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Giant Interactive Group Inc. (NYSE:GA)

Q2 2012 Earnings Call

August 6, 2012 9:00 PM ET

Executives

Richard Chiang – IR

Jazy Zhang – CFO

Wei Liu – President

Xuefeng Ji – VP, R&D

Analysts

Timothy Chan – Morgan Stanley

Tom Chong – BOCI

Eddie Leung – Merrill Lynch

Steve Zhang – Macquarie

Mark Marostica – Piper Jaffray

Ruby Zhang – Nomura Securities

Atul Bagga – Lazard Capital

Martin Bao – CICC

Wendy Huang – CIFB

Adam Krejcik – ROTH Capital Partners

Andy Yeung – Oppenheimer

William Huang – Barclays

Wallace Cheung – Credit Suisse

Jia Long Shi – CLSA

Operator

Good morning and good evening, ladies and gentlemen. I would like to welcome everyone to the Giant Interactive Group’s Second Quarter 2012 Earnings Conference Call. I must advice that this conference is being recorded today, Tuesday, the 7th August, 2012. After the presentation, there will be a questions-and-answer session. Please follow the instructions given at that time, if you would like to ask a question.

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

Richard Chiang

Good morning, ladies and gentlemen. Welcome to the Second Quarter 2012 Earnings Conference call for Giant Interactive Group. With me today are Ms. Wei Liu, President; Ms. Jazy Zhang, Chief Financial Officer; and Mr. Xuefeng Ji, Vice President of Research and Development.

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

Before we continue, I would like to remind you that statements on this call that are not strictly historical in nature constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and as defined in the Private Securities Litigation Reform Act of 1995.

These forward-looking statements can be identified by terminologies such as will, expects, anticipates, future, intend, plans, beliefs, estimates and similar statements, and among others, include statements regarding the ability of the company to cooperate with online platforms in addition to Qihoo 360, the sustained progress and performance of ZT Online 2 after the launch of its first expansion pack and the Micro-Client version, the sustained growth and diversity of the company’s user base asset launch and the testing of pipeline games, the capacity of World of Xianxia to become another blockbuster MMORPG of the company, the ability of the company to capture new growth opportunities in domestic and international online game markets as it implements of the company strategy in connection with web games, the company’s moderate sequential growth in the third quarter of 2012 and a time table for testing and release of new games and expansion packs in the company’s game pipeline.

These forward-looking statements are not historical facts, but are instead represent only our belief regarding future events, many of which by their nature are inherently uncertain and outside of our control. Our actual results and financial condition and other circumstances may differ possibly materially from the results, anticipated results and financial conditions indicated in these forward-looking statements.

Among the factors that could cause our actual results to differ from what we currently anticipate may include a deterioration in the performance of ZT Online 1 series, failure of ZT Online 2 to grow as expected, unexpected delays in developing expansion packs or in the timetable for testing and launching our gains, our dependence on ZT Online 1 series and ZT Online 2, which currently account for the majority of our historical net revenues, failure of our web games and our first FPS game to grow as successful as expected, our uncertainties with respect to the PRC legal and regulatory environments and the volatility of the markets in which we operate.

Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results of Giant to be materially different from historical results or from any results expressed and implied by such forward-looking statements. These factors include but are not limited to risk discussed in filings with the Securities and Exchange Commission including our annual report on Form 20-F filed on April 23, 2012.

All forward-looking statements are qualified by this cautionary statement, and Giant undertakes no obligation to revise or update this information to reflect events or circumstances after today.

In addition, please note that references in the presentation to dollars refer to U.S. dollars.

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

Jazy Zhang

Thank you, Rich. Good morning to those of you in Asia and good evening to those of you in the West. I will first read the prepared remarks from our President, Ms. Wei Liu, and then I will walk you through our financial highlights and update you on our game development progress.

We are pleased to report that our strong start in 2012 has continued to gain momentum this quarter with continuous sequential growth in both our top and bottom line, which was mainly driven by sustained performance from ZT Online 2. We’re also pleased that the successful release of ZT Online 2 first expansion pack has led the game to new heights and as a result we continue to see an improvement in both active paying accounts and average revenue per user this quarter.

We also made a breakthrough in terms of game offering through our collaboration with Qihoo 360 to launch the Micro-Client version of ZT Online 2 changing online on Qihoo 360 platform. This Micro-Client version provides opportunities for less (inaudible) to experience the core element of ZT Online 2 through a much smaller installation game file. Our collaboration with Qihoo 360 will enable us to tap into its large and diverse user base, which will provide us with opportunities to draw new gamers to our titles. Going beyond this collaboration, we look forward to forming more business partnerships and strategic alliances with online platforms in China in the future.

In the second half of 2012, we have a pipeline of highly anticipated releases to provide our next phase of growth.

Allods Online is licensed from Russia’s Mail.Ru and will be our first western-themed MMO. With beautiful 3D graphics and deep gameplay, it should complement our existing portfolio very well beginning the third quarter. The game will also help us further build our experience in publishing foreign games in China presenting additional future growth opportunities.

World of Xianxia is our next internally developed MMORPG. It will have incredible 3D graphics and a Chinese fantasy theme. With ZT Online 2, we have proven that we can stay one step ahead of our competitors even in the current competitive MMOs landscape. World of Xianxia will be our next innovation in the MMO space. We have pioneered group versus group gameplay and revolutionized the social structure within an MMORPG to create another groundbreaking game following ZT Online 2’s blockbuster success.

The game is expected to help us innovate path to MMO competition once again when it is launched in the fourth quarter. Our first FPS game, Glorious Mission is also expected to begin engineering tests in the fourth quarter 2012. We will go through our game pipeline in detail later during the call. While our core competencies remain in MMORPG development, we are always looking to diversify our game development pipeline. In recent years, webgames have become very popular in China as they require no file download and are easy to play. The domestic webgame market is expected to continue to grow rapidly.

To capture the new growth opportunity, we have placed our strategic focus on webgame development since the beginning of this year. Additionally, we believe webgames will enable us to broaden our reach to overseas online game markets and we have built our infrastructure with this in mind. While our webgame design teams are working at full speed, our game operation and business development teams are working hard to source domestic and foreign partners to publish our growing pipeline of webgames. Three of our webgames Genesis of the Empire, the Sky and Marine Tycoon are expected to be launched in the second half of this year. To conclude, our commitment in bringing the best possible experience to gamers remains unchanged.

Over the years, we have built an impressive track record in developing and operating quality MMORPGs and we are now keen to replicate this success in webgames. We’re extending our offerings to a broader audience through micro client versions of our games and are keen to develop partnerships, both domestic and overseas, to extend to our reach to a larger and more diverse user base. We believe our focus on overseas market expansion and the formulation of strategic partnerships places us in a great position to achieve sustained medium to long-term growth.

This concludes the opening remarks from President Liu and I’ll now walk you through our key operational metrics and financials for the second quarter. Please refer to slide 8 of our presentation. As you can see, all operational metrics continue to grow steadily. Our total active accounting – total active paying accounts or APA were up 1.4% sequentially and 11.1% year-over-year to $2.2 billion in the second quarter 2012. Average Revenue Per User, or ARPU, was RMB233 in the second quarter, up 1.9% sequentially and up 9.7% year-over-year. Average Concurring Users, or ACU, were 685,000, up 0.5% sequentially and up 4.7% year-over-year. Lastly, our Peak Concurring Users, or PCU, were up 0.9% sequentially and up 8.7% year-over-year to $2.3 million in the second quarter of 2012.

The improvement in operating metrics was mainly driven by the continued success of ZT Online 2, especially after the launch of its first expansion pack this quarter. The sequential rise in APA demonstrated our ability to convert new ZT Online 2 users to paying users. In addition, as leaders progress through the game, they gradually spend more in the game. With the launch of our micro-client version, we are confident that ZT Online 2 can reach new heights.

The healthy performance of our core portfolio contributed to our positive financial performance for the quarter, which is illustrated on slide 9 and 10 of presentation. Net revenue for the quarter was $83.1 million, up 3.8% sequentially and up 21.1% year-over-year. Our core business, online game revenue grew 3.4% sequentially and 22.4% year-over-year to $79.6 million. Gross revenue for the quarter was $72.6 million, up 4.5% sequentially and up 23.7% year-over-year. Gross margin was 87.3% in the second quarter 2012 compared to 86.7% in the previous quarter and 85.5% in the second quarter 2011.

Total operating expenses for the quarter were up 7.3% sequentially and up 13.9% year-over-year to $21 million. As a percentage of revenue, total operating expenses were 25.2% for the second quarter 2012 compared to 24.4% in the first quarter 2012 and 26.8% in the second quarter 2011. The sequential increase was mainly due to the increase in marketing campaigns for the launch of the experts’ expansion pack of ZT Online 2 in the second quarter 2012.

R&D expenses for the quarter were up 9.4% sequentially and up 35.5% year-over-year to $12.7 million. As a percentage of revenue, R&D expenses were 15.3% in the second quarter 2012 compared to 14.5% in the first quarter 2012 and 13.6% in the second quarter 2011. The sequential increase was due to expenses related to certain game projects no longer being capitalized, while the year-over-over increase was mainly due to increased share based compensation expenses, related to the restricted shares granted at the end of November last year.

Sales and marketing expenses for the quarter were up 111.6% sequentially and up 19% year-over-year to $7.5 million. As a percentage of revenue, sales and marketing expenses were 9% this quarter compared to 4.4% in the previous quarter and 9.2% in the second quarter 2011. As mentioned earlier, we launched a series of marketing campaigns for the first ZT Online 2 expansion pack during the quarter, leading to a sequential and year-over-year increase in this expense item.

General and administrative expenses for the quarter were up 0.4% sequentially and up 39.1% year-over-year to $6 million. As a percentage of revenue G&A expenses were 7.2% this quarter compared to 7.5% last quarter and 6.3% in the same quarter a year ago. Both increases were due to the share-based compensation expenses related to the restricted shares granted at the end of November last year.

Moving to our bottom line, net income attributable to the company’s shareholders during the quarter was up 5.2% sequentially and up 2,920.6% year-over-year to $48.4 million. The net margin for the quarter was 58.2% compared to 57.4% in the previous quarter and 2.3% in the second quarter 2011.

On a non-GAAP basis excluding non-cash share-based compensation and one-time accrued withholding tax associated with repatriation of cash less special dividend, net income attributable to the company’s shareholders was up 5.2% sequentially and up 23.6% year-over-year to $53.4 million. Non-GAAP net margin for the second quarter 2012 was 64.3% compared to 63.4% in the previous quarter and 62.9% in the second quarter 2011. Basic and diluted earnings per ADS for the quarter were $0.20 and $0.20 respectively on a GAAP basis and $0.23 a share and $0.22 a share respectively on a non-GAAP basis.

Moving on to our balance sheet on slide 11. As of June 30, 2012 our cash and cash equivalents and short-term investments totaled $314.6 million compared to $290.4 million as of March 31, 2012. The sequential increase was due to the increase in cash collections as a result of the growth of our game business. As mentioned earlier, we’re expecting a number of new releases in the second half of 2012. I will now review our game development for existing and pipeline games as shown on slide 13 and 14.

For the ZT Online 1 series, we created some new updates, all three of those are original free to play ZT Online, we rolled out new PK tournaments to increase engagement in existing players and to bring former players back. For ZT Online Classic Edition, we launched new customization options and improvements to the user interface. For ZT Online Green Edition, there were new features and that added to the newest expansion pack.

Regarding ZT Online 2, on July 27th we announced our collaboration with Qihoo 360 to operate changing online the micro-client version of ZT Online 2, which we expect to launch in August. The Vietnamese version of ZT Online 2 launched in the second quarter 2012 and local marketing campaigns will start in September.

With respect to (inaudible), we released an updated version in June which included a new character, a new test and has been well received by the gamers. Our team is currently developing additional localized content for this game, as well as instance dungeons.

For Allods Online, a 3D free-to-play fantasy MMORPG developed by Mail.Ru Inc, we conducted a second engineering testing on May 3, 2012 and gathered positive user feedback. The game is expected to enter into close beta testing at the end of August.

In July, we completed a month long engineering test for World of Xianxia self-developed 3D fantasy style MMORPG with ancient Chinese mythological background and vivid style graphics and has generated a significant amount of interest among gamers. Our team is currently optimizing the game based on user feedback and adding new content. We plan to commence our limited closed beta testing during this fourth quarter 2012. We are targeting to launch three versions in the second half 2012.

Genesis of the Empire is an action role playing game based on the Three Kingdoms era of ancient Chinese history and is expected to undergo engineering testing in the third quarter and commercial launch in the fourth quarter 2012. The Sky is also an action role playing game incorporating core gameplay mechanics from the ZT Online series and is expected to undergo engineering testing in the third quarter and commercial launch in the fourth quarter. Marine Tycoon is a maritime themed strategy game, currently undergoing engineering testing.

As per Glorious Mission, our first FPS game, it is expected to begin engineering testing in the fourth quarter 2012. The game is being developed by an experienced team whose core members have up to 12 years of FPS development experience. This game is based on the Unreal 3 engine. The game will be able to display cutting-edge graphics as well as scowling them down to accommodate a wide range of hardware requirements in China.

On the content side, due to our partnership with the Chinese Military, this is only game in the world playable from the perspective of the People Liberation Army, or PLA. With support from the PLA, Glorious Mission will enable players to use weapons, equipments and vehicles modeled after the real ones used by Chinese soldiers. While we are pleased with our performance this quarter, we expect revenue growth to remain flat to moderate for the third quarter 2012, yet with a strong lineup of new game releases such as World of Xianxia, Allods Online, and a series of webgames including Genesis of the Empire, The Sky, and Marine Tycoon, and Glorious Mission in the second half of 2012 and into 2013. We are confident that we will finish strong for the full year 2012.

That concludes our prepared remarks. Once again, thank you for joining us today. We will now open the line for questions.

Question-and-Answer Session

(Operator Instructions). Your first question comes from the line of Timothy Chan from Morgan Stanley. Please ask your question sir.

Timothy Chan – Morgan Stanley

Good morning. Thanks for taking my question. Congratulations on first solid quarter. My first question is that could you maybe help us understand the fastest moderate revenue growth guidance for third quarter? I believe as you said in the last call CT 092 that begin to support the revenue growth after a few months of dipping the record high GPU. And I have the second question, thank you.

Richard Chiang

Okay. Thanks, Tim.

Wei Liu

(Interpreted). Hi, Tim as far as the third quarter guidance, because – due to the fact that we won’t have many new games launches during the third quarter, the revenue from ZT 2 and ZT 1 will be relatively flattish compared to the previous quarter. As you know, ZT 2 will begin our micro-client version changing online on the Qihoo 360 platform in the third quarter, but for any new launched goal at to get new users to come in play the game and not necessarily monetized right away.

Timothy Chan – Morgan Stanley

Thank you. My second question is related to webgame. Obviously you have a pretty good lying up webgames, could you please talk about how these webgames are different from the ones that we are now seeing in the market and different the promotion strategy for webgames will be comparing to your MMOG? Thank you.

Wei Liu

For a web game strategy, currently we have six web games in development pipeline and they are of all different various (inaudible) accommodating to the different popular types of games that are available in the market today. But like our company culture and history, we are trying to leverage our focused strategy in developing the highest quality games that we can and to compare with other games in the marketplace.

On the operation side, we are going to be highly flexible on the cooperation that we do on third party platforms and also we will operate each game simultaneous on our platform as well. And also web games are also going to be very suitable for overseas expansion which is a new area of growth for us.

Operator

Your next question comes from the line of Thomas Chong from BOCI. Please ask your question.

Tom Chong – BOCI

Hi, good morning everyone. I have two questions, the first question relates to what are your expectations for the DEC092 in terms of big contravene uses and also can you comment about the performance of the ZT original in the second quarter? Thanks.

Wei Liu

As you know, for ZT 2, we launched a new expansion pack for the game, the first expansion pack for the game in April this year, and it reached 540,000 PCU. This PCU has been very stable since then and the next catalyst for the PCU should be one the launch of the micro-client version on Qihoo 360 platform as well as overseas expansion to the Vietnamese market, where large scale promotions should start in September. And so we like to take things one set at a time and our next PCU targets will just be incrementally higher than what we have now.

Jazy Zhang

(Interpreted). For ZT Online original, as you know this is a seven-year old game now, so on the whole it’s always been very stable. But at end of the gaming quarter, there could be some fluctuations just due to its age, but these fluctuations are within our expectations for this kind of aging game. So our development team, their goal is just to maintain game performance and prolong life cycle of the game as long as they can. They done the very admirable job but the new growth catalyst for the company will be more to on ZT Online 2 and the new games that we’re releasing in the upcoming months, two new MMO games and the new web games coming out in the second half of this year. And these will definitely help to decrease our reliance on our legacy game.

Tom Chong – BOCI

Thanks. My second question is related to R&D headcounts. Can you give us some color about the total R&D headcounts in the second quarter as well as the big bang between MMO and web games and what is management target by the end of this year? Thanks.

Jazy Zhang

For R&D headcounts in the second quarter it’s little over 1,000 developers with a slight increase over the first quarter and for web games projects there will be under 200 developers and the rest of the 1,000 plus will be on MMO development.

Operator

Your next question comes from the line of Eddie Leung from Merrill Lynch. Please ask your question.

Eddie Leung – Merrill Lynch

Hey, good morning, guys. Thanks for taking my question. Only one question, as you guys mentioned that there will be a few new games in the second half. So, wondering if you could give more granularity in terms of the margins for the second half to avoid any surprises. Thanks.

Jazy Zhang

Thanks, Eddie. I’ll take your question. So yeah, we do plan to launch a few games in the second half, mainly in Q4 this year with two MMOs. One is self-developed, one is licensed game and three are web games. In terms of margin for this year, we believe that the revenue contribution comes from web games will be relatively small. We – actually we’ve done some calculation, we think that at the end of the year we will still be able to achieve approximately 50% net margin and 60% plus for operating margin. EBITDA, we do understand – in terms of the margin profile, we do understand that by working with other online platform companies to run our webgames, the overall net margin will be lower, but given the portion of the revenue contribution coming from webgames being relatively small this year we believe that overall margin will be similar to what we guided earlier.

Eddie Leung – Merrill Lynch

Just one follow-up question on your revenue recognitions for webgames, are you going to book only the net revenues excluding the revenue sharings to your partners or are you guys going to a book the gross revenues and then treat the revenue sharing as cost of services?

Jazy Zhang

Great. I’m glad that you follow up with additional questions. Yeah, so generally speaking if we rely on other platforms to run our webgames, yes, we will report on net amount on our top line. And also keeping in mind that we haven’t minority shareholder for our webgames team, so that they own 49% and Giant own 51%. So overall if you look at webgame business alone, the net margin is going to around 40%. So that’s assuming that we 100% rely on either platforms to run our webgames. If we also operate our webgames on our own platform, the overall margin will be slightly higher than 40%, so it will be a mix at the end of the day

Operator

Your next question comes from the line of Steve Zhang from Macquarie. Please ask your question, sir.

Steve Zhang – Macquarie

Hi, thanks for taking my question. I have a question regarding your micro-client version of ZT 2. What is your overall strategy with this partnership? Are you hoping to actually convert these users to a full-client version for ZT 2 or you’re just hoping that this will be a new revenues for you?

Richard Chiang

Thanks, Steve.

Wei Liu

For the micro-client version of ZT 2 well, as you know the micro clients are an evolution for the industry in terms of technology. Full-scale MMO games will be able to deliver that experience to smaller downloads. So this is a type of technology that we will implement more of in the future. It’s also – the micro-client version is also the version that we’re using to cooperate on Qihoo 360’s platform and also for our overseas market in Vietnam. And the goal of these two versions, the micro-client, is to get new users. Previously with our own full scale clients, definitely we’ve been very good at retaining the users we’ve gotten from the marketing that we’ve done ourselves. But we want to increase our reach even more beyond our typical marketing tactics to reach new users.

Steve Zhang – Macquarie

Okay, great. And this is a follow-up. Do you expect the micro-client users to be lower paying ratio and lower ARPU given that there is expected to be more casual gamers?

Wei Liu

Because we haven’t fully launched the version yet, the micro-client version yet, we don’t know for sure but based on our expectations, paying ratio and ARPU could be slightly lower, but within a similar range, as before.

Operator

Your next question comes from the line of Mark Marostica from Piper Jaffray. Please ask your question sir.

Mark Marostica – Piper Jaffray

Yes, thank you. I wanted to get a sense for the marketing spend trend in the third quarter and in the fourth, given your launch plans for the balance of the balance of the year?

Wei Liu

Sure, Mark. Yeah. So, with respect to the marketing expenses for Q3 – Q3 marketing expenses compared to Q2 will be slightly lower as we do not expect many launches of new games in Q3. But for Q4, we will be launching several games. But for webgames, if we work with other online partners, we will not be responsible for marketing expenses. So, overall Q3 and Q4 we expected the total marketing spending to be under 10% of our topline revenue.

Mark Marostica – Piper Jaffray

Okay. Thank you for that. And then as a follow-up, with some micro-client version of the ZT 2, do you expect any cannibalization whatsoever given that you’re – I know you’re trying to reach new users, but I’m just trying to get a sense of that’s something you anticipate?

Wei Liu

We don’t expect much cannibalization with the launch of the micro-client version because although the contents is the same in both versions, for those existing players they have already established their accounts in current servers and it will not be worth it for them, or it will be helpful for them to start all over again in new servers.

Operator

Your next question comes from the line of Jin Yoon from Nomura Securities. Please ask your question.

Ruby Zhang – Nomura Securities

Hi. This is Ruby Zhang sitting in for Jin Yoon, just a housekeeping question. What’s your visibility on your operating margins in the third quarter and for the full year?

Jazy Zhang

Operating margin will be around 60%.

Ruby Zhang – Nomura Securities

Okay.

Jazy Zhang

For Q3 –

Ruby Zhang – Nomura Securities

And that’s your non-GAAP?

Jazy Zhang

GAAP.

Ruby Zhang – Nomura Securities

That’s GAAP. Okay.

Jazy Zhang

Yes.

Ruby Zhang – Nomura Securities

All right. Thank you very much.

Jazy Zhang

You’re welcome.

Operator

Your next question comes from the line from Atul Bagga from Lazard Capital. Please ask your question.

Atul Bagga – Lazard Capital

Hi, guys. Thanks for taking my question. Can you remind us what is the percentage of revenue coming from ZT and ZT 2 in second quarter and how it might have changed sequentially?

Wei Liu

I’m sorry. Can you repeat your question, Atul?

Atul Bagga – Lazard Capital

Sure. The percentage of your revenue coming from ZT and ZT 2 in second quarter and how it might have changed sequentially?

Wei Liu

Sure. As you know we don’t really breakdown revenue contribution for each games officially, but our existing games such as ZT Online 1, ZT 2 are both very stable and ZT 2 is definitely still growing at this stage in its lifecycle. During near the end of this year fourth quarter when our games are launching, they will definitely dilute the contribution from our legacy game. And in the future we’ll rely less and less on our legacy game so that our revenue stream will be even more diversified and healthy.

Atul Bagga – Lazard Capital

Okay. And you talked about strong growth in ZT 2 in second quarter and some weakness in ZT is given that ease of the game. Can you talk about your ability to put some of the old ZT players into either ZT 2 or other games within the portfolio?

Wei Liu

Sure. It’s not the company strategy to transfer gamers from one of our games to another one of our games. Each of our project teams, their goal is to maintain and grow its current performance and user base. So even for ZT Online 1, even though it’s a seven-year old game now, it has its own community among its users. So it’s very sticky and they definitely built their own relationships over time in that game. For example when we launched ZT 2, they actually didn’t like the game, the new game because they had already existing bonds and relationships in their old game. And due to this sticky nature of this community they went back to ZT 1. So for each of our games, we want to just maintain and grow each of their user bases.

Operator

(Operator Instructions) Your next question comes from the line of Martin Bao from CICC. Please ask your question.

Martin Bao – CICC

Thank you. I have a question regarding Giant’s licensing strategy and some recent change of preferences and Giant is approaching for the licensing of all the online game products. I am wondering whether you can share more about your strategy and some little bit more details on the licensing strategy?

Wei Liu

Thanks Martin. Let me clarify, so do want us to talk about our licensing strategy in terms of becoming publisher of foreign titles or exporting our games to foreign market?

Martin Bao – CICC

More related to the exporting of our games to foreign market.

Wei Liu

For our licensing export strategy to overseas, this is already become an important part of our company’s strategy. As you know, the global game market is still very healthy and growing. So, due to new genres such as current webgames and mobile games in the future, there’ll be plenty of opportunities for people all over the world to access the same products. We can definitely imagine that more and more games in the future will be played globally among different players around the world.

So, Chinese games will eventually become more and more westernized or more and more international looking, and so in this regard we’re definitely building up our current teams that specialize in this year and you’ll see more and more products and games from us that are suitable for overseas expansion.

Operator

Your next question comes from the line of Wendy Huang from CIFB. Please ask your question.

Wendy Huang – CIFB

Thanks for taking my questions. Firstly, can you share what’s the average development cycle and also the development cost for your webgames?

Wei Liu

For the cost and development cycle of web games, this development cycle is usually six to nine months and the costs will be under US$1 million.

Wendy Huang – CIFB

Okay. Certainly, given the recent discussion regarding the (inaudible) by the overseas safety Chinese companies, this joint has any restructure plan or any due listing plan or do you have anything amounted to maybe protect foreign shareholder’s interest over the assets that away? Thank you.

Wei Liu

Sure. We currently don’t have any plans to restructure or dual listings.

Operator

Your next question comes from the line of Adam Krejcik from ROTH Capital Partners. Please ask your question.

Adam Krejcik – ROTH Capital Partners

Yeah, hi. I have two questions. The first one just so I can understand your Q3 guidance a little better, so how much revenues are you expecting from ZT 2, the micro-client version as well as Qianjun Online because, it sounds like your guidance conservative and if you the junior games or is there just little visibility right now?

Wei Liu

Yeah, I’ll answer your question, Adam. So, we actually – we do not taking to account the revenue, expected revenue from ZT 2 on micro-client version as well as outlook into our Q3 guidance. Due to the nature of the business at early stage, and Q3 we do not take into account those two games. But we do believe that they will make revenue contribution in Q4.

Adam Krejcik – ROTH Capital Partners

Should we – is it fair to assume that revenue growth on a sequential basis will reaccelerate in Q4?

Wei Liu

Yes.

Adam Krejcik – ROTH Capital Partners

Okay. And then my second question is, I noticed deferred revenues and advances from customers was down this quarter, in fact the second quarter in the row, so just curious why that deferred revenue trends adapts?

Wei Liu

So for the advances from distributors, that’s because currently as of the end of Q2 we’re doing nearly half of our business online instead of completing the distributors in the past. So we’re doing half online directly and half through distributors. That’s why there is some distributors have come down.

And secondly, with respect to deferred revenue, this is really a dynamic number. It’s lump sum including all of our games. In general, when you have a older game, it’s – if you look at the curve, the revenue balance is – deferred revenue balance is declining, therefore new games you would expect the deferred revenue balance to increase. So this is really a net number.

Operator

Your next question comes from the line of Andy Yeung from Oppenheimer. Please ask your question.

Andy Yeung – Oppenheimer

Hi, good morning. I have two questions today. Now my first question is about your game pipeline. It seems like while the pipelines (inaudible) in third quarter. That’s actually a pretty strong quarter for group in a way in fourth quarter. Is this pace of product production well defined and also are you concerned about training your engineering and marketing resources in the second half?

Xuefeng Ji

As for our pipeline games, Allods Online is actually coming out at the end of August and towards the second half or middle of Q3. And while marketing was starting that period, revenue, we haven’t forecasted much revenue contribution in the third quarter because the focus will be trying to get new gamers in the beginning, not necessarily manipulation from the very beginning. So, more significant revenue contribution will start until fourth quarter, but the marketing will start in the third quarter. For World of Xianxia, that game will also come out in the second half of the fourth quarter. So, the marketing campaign for these two games will be pretty spread out, will be pretty – will not be hard to manage. As for the webgames, as Mr. Ji mentioned earlier, these will be co-operated or put on third-party platforms and they will handle most of the marketing campaigns, so they will not conflict with our own marketing for our two MMOs.

Wei Liu

And Mr. Ji just want to add another point that based on current testing of World of Xianxia during August, the testing results and figures have all been very positive. And so it seems like it will be very heavily anticipated by gamers and also our upcoming web games such as Genesis of the Empire and The Sky, based on some internal testing the results have been very good as well. So I think these will make a quick scratch in the market when they are released.

Andy Yeung – Oppenheimer

That’s great. My second question is about mobile. It seems like you have – you’re pretty optimistic about web-based game and have put in some resources to develop webgames. I’m wondering if you can share your view on mobile game space?

Wei Liu

Sure.

Xuefeng Ji

For the mobile game markets, as everyone knows this will be high growth area of the industry in the future, but currently especially in China, the mobile game market is not that sophisticated yet. It’s still in the sort of infancy and its developmental or testing stage especially when it comes to monetization. So, our goal right now is just to get new talents, the best mobile developers that we can and prepare for this growth in the future.

Operator

Next question from (inaudible) from Citi Group. Please ask your question.

Unidentified Analyst

Hi, thanks for taking my questions. I would like to ask would you please share some insight about the revenue sharing scheme for launching the micro end – the micro terminal with the 360, and I have follow up? Thank you.

Wei Liu

Okay. Unfortunately, we can’t disclose the revenue splits with our corporation with the Qihoo 360, but we can tell you that we’ll defiantly try to be the best business partner with them and they’ll do their best to be – definitely promote our ZT online, the micro-client ZT 2 as a blockbuster game on their platform. So, we’re definitely focused on working heavily together.

Unidentified Analyst

That’s very helpful. Thanks. So my follow-up is, you guys share that you are planning to move from the MMOs, this hardcore gradually into the micro end in the future in the longer term, so doesn’t that mean that the – and because you are the revenues with the partners and doesn’t that mean in the future the revenue growth booked by Giant will likely to slow down even despite of the popularity of this game.

Jazy Zhang

Yeah, I think, if you really isolate – I mean, if we, if you assume let’s say more than 50% of our business will come operation of others of micro-client version. Yeah, at the end of the day you will probably – yeah, it would affect net margins. But this will come better gradually, I mean we do have a long-term plan to – in the future when we rollout our MMORPG we’ll have micro-client version for all of our new games. But that will happen gradually. We do not expect our net margin to change drastically any time soon and we are quite confident that next year we will maintain our net margin at around 50%.

Operator

Your next question comes from the line of William Huang from Barclays. Please ask your question.

William Huang – Barclays

Hi, good morning. My question is about World of Xianxia, if I compare current momentum with the previous traction of ZT Online 2 or other MMO titles before launches, any particular difference you know there from the game? What is the revenue expectation for the game when you launch 4Q? Thank you.

Wei Liu

World of Xianxia, we recently did a round of engineering testing that started on July 7. The testing results were very positive, similar to the – similar testing results during similar phase of testing for ZT 2 back in a day. But we need to take things once step at a time. Eventually when World of Xianxia has ruled out this year, our user number expectations or hopes would be one step at a time, maybe a 100,000 PCU at a time. And so the marketing campaigns, how much investment we put into the launch will all depend on the upcoming rounds of testing from now until then.

William Huang – Barclays

Thank you.

Operator

Your next question comes from the line of Wallace Cheung from Credit Suisse. Please ask your question.

Wallace Cheung – Credit Suisse

Hi, thanks for taking my questions. Quick one. As we see a lot of like fast-growing web-based game companies now all stand on their own companies, do you think is actually is more necessary that the real the web-based games business either through a separate studios, which is outside from your core sort of MMOG kind of different studio or maybe you haven’t do better pursue a eminent strategies as such you may can provide more incentive for the individual through the business? Thank you.

Wei Liu

So the webgames have become a new joiner in the industry over the past couple of years due to the lower costs and so these are smaller studios, have been able to create them very easily, but because of the – of their lack of resources the game quality of the games have been inferior. Some of these web games have also had shorter lifecycles compared to MMO or client-based games. So, our advantage for Giant is based on our abundant resources, our understanding of long lifecycle games and our experience in developing MMOs will give us an advantage in terms of quality; we will be able to deliver higher quality web games in the market with longer lifecycles. So, I think this will definitely be a high growth area for us as well.

Wallace Cheung – Credit Suisse

Thank you. Just two quick questions. (Interpreted) So just to translate the question response back into English, the question was about management of financial incentives given to different game developers and teams on webgame projects versus client-based MMO projects.

Wei Liu

Our was response was that within Giant Interactive all of our development teams with the exception of the original ZT 1 (inaudible) share of the – or put up their own capital for their own share of the game project and based on different cost structures in the type of game and marketing, there is going to be a revenue share when the game is released that the developers can earn and this is basically our R&D restructuring that we did last year.

Xuefeng Ji

The second question was that currently a lot of webgames in the market place have lower lifecycles, shorter lifecycles, but do have higher ARPU. And our response is that, yes, it’s true. This trend, currently it’s based on couple of different factors. Sometimes it’s due to the game’s content itself and also because of user habits. And for us, for our webgame development, we definitely want to leverage some of these trends where, for example, are easier or more accessible for users to play because they don’t have to download a big client, but at the same time, we want to bring our own competitive advantages into webgame development.

For example, we have a lot of experience and understands how to leverage the community experience in the game and make it sticky based on social structures and bonds based on our MMO games and we want to add these features into our webgames to be able to provide a webgame that has a longer lifecycle than what is currently in the marketplace. We do know that there is lot of differences between webgames and MMOs, but we believe that we will be able to add a lot of our competitive advantages into the webgame market.

Wallace Cheung – Credit Suisse

Okay. Thank you very much.

Operator

Your final question comes from the line of Jia Long Shi from CLSA. Please ask your question.

Jia Long Shi – CLSA

Hi, thanks for taking my call. I have a follow-up question. So, could you give fine colors on the investment and development cycle for MMO? Thanks.

Wei Liu

For MMO development, usually it takes about two years for us. And for the size of the team, it’s usually 60 to 100 people and for the costs its usually less than USD5 million.

Operator

I would like to hand the conference back to Mr. Rich Chiang. Please continue sir.

Richard Chiang

Thank you again for joining us today and we look forward to talking to you about our progress in the near future. Have a nice day.

Operator

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

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Source: Giant Interactive Group Management Discusses Q2 2012 Results - Earnings Call Transcript
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