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Shanda Interactive Entertainment Ltd. (NASDAQ:SNDA)

Q4 2007 Earnings Call

February 25, 2008 8:00 pm ET

Executives

Maggie Yun Zhou – Manager, IR

Jun Tang - President, Director

Grace Wu - Chief Financial Officer

Tianqiao Chen - Chairman of the Board, Chief Executive Officer

Analysts

Dick Wei - JP Morgan

Andrey Glukhov - Brean Murray, Carret

Tony Gikas - Piper Jaffray

Alicia Yap - Citigroup

Analyst for Paul Cheung – Oppenheimer

Jenny Wu - Morgan Stanley

Kar Kuwong – Neeman & Co.

Analyst for C. Ming Zhao – SIG

Leah Hao - Goldman Sachs

Operator

Welcome to the Shanda Interactive Entertainment fourth quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Maggie Yun Zhou, Shanda's IR manager. Please proceed, ma'am.

Maggie Yun Zhou

Thank you. Good morning and good evening to all participants. On behalf of Shanda I would like to welcome everyone to our fourth quarter and full year '07 results conference call. Here with us today are Mr. Tianqiao Chen, our Chairman and CEO; Jun Tang, our President; and Ms. Grace Wu, our CFO.

Before we begin, I would also like to remind you that management's comments during the call will contain forward-looking statements that are based on our current expectations and are intended to qualify for the Safe Harbor from liability from such statements established in the U.S. Private Securities Litigation Reform Act of 1995.

All statements other than statements of historical fact during the conference call are forward-looking statements which are subject to significant risks and uncertainties. Actual results may differ materially from those contained in the forward-looking statements.

Please do take a minute to read the Safe Harbor statements in the press release. Now with that I would like to turn the call over to our President, Mr. Jun Tang.

Jun Tang

Thank you, Maggie and welcome everyone to the conference call. In Q4, we achieved another quarter of solid growth. Our consolidated net revenue grew 8.8% quarter over quarter and 51.8% year over year to a record $97.8 million exceeding our guidance of sequential growth of 4% to 7%. Online game revenues increased 8.6% quarter over quarter and 53% year over year to reach $94.3 million.

Net revenues from our MMORPG games rose 9.3% quarter over quarter and 59.4% year over year to $82.6 million with strong contributions of expansion packs from Mir II, Woool, The Age, and Feng Yun and the newly commercialized game called World Hegemory.

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In the four quarter, we also released expansion packs and also organized a lot of in-game events for the old existing titles and upcoming new games. Our MMORPG active paying accounts also posted a solid growth of 12.7% to 3.47 million, contributed by the higher conversion from players to paying customers for existing titles as well as the new users from DDO and World Hegemory.

ARPU for MMORPGs was down 3.1% quarter over quarter in Q4 to RMB 57.8, primarily due to the dilution caused by the relatively low ARPU from new APA. We expect to see ARPU from these new accounts increase over time.

We were especially pleased with the performance of our casual games business this quarter. Q4 is typically a seasonally slow quarter as students return to school. This was reflected in sequential declines in APA to 1.58 million from 1.82 million in Q3. However, revenues from casual games in Q4 rose 4.4% quarter over quarter and 19% year over year to $11.7 million as we diversified and enhanced our user portfolio and demographics. This growth resulted in a 20.6% increase in ARPU to RMB 18.1.

During the quarter, we released expansion packs and held promotions for each of our main casual games titles. In addition, we commercialized three new casual games: [Push Push] Online, Disney Magicboard Online, and Pop Land.

In addition to our current diversified portfolio for content, we have announced a strong pipeline of eight MMORPGs and six casual games for 2008 and beyond. For first quarter 2008 in particular, we expect to see new expansion packs and value-added service to support continued growth in our existing MMORPG titles. Expansion packs slated for launch in Q1 include packs for Mir II, Woool, The Age, Latale, RO, Archlord and FengYun Online. We also commenced closed beta testing of Changchun Online in mid-January, which attracted over 860,000 applicants for 10,000 limited accounts.

For casual games, in addition to planned promotions around the Chinese New Year holiday, we plan to commercialize X-Up, an Olympic-themed table tennis game developed at Actoz. We will also introduce expansion packs for Maple Story, BNB, Crazy Kart and the Tales Runner.

In January, Shanda was the biggest winner at the fourth annual China Game Industry Conference. We received a total of 16 awards, including the best game operator in China, where our Chief Executive Officer Mr Chen and myself were recognized as amongst the most influential figures in China's game industry. Awards from this conference are considered the most prestigious awards in China's online game industry and this level of recognition demonstrates Shanda's continued success in providing our users with high quality, rich content that deliver a fun and game experience.

In summary, our MMORPG games saw a significant expansion in the number of users, where our casual games business posted strong results in a seasonally slow quarter. Shanda is well positioned for future growth on the back of our diversified content portfolio, strong pipeline and integrated platform as the number one online game operator in China.

Now I will turn the call over to our CFO Grace Wu.

Grace Wu

Thank you, Jun and good day, everyone. I will now discuss our fourth quarter and full year 2007 financial results. Please note for discussion purposes, all numbers were translated into U.S. dollars based on an exchange rate of 7.3046 RMB per U.S. dollar.

As Jun has already talked about the total revenues on game revenue, I will start directly with other revenues, which were $3.5 million in this quarter, up 13.9% quarter over quarter and 25.5% year over year. The sequential increase in other revenue was primarily driven by [inaudible] revenue.

Gross profit was $65.6 million in the fourth quarter, compared to $62.7 million in the preceding quarter, and $40.5 million for the same period in 2006. Gross margins for the fourth quarter of 2007 was 67.1%, compared to 69.8% in the third quarter, and 2.9% a year ago.

Income from operations were $38.2 million, up 79.7% year over year and 8.1% quarter over quarter. Operating margin was 39.1% in Q4 '07. This compared with 39.3% in Q3 and 33% in Q4 '06. Product development expenses increased 10.3% quarter over quarter to $7.5 million, mainly due to increased to R&D-related compensation expense and R&D-related spending. Sales and marketing expenses decreased 15.4% sequentially to $7 million due to lower advertising and marketing expenses in the quarter. General and administrative expenses increased 5.2% quarter over quarter to $12.9 million, primarily attributed to share-based compensation and higher staff-related expenses. Share-based compensation was RMB 17 million which was about $2.3 million in the fourth quarter of 2007.

Net non-operating income for the fourth quarter was $5.1 million compared with $4 million in the third quarter of 2007 and $13 million in the fourth quarter of 2006. The year-over-year decline is mainly because of a one-time gain of $9.2 million recorded in Q4 '06 from the sale of SINA shares. Non-operating income from government financial incentives amounted to $1.9 million in Q4 '07 compared to $1.2 million in Q4 '06 and $2 million in Q3 '07.

Income tax expense for the fourth quarter of 2007 was $3.3 million compared to $6.6 million in Q3 and $1.4 million in Q4 '06. This QoQ decline was primarily due to the cessation of tax holidays for certain entities and the change in income tax rate pursuant to the new Chinese income tax law which went into effect as of January 1, 2008 in consideration of the future benefits expected to be realized. When the Chinese tax authorities finalized the regulations on the applicable requirements and procedures to apply for the preferential tax treatment, the expected future tax benefits from the deductible temporary differences as of December 31, 2007 might be adjusted based upon the future income tax rate applicable to certain PRC subsidiaries of the company.

As a result, net income in Q4 '07 was $40.1 million compared to net income of $32.9 million in Q4 '06 and $32.7 million in Q3 '07. Diluted earnings per ADS were $0.54 in Q4 compared to $0.44 in Q3 '07 and $0.46 in Q4 '06.

Non-GAAP net income, which excludes share-based compensation and the impact on disposal of SINA shares, increased 67.8% year over year and 22.1% quarter over quarter to $42.4 million in Q4 '07. Non-GAAP diluted earnings per ADS were $0.58 in Q4 '07 compared with $0.34 in Q4 '06 and $0.48 in Q3 '07.

The effective tax rate was 7.5% in Q4 '07 compared to 15.4% in Q3 and an adjusted effective tax rate of 5.2% in Q4 '06, excluding the one-time capital gains on the sale of SINA shares, which is non-taxable.

For the full year 2007, consolidated net revenues increased 49.1% year over year to $337.8 million. Non-game revenues increased 53.6% year over year to $324.6 million. Operating income increased 166.2% YoY to $137.7 million and operating margin was up from 22.8% in 2006 to 40.8% in 2007.

Net income for the full year 2007 was $191.1 million, representing an increase of 163.8% from 2006. Earnings per diluted ADS was $2.62 compared with $1 per diluted ADS in 2006. Non-GAAP net income was $141.3 million, an increase of 105.4% from the previous year. Non-GAAP earnings per diluted ADS was $1.94 compared with $0.96 for the full year 2006.

For the full year 2007, adjusted effective tax rate excluding the capital gain impacts on sales of SINA shares, was 11.8% compared with an adjusted effective tax rate of 7% in 2006.

Turning to our balance sheet, cash and cash equivalents totaled $271.9 million and $381.7 million including short-term investments and marketable securities. Our cash position decreased from $503.8 million at the end of Q3 '07 mainly due to the redemption of our $275 million worth of convertible notes, which was completed on November 15, 2007.

Deferred revenues decreased 2.1% quarter over quarter to $56 million, due to seasonality following the pre national holiday purchasing of prepaid cards for our distributors in the third quarter.

Before I turn to Q1 '08 guidance, we caution that we cannot predict the future exchange rate of RMB against the U.S. dollar and therefore cannot accurately with any degree of certainty estimate the fact of any change in exchange rates in our financial results.

Accordingly and given our financial targets we assume no change in exchange rates in Q1 '08 and have adopted a standard exchange rate as of December 31, 2007 which is 7.3046 RMB equals to 1 US dollar. Our actual results could differ, however, from our financial targets.

Now, based on current business outlook, we expect our consolidated net revenues for the first quarter 2008 to increase 62.9% quarter over quarter, while our operating margin for the fourth quarter to remain at a similar level compared to the fourth quarter 2007.

That concludes my financial discussion. I would now like to turn the call to our CEO Mr. Tianqiao Chen for his remarks to be followed by a Q&A session.

Tianqiao Chen

Thank you, Grace. Shanda closed the year 2007 with another very strong performance during our fourth quarter based on the successful implementation of our 3Cs strategy. The eighth consecutive quarter of growth since initiating our CSP model in late 2005 putting our compound growth rate at 11.1%, demonstrates the long-term feasibility and sustainability of our 3C strategy and the ability of our balanced portfolio business model.

At the same time, I'm also happy to see the increased recognition of our Shanda brand nationwide with Shanda, its management team and games receiving a total of 83 national industry-related awards in the year 2007.

Despite the snowstorm, our net revenue I expect to exceed a milestone of $100 million in the first quarter of '08, based on the guidance provided by Grace earlier. This is a testament to our successful strategy and execution in our 3Cs strategy: Content, Community and Commerce.

All our efforts and resources needed to transition our business model have been focused on our 3Cs strategy, which I have been highlighting for the past seven quarters. However, some analysts and investors still question how Shanda is able to sustain its remarkable growth without the full understanding of our 3C strategy. I am very happy to take this opportunity to once again communicate our long-term strategy.

First on Content, Shanda currently focuses on online games for its content strategy. Shanda currently operates the highest number of games simultaneously in China. We do not pursue the feature and blockbuster games strategy; instead we prefer a balanced portfolio approach of acquiring a diverse offering of games targeting a diverse user market.

Our pipeline of both announced and unannounced games consists of over 20 games over the next two or three years. This pipeline includes 3D and 2D MMORPG, casual games, martial arts games and sports games. In addition to in-house development and licensing, we also have pioneered a co-development and investment strategy as outlined in projections in our full year plan.

We believe we have covered all segments of the online games market with an emphasis this year on sports-related games in connection with the upcoming Olympics. We believe our track record in the past eight quarters of operating a diverse portfolio of games targeting a diverse user base validates our strategy.

Over the past couple of years we have dedicated significant resources to enhance our ability to operate multiple games simultaneously. We can now say the more games the better it is for Shanda.

Second on Community. Content attracts users, community retains users. Eventually, content and user communities will attract new users. We believe that online games foster ideal online communities where SMS and Web 2.0 are already reality. This is the reason why online games now enjoy the strongest user segment and highest monetization rates among all online games model. The only difference between the online games community and other virtual communities is that an online community lives primarily within a fictional game environment.

Shanda will approach transferring the online game communities into real life and integrate different online game communities. We are confident that the more content we produce, the stronger the community we will build. Shanda has been working relentlessly over the past five years and has established an integrated platform to facilitate the goal.

Though we are not yet prepared to disclose the execution plan at this time, we believe Shanda's community will have all of the advantages of the Web 2.0 community while allowing us to generate revenues and remain profitable.

Third on Commerce. Shanda’s independent ecommerce is built on the success of our online games. Our ecommerce system is unique in that transactions of virtual items solve or eliminate the logistics issues of delivery and inventory. Additionally, our ecommerce system is able to monitor the complete course of transaction, execution, consumption and user behaviors. Currently Shanda's ecommerce system includes product introduction, platform interface and distribution channel management.

One of the highlights in 2007 is that direct payment transactions account for 30% to 40% of our total revenues in addition to physical and virtual prepaid cards which minimize the negative impact on our business from events such as the recent snowstorm.

In addition, our announced in-game advertisement initiatives are part of the efforts to try and complement our commerce strategy. We expect meaningful contribution from this initiative in 2009.

Furthermore, Shanda has built up an extensive distribution network covering nearly 100,000 Internet cafes through our subsidiaries systems technology.

In summary, Content, Community and Commerce are the three pillars for the next phase of Shanda's growth. More content increases the fitness of the community and the ecommerce systems, which in turn attracts more content. Shanda will continue to focus on quality online games and other high quality content to strengthen our community and ecommerce systems.

Last, but not least, I would like to take this opportunity to extend our appreciation to all of our shareholders, business partners, board members and employees for their continued support and confidence in 2007.

That concludes my formal remarks. I would now like to turn the call back to Maggie.

Maggie Yun Zhou

Thank you Mr. Chen. We are now ready for questions. Operator, we can begin the Q&A session now.

Question-and-Answer Session

Operator

Your first question comes from Dick Wei - JP Morgan.

Dick Wei - JP Morgan

My question is on the longer term game licensing strategy. I believe Tianqiao Chen

was mentioning that the pipeline has more than 20 games for the next two to three years and I wondered, what are the limitations of licensing more games? Say 40 to 50 games in the next two or three years? Is it more of a capital constraint; 230 million of cash constrained or was it more of the operational constraint? Thanks.

Tianqiao Chen

[Translation not supplied] [break in audio]

Operator

Your next question comes from Andrey Glukhov - Brean Murray, Carret.

Andrey Glukhov - Brean Murray, Carret

Can you discuss what was the combined contribution from your top two games in the quarter?

Separately, could you please discuss the timing of Changchun, which I believe is your biggest title for the year? When do you expect to commercialize it? Thank you.

Jun Tang

Well let me just combine this question and answer all of them. To the first question, our strategy is to have more diversified games including broad-based type of games and also [inaudible] games into our portfolio. For example, over the last 12 months, we probably will have more than 10 games, and it's difficult to have each of them be successful, but we believe it's more difficult to have none of them be successful. That's our strategy. So that's why I try to maintain our revenue very stable. Our whole strategy is to try to reduce that to be a more stabilized business model which is stable growth, stable diversification strategy.

Secondly, to your question, we generally do not publicly have the particular numbers for each of the games but again, due to the fact that we have over 15 games in our operation each of the games will contribute. Some of them may probably be a very high contribution, but some of them may not be that high but again, we are moving to a very healthy, kind of diversification of our games.

In terms of the Changchun Online we had a closed beta testing, as I mentioned, we attracted over 600,000 applicants for only 10,000 accounts and the feedback was extremely positive. We are working to tune the game a little bit more and we hope we can have our open beta testing or commercializing in the next quarter or so. That's our plan.

Operator

Your next question comes from Tony Gikas - Piper Jaffray.

Tony Gikas - Piper Jaffray

Of the 20 games that you have in the pipeline, could you characterize how many of those will be licensed properties? How many of those will be developed internally by your development studios?

If you could also just outline where you stand today in terms of the games that you have launched already, how many of them are licensed and how many have been developed internally? If you could just remind us of those numbers please.

Jun Tang

In upcoming games if you look at the MMORPG games we have eight MMORPG games and four of them will be internally developed games including the majority ownership of the Actoz which are half of them and half of them will be licensed. If you look, our existing titles we're operating and the numbers involved are the same. So half of them are licensed and half of them are internally developed, and that's our strategy. Our strategy is to have two pipelines; one is internally developed and one is licensed and we try to balance in terms of the total numbers.

Tony Gikas - Piper Jaffray

And then in terms of the games that will be launching this year, will the mix be to positive gross margin or neutral?

Jun Tang

As I said, half of them will be internally developed; half of them will be licensed and it will continue to be the strategy so we're not going to see a significant change in terms of our margins.

Tony Gikas - Piper Jaffray

Could you give us an update on the tax rate that we should using for 2008?

Grace Wu

No, the new income tax law just got announced late last year and there was a subsequent explanation announced in early January. Again, before it gives detailed rules about how to apply and the procedures for the new tax preferential treatment, there is a statutory tax rate of 25%. However, based on our own assessment we believe that there is a very good likelihood we can still enjoy certain preferential treatment from the tax authorities.

So currently our estimated tax rate for 2008 would be somewhere between let's say 18% to 25%.

Operator

Your next question comes from Alicia Yap - Citigroup.

Alicia Yap - Citigroup

As we see across the board from all the online games companies, they all deliver very strong very revenue growth, driven by both increases in the number of gamers and also the ARPU in the fourth quarter. Do you think that this growth is sustainable and for how long? Or is there a risk of either saturating the market, namely the ARPU actually tops out or the competition actually results in a more winner-versus-loser landscape in the future?

Tianqiao Chen

Yes. If you look back at the last eight quarters we had a continuous eight sequential growth quarter over quarter even without adding many of the new titles. Again, it's proven our strategy to be very, very successful which is we're not just operating a game, we are operating a community. On that community we keep adding our expansion packs. That's our core competence of the company. We keep adding each quarter adding expansion packs. It's more like releasing a new game. If you look at today's game compared to last year or two years ago, the game itself has totally changed.

So I think we have the confidence to maintain that kind of change. As Grace has projected, next quarter we have a 7% to 10% sequential growth and this isn't a one-off example; we have that kind of confidence. We think our strategy has been proven over the last eight quarters and it will continue to do that as long as we do things right.

Alicia Yap - Citigroup

My question is more on the overall industry. Do you think that some of the winners may actually take shares from some of the losers or do you think the market is actually expanding?

Grace Wu

As you mentioned, the very impressive performance by all the industry during the fourth quarter of 2007, I believe it's very solid evidence to tell people how large the growth potential is for the whole industry. We never believed that it had to be a very highly competitive or very secular environment. We believe there is robust potential out there for every industry player to find it's own position and excel. That's why our Chairman, Mr. Chen, he mentioned that everyone should work together to enlarge the industry and help the industry to have healthy growth.

That's how we see this industry and that's how we position ourselves as the leader in this industry.

Alicia Yap - Citigroup

I see. That's very helpful. My second question is for Changchun Online, as you are preparing to start open beta testing soon what type of gamers are you anticipating in attracting? Will some of these players actually come from your own games, namely Mir II and World of Legends? Maybe you can help us understand that.

Jun Tang

Yes, from our last closed beta testing results, gamers are extremely positive about it's nature and it's agenda. If you look back at past experience, we haven't seen the cannibalization among the games once we release the new titles and we do not think that kind of penetration will happen on Changchun Online as well. We don't see cannibalization.

Our user stickiness is very, very strong even with others new game release we didn't see that kind of cannibalization either, so I think we are very positive. Again, as Grace mentioned earlier, the whole industry and the user base is so huge and people are still waiting for a lot of new titles. Around like 30% or 40% of the gamers are resting and shopping around so we're trying to attract that kind of user to come to our newly released titles.

Alicia Yap - Citigroup

For your longer-term plan, we heard that you might be interested in getting back to a set-top box strategy, similar to the EZ box strategy some time ago. If I remember correctly, a couple of quarters ago you also mentioned a bit about your soft console strategies. Can you comment whether you are still moving in that direction or whether you are still focusing more on the games?

Jun Tang

As Mr. Chen had mentioned earlier, our 3C strategy covers a lot of things. We try to make our entertainment content pushable to the PC, over the wireless sets and also the home set. We try to pick on these type of things and we never gave up on any of them and we will continue to pursue that kind of opportunity if the time and everything is ready.

Operator

Your next question comes from Paul Cheung - Oppenheimer.

Analyst for Paul Cheung - Oppenheimer

How big is your sales and marketing force and how big is your R&D team?

Grace Wu

We currently have probably about 700 people for our sales and marketing team, and on R&D –

Jun Tang

700 including the top sales and also the R&D people. So in general, if you look at the detailed numbers, I think as I mentioned earlier, around 700 at the time being, it will be changing, 700 to 800 people are R&D and of course mentioning the 700 including a lot of the not full-time sales, the marketing sales people. That's our primary numbers, and also we have lots of customer service people as well.

Analyst for Paul Cheung - Oppenheimer

Yes, between 700 and 800 including R&D and sales marketing?

Jun Tang

No, 700 is another 700 – 700 are the marketing people. That's including non-full-time, students kind of thing.

Analyst for Paul Cheung - Oppenheimer

About 700 to 800 R&D, right?

Jun Tang

Yes.

Grace Wu

In ’07 we probably had over 200 R&D engineers based in Korea under our subsidiary.

Analyst for Paul Cheung - Oppenheimer

Oh, I see what you mean. Okay, so plus 200, right? You said 700 or 800?

Grace Wu

That's why the number is confusing, sorry.

Analyst for Paul Cheung - Oppenheimer

What about local, like customer service people. How big is that team?

Jun Tang

We have around 300 customer service people based in Shanghai. Also we have a couple of hundred in other locations.

Analyst for Paul Cheung - Oppenheimer

Do you have that contracted, like sales people, and local people? Those people who actually go to the cafes?

Jun Tang

Yes, we call it the promotion people. As Grace said, we have 700, I think the majority of them are in promoting in the Internet cafes. That's what we call the contract people.

Analyst for Paul Cheung - Oppenheimer

Okay, so add together you would have 700 marketing; 1,000 all together, sales and marketing?

Jun Tang

No. When we call them sales and marketing, as Grace mentioned, it is about 700 people sales and marketing. 700 to 800 are R&D people, and also we have G&A and also operating people, you know is also a big chunk of our total headcount.

Analyst for Paul Cheung - Oppenheimer

Just now we said that sales and marketing does not include the 300 customer service and does that include that 700?

Jun Tang

No, those numbers are not included in the sales and marketing.

Analyst for Paul Cheung - Oppenheimer

How fast do you think you're going to be expanding these teams, both R&D and the sales force? Let's say in '08?

Jun Tang

As I mentioned, we are having several in-house developed games and we don't expect to have dramatic growth in terms of headcount. We may increase a little in this area but not in terms of the headcount itself, both R&D, sales and marketing and also customer service. So the headcount virtually will be flat.

Analyst for Paul Cheung - Oppenheimer

Also I heard the casual games sector rose pretty fast now. Do you think the casual game will grow faster in terms of revenue contribution than MMORPGs?

Jun Tang

If you look back at the last few quarters, casual games is a very seasonally factored type of a game. If you look at Q3 it was particularly strong and the other quarters may not be as strong as Q3. But seasonally, sometimes it will go faster than MMO, sometimes it will probably be lower than MMO but in general we think the growth rate should be similar to our overall revenue growth.

Analyst for Paul Cheung - Oppenheimer

What's the percentage of revenue is contributed by casual games now?

Grace Wu

In the fourth quarter '07 casual games account for about 12% of our revenue and for 2007 as a whole it's only about 13.4%.

Analyst for Paul Cheung - Oppenheimer

So in the future I bet it would remain in a similar range right?

Grace Wu

Right, the Changchun game itself, the business model is a little different from MMRO because we provide actually a very different entertainment exchange that helps us to target a different user base, so it's actually very, very important to us. We actually have more active user accounts in our casual games because we mentioned the ARPU may not be as high as MMOs however for our longer-term strategy this is a very important strategic area for our 3Cs strategy.

Operator

Your next question comes from Jenny Wu - Morgan Stanley.

Jenny Wu - Morgan Stanley

We see ARPU declined in fourth quarter due to the launch of the new games so in 2008 we would see more games to be launched. Are we going to expect a nice rebound for ARPU or we will see ARPU still to be under pressure in the coming quarters?

Jun Tang

Actually we are very happy about the last quarter's performance. You see we increased actual paying accounts in the double-digits and the ARPU was slightly down and as I mentioned it was primarily due to the dilution of the new active paying accounts. That kind of trend we're very excited about that because the whole pool is so huge if you look at the total user numbers and compare to the active paying accounts, only a few percent of that. So we do have great room to increase on the active paying account side.

On the other hand of the ARPU, if you look at our friends, their ARPU is over RMB 100 and we are sitting in RMB 57, RMB 58 kind of thing so we still have that kind of room to grow as well. So with new games coming up, sometime we may some of it flat in terms of ARPU, or slightly down, but as long as we can increase the active paying account number, that's something that we are extremely excited about and that's something we are pursuing, that kind of a trend.

Jenny Wu - Morgan Stanley

And my second question is regarding your gross margin. It declined in fourth quarter. What is the major reason? Please help us understand the future trend.

Grace Wu

The main reason the gross margin has a slight adjustment compared to third quarter is actually we accrue certain impairments provisions for one of our games, DDO, because the game, ever since we launched, the operation model it's actually different from what was earlier anticipated. Therefore, we took a prudent approach and tried to accrue certain provisions for it. That impacted gross margin in Q4 ’07. The related expense is actually categorized in other under cost of services.

Jenny Wu - Morgan Stanley

So going forward what's the trend?

Grace Wu

We guided for fourth quarter operating margin was 39.1% and we guided for 1Q '08 to have a similar rate of operating margin compared to 4Q '07.

Operator

Your next question comes from [Kar Kuwong – Neeman & Co.]

Kar Kuwong – Neeman & Co.

You mentioned that you've made certain provisions for DDO because of the business conditions change, and that was recorded in the other line. Do we expect to see a similar amount of expense in the other part of cost of services going forward?

Grace Wu

No. Pretty much most of the provisions have been accrued for DDO. So we don't expect to see the similar level of provision in 1Q '08.

Kar Kuwong – Neeman & Co.

The conversion rate for non-paying accounts and paying accounts I think it was 6% last quarter, what was it this quarter?

Jun Tang

Are you asking the total paying accounts number versus the total user base?

Kar Kuwong – Neeman & Co.

Yes.

Jun Tang

We had 17.3% in Q4, if you look at the last quarter of 6.7 so as I mentioned, we do have a lot of room to grow from last quarter '06, 6.7 and Q4 was 7.3 and we try to pursue higher conversion rate Again, we have a long way to go.

Kar Kuwong – Neeman & Co.

Also, can I get a rough idea of the contribution of the new games, such as from Feng Yun and Woool [inaudible] in this latest quarter?

Grace Wu

I'm sorry, we do not disclose individual game breakdowns.

Kar Kuwong – Neeman & Co.

Okay, that's fine. In terms of thinking about the ARPU for existing games, did you see continued growth in that number as to the decline that we saw in the overall?

Jun Tang

In terms of the existing titles, yes, we are seeing casual continued growth. But again, our strategy is try to grow the active paying accounts number. In the meantime, we try to grow the ARPU number as well, but we try to grow the active paying account number faster than the ARPU growth.

Kar Kuwong – Neeman & Co.

Okay, and for in-game advertising, could you talk about some of the trends you're seeing there and how we should expect it to play out over 2008?

Jun Tang

Actually in the last month we have publicly announced our team, our business model, our strategy and our partner, and also our amortizing customers as well. So I think everything has been kicked off last month and we should be able to see some of the revenue in over the quarters. So that's the current status. We're very happy and very excited about this new business.

Operator

Your next question comes from C. Ming Zhao – SIG.

Analyst for C. Ming Zhao – SIG

We have several questions. The first question is regarding the game pipeline. Shanda recently licensed a lot of MMOR games and casual games. Can you tell us when we should expect these titles to launch open beta? Specifically, which games are to be launched in the first half of this year and the new game [Ion], is it a free to play item-based game, too?

Jun Tang

Yes. As I mentioned, we're going to have eight in the MMORPG games; out of them one of them will be the first half, the rest will be the second half, in terms of MMORPG games.

Also, the business model will be our CSP model, which we have proven that kind of a model to be very successful, and we'll continue to do that.

In terms of the casual games, we will have [inaudible] in the first half and the rest of them will be the second half. That's the overall pipeline timeline. It may change.

Analyst for C. Ming Zhao – SIG

What is driving the revenue to grow in the fourth quarter? Does that include any in-game advertising revenues?

Grace Wu

In the fourth quarter, the major drivers are the MMORPG and the casual game growth. For advertising-related revenues, we report it under other revenues. For the other revenue category as a whole, advertising revenue is driving that growth.

Operator

Your next question comes from Leah Hao - Goldman Sachs.

Leah Hao - Goldman Sachs

I have a detailed question regarding your licensing fees in the cost of sales. I thought after the consolidation of Actoz’s share that the licensing fee might be stabilizing and I was just wondering, can you spell out the contribution of the licensing fee for this quarter and comment on the trend going forward please?

Grace Wu

As you mentioned, everything to [inaudible] Actoz the licensing fee will be relatively stable. It probably will be a good reference to estimate it based on a percentage of revenue. As you can see from third quarter or fourth quarter 2007 ongoing licensing fees as a percent of revenue are relatively similar.

Leah Hao - Goldman Sachs

Okay, so you would expect that trend to continue going forward, right?

Grace Wu

Yes.

Leah Hao - Goldman Sachs

What's the tax rate that we should be assuming for next year?

Grace Wu

Tax rate for 2008?

Leah Hao - Goldman Sachs

Yes.

Grace Wu

As we mentioned earlier, there's a new income tax law effective January 1, 2008 and before the detailed information is available, currently all corporations are required to report under the statutory tax rate of 25%. However, we’re still pretty comfortable that we will be able to apply certain tax preferential treatment once the detailed rules are available.

We provided an earlier estimate of a potential tax rate range of 18% to 25% at this moment, and we will update everyone when more information is available.

Operator

There are no further questions. I would now like to turn the presentation back to Ms. Maggie Zhou. Please proceed ma'am.

Maggie Yun Zhou

Thank you, everyone. Thanks for joining us today. That concludes our formal remarks. Have a good day.

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Source: Shanda Interactive Entertainment Ltd. Q4 2007 Earnings Call Transcript
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