III players-- actually I explained this before -- that we see around 60% of them are newusers. Of course 40%, is from users thatmigrated from Westward Journey II. Sothat’s the percentage out of Westward Journey IIII players. I hope that answers your question.

The next question is on the Olympics. I don’t know how toestimate that but I think the best thing that we are thinking about and what weare doing on that is that obviously we will have Olympic-related game play ordesign within our games so that our gamers will continue to play in our gamesand be able to also enjoy the Olympics and also be able to ride on this Olympicsand to have games just like Olympic games that we have those kind ofpersonality and play features within our games so that they can enjoy both atthe same time, within our games. Sothat’s the simplest strategy to do it.

Operator

Your next question comes from Alicia Yapp - Citi InvestmentResearch.

Alicia Yapp - CitiInvestment Research

I have a couple questions. First of all on the sales andmarketing costs, do you plan to also boost up your marketing cost when youlaunch your Tianxia II and Datang II later or any other expansion pack on WestwardJourney III and Fantasy Westward Journey as well?

Michael Tong

I think that the marketing costs going forward for thelaunch of the expansion pack and other new games would be basically compared tothe previous way of how we do it, and so that I won’t say there will be anykind of specific boost; it would be thenormal way of doing our marketing.

Alicia Yapp - CitiInvestment Research

So you plan to launch Tianxia II closed beta in the firstquarter ‘08. What is the plan for thecommercial launch and do you have any plans to convert Tianxia to actually afree-to-play model?

Michael Tong

The current plan for Tianxia II continues to be a time-basedgame and then again in general we are able to commercialize a game after aroundtwo months after the open beta launch.

Alicia Yapp - CitiInvestment Research

Can you comment in general on the Chinaonline games industries? Have you seen any change in the competitive landscape,or do you expect to see a major shift of competitive forces in light of therecent online games IPO? Thank you.

Michael Tong

Well in commenting on the Chinese game industry is thatwhile we continue to see the overall growth of the industry being very healthy,we see a lot of new users coming into the industry. We see broadbandpenetration continuing to increase and overall Internet penetration continuingto increase. Obviously there has been a lot more competition in the gameindustry, and we see new companies being IPO’d during the past quarter. We sawat least three during the past half year.

Obviously that’s continuing a trend of more and moreitem-based games rather than pay-to-play games, and that’s why we also haveitem-based games coming out from ourselves, the like of Fly for Fun and thelike of Datang. Of course, for NetEase we continue to be very strong in termsof the research and development and we have a very good team and a very hugeteam in developing different projects to compete in this market.

Operator

Your next question comes from James Mitchell - GoldmanSachs.

James Mitchell -Goldman Sachs

Well thank you for taking my questions, which are kind ofhousekeeping questions. First, if I look at the user numbers you disclosed forFantasy Westward Journey and Westward Journey II, it seems to be up around 2%quarter on quarter, whereas the game revenue is down around 1% quarter on quarter.Is there anything underlying that in terms of distribution discounts or is justa rounding error?

Secondly, if I look at the game gross margins ticking downquarter on quarter, is that principally because you have released a new game orgoing forward if you have similar revenue from basically three large gamesrather than from two large games, would that automatically be a slightly lowergross margin activity publishing three games with the same revenue than twogames with similar revenue? Thank you.

Onward Choi

For the first question I think there has not been much changein our discount policy for the sales of the point cards. The decrease inrevenues for the games business as compared in terms of the percent change, I can say that the main difference from therecognition of these expired points contributes to the decrease.

As for the second question about the gross margins, I thinkthe slight drop in the gross margin as compared with the last quarter’s wasmainly because we have increased more of our headcount to strengthen our teamsto run the business, and this accounts for the reason for the decrease in thegross margins.

James Mitchell -Goldman Sachs

So in the second quarter you have a slightly higher of proportionof revenue from expired points and in the third quarter you had a slightlylower proportion of that?

Michael Tong

Yes.

Operator

Your next question comes from Evan Wilson - PacificCrest.

Evan Wilson - PacificCrest

Could you help us quantify the extra costs that you expectto incur by being forced to operate both Westward Journey II and Online JourneyIII?

Specifically, do you get any synergies between the gameswith respect to marketing support, infrastructure costs, etcetera?

The second question would be on Fantasy Westward Journey,since you decided to release Westward Journey III as an item-based game,clearly you think that for some games an item-based sales model is the rightstrategy. Could you talk to us aboutwhat would need to change or what your perspective is of the potential ofFantasy Westward Journey being item-based sometime in the future? Thanks.

Michael Tong

You actually have a very good question. When we decided to have the two games totallyseparate and operated separately, we also have thought about the question ofdividing the teams into two and luckily we have a very good pool of goodprogrammers and designers. So basically we are able to promote a senior programmer tohead the game going forward for Westward Journey II, and then the original chiefdesigner for the whole project becomes the Westward Journey III. They continue to work on the Westward JourneyIII.

So that’s basically what we did. Of course, we continue to have a pool of goodresources. So I think on the programmingside and on the graphics side, it’s easier for us to allocate. It’s really the design team that we reallyhave thought about and believe that we will still be able to solve this problem,which is a very big operational problem.

On the second point is that we don’t have any plan to makeFantasy Westward Journey to become an item-based game, so simply that.

Evan Wilson - PacificCrest

Just a follow-up on the first response. Is there any way that you could give us apercentage, some type of percentage quantification on the costs associated withoperating the second game on top of your existing costs? Or your previous costsfor Westward Journey II?

Michael Tong

I’m sorry, I can’t. Ican’t give you a percentage because we have our programmers, graphics designersand R&D team in one single pool so it would very hard to decide that, butthat is really again, it’s not the problem. The problem is really on the design team. Are we able to find the right design team tocontinue to operate the two games separately? The answer is that we decided and we have fixed that and basicallysolved the problem.

Operator

Your next question comes from Tian Hou - C.E.Unterberg.

Tian Hou - C.E.Unterberg

I just wondered if you have any expansion pack releaseplans? Is it in Q4 or Q1? I knowyou just released one for Fantasy Westward Journey, and how about for WestwardJourney II and III?

Michael Tong

So for Fantasy Westward Journey there will not be any newexpansion pack for Q1, because we have just released one in the end ofSeptember. So the next one should bearound six months later, most likely to at the beginning of the second quarter.

William Ding

For Westward Journey II, I think that would be maybe one thatwe would plan in the second quarter of 2008.

Tian Hou - C.E.Unterberg

So how about Westward Journey III?

Michael Tong

That would most likely be in the same quarter as well, Ithink.

Tian Hou - C.E.Unterberg

I saw from your website you have some server changes likeWestward Journey III server migration; and then also Fantasy Westward Journeyyou have some announcements that you may merge some servers. So, my question is really, how do many serversdo you have for each of games right now?

Michael Tong

Sorry, I don’t have this particular number right now, and,can I give you it by email?

Tian Hou - C.E.Unterberg

Yes, no problem.

Operator

At this time, there are no further questions. Please go ahead with your concludingstatements.

Brandi Piacente

Thank you once again for joining us today. Please feel free to contact us if you havefurther questions.

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