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Shanda Games Limited (NASDAQ:GAME)

Q2 2012 Earnings Conference Call

August 26, 2012, 21:00 p.m. ET

Executives

Ellen Chiu - Director, IR

Xiangdong Zhang - CEO

Richard Wei - CFO

Analysts

Timothy Chan - Morgan Stanley

Dick Wei - J.P. Morgan

Muzhi Li - Citigroup

Thomas Chong - BOCI

Martin Bao - CICC

Andy Yeung - Oppenheimer

Mark Marostica - Piper Jaffray

Operator

Ladies and gentlemen welcome to Shanda Games Limited Second Quarter 2012 Financial Results Conference Call. The conference call will be recorded and available for replay in its entirety. A copy of Shanda Games 2012 second quarter results announcement can be found and downloaded from its Investor Relations website at ir.ShandaGames.com. At this time all lines have been placed in listen-only mode and the floor will be opened for questions following today’s presentation.

I’d now like to turn the call over to Ellen Chiu, Shanda Games Investor Relations Director. Please proceed Ma’am.

Ellen Chiu

Thank you. Good morning and good evening everyone. On behalf of Shanda Games I’d like to welcome everyone to our 2012 second quarter financial results conference call. With me today are Mr. Xiangdong Zhang, our CEO; and Mr. Richard Wei, our CFO.

Before we begin, I’d also like to remind you that managements comments during the call will include forward-looking statements that are based on current expectations and are intended to qualify for a Safe Harbor from liability for such statements established in the U.S. Private Securities Litigation Reform Act of 1995. All statements that are not statements of historical facts 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. So, please take a minute to read the Safe Harbor statement in Shanda Games’ second quarter 2012 earnings release.

In addition, please note, for discussion purposes, all numbers will translate into U.S. dollars based on the exchange rate of RMB6.3249 per U.S. dollar.

Now I’d like to turn the call over to our CEO, Mr. Xiangdong Zhang.

Xiangdong Zhang

Thank you, Ellen, and thank you all for joining us today. Especially, those of you who are taking time from your Sunday evening. Before we begin I’d like to command an announcement issued earlier on the resignation of Mr. Alan Tan as company’s Chairman and CEO. I’d like to thank Alan for his tremendous contribution to the company over past several years in his help for us. We do have a strong management system and a team to execute the company’s corporate strategy. We wish him success in his future endeavor. In the meantime I’m honor to take over Alan’s duty as CEO during this period of time. I look forward to leading the company to solidify its position as one of the premier online game companies in China and drive its long-term growth.

Our second quarter results were in line with our guidance. However, we remained cautious given the current macroeconomic conditions. We believe we are moving into the third quarter with improved games and healthier volume. In the second quarter of 2012, total net revenue declined 14.4 percentage year-over-year and 18.6 percentage quarter-over-quarter. Net revenue from online games operated in China decreased 16.6 percentage year-over-year and 19.3 percentage quarter-over-quarter.

Other revenues primarily representing net overseas revenues increased 23.3 percentage year-over-year and decreased 10.6 percentage quarter-over-quarter. The decline of overseas revenues is mainly due to the sale of Mochi Media in the first quarter. Slow down in the second quarter occurred primarily because we reduced a level of monetization in our legacy games in order to lengthen our life cycles in Beijing.

We delayed the released schedule for server expansion packs in order to take advantage and a push through a number of other initiatives that we believe could help revive our performance in the second half and down. Overall, we continue to enhance and to verify our portfolio of games and franchise. We believe it is critical for long-term success of our business and continue to believe creative and compelling new game content. We remained focused on the games that we expelled to drive growth in the quarters to come.

I’d like to reiterate our AAA strategy which will continue to serve as the cornerstone of our approach to grow our business. The three As stand for three critical element: All-Star, All-Platform and All-Region.

All-Star, interest that we have a strong pipeline of games and that we are able to successfully launch these games. All-Platform enables us to take our successful clan-based titles and port them to other platforms and the developers are really interested that we extend our successful games to other geographic areas.

Let me start with All-Star component of our strategy tends to provide game players with rich content derived from our pipeline of new games and franchise. Our pipeline is anchored by numerous titles or in various strategic stage of development, Age of Wushu. And exciting 3D MMORPG jointly operated with Snail Game finished open-beta testing early this month and has received a positive feedback. The collaboration with Snail Game represents a new channel of game surfing. We are also excited about the first quarter launch of RIFT, a 3D fantasy MMORPG we licensed from Trion Worlds. We have just received government approval and are the final stage of localization. For World Zero we plan to conduct another round of testing in the fourth quarter. For Final Fantasy XIV we plan to commence localization of its new version in the fourth quarter.

Looking beyond this year, we are planning to release additional new games including Dungeon Striker from our Eyedentity, Ghosts 'n Goblins and we licensed from Capcom. And Age of Dawn an in-house game concurrently adapted from a popular online novel as it has been published on Shanda’s Cloudary platform.

Beside from the new titles our exciting games continue to attract new users and we accept to see solid growth coming from many of these titles. We launched expansion packs for Dragon Nest just recently. And we are excited to see a gradual pick up in these games miniware. We plan to introduce upgraded version of Woool and Mir II in the coming quarters. Woool II is an important upgrade of Woool and was launched earlier this month.

As we have mentioned before we anticipate revenue growth and monetization to pick up on the back of both new games and expansion pack launches. For the second quarter [game-based] revenue contribution over 10 percentage of our revenue include Mir II, Woool, Dragon Nest and AION which contributed 32 percentage, 17 percentage, 13 percentage and 12 percentage of total revenue, respectively. Since the implementation of our All-Star strategy, our reliance on Mir II and Woool has steadily decreased, as we were able to successfully launch and maintain online new games. We believe the positive feedback from Age of Wushu and expansion packs from Dragon Nest and Woool have given us a great start moving into the second half of 2012. We realized that we still have a long way to go; however, with the proven track record of partnering with developing and localization with online games will lead the All-Star component of our strategy will lay out the foundation for our future growth.

To move on to All-Platform strategy to our PC client game pipeline. We are also experiencing our capacity to operate games on other platform or devices including micro-client online games, web games and mobile games in response to the changing behavior of our game players. We have introduced a novel micro-client versions of our games, the micro-client version of Mir III, Woool (inaudible) have been well received by game players since our launch.

We plan to further release micro-client versions of Legend of Immortals, Mir II and (inaudible). This micro-client games and to provide our game player with best user experience and easy access to these games, in order to have us diversify and expand our user base.

As to web game, we co-developed Championship Manager with Square Enix and plan to launch it soon. This first managed game represents a new game genre for us and should have us attract new type of games miniware. We also leveraged our existing franchise by launching a web version of Woool and (inaudible) during the fourth quarter this year. We also intent to realize a long-term potential of our high quality games on mobile phones and tablets.

On mobile game platform, game players has yielded initial success with the launch of mobile version of Woool called Woool of Paladin last month. Within the first two weeks of its launch this game has already been downloaded more than 1 million times with more 10 mobile games in our pipeline. We have [content] in prospects for the mobile division.

Moving forward we intent to leverage our game platform to our launch our mobile games where we also continue to implement [atom] based module in mobile games to improve playability and provide high quality product. As the market continues to develop we intent to acquire mobile game titles that appear to game players. We believe our micro-client web and mobile games will hit us with new and engaged community on our existing intellectual property. We believe that this development we are experiencing our call brand and franchise. We are providing such new innovations we seek to achieve balance between taking our franchise to a new place and the returns to the core appeal to our game player to them in the first place.

Now finally our rating strategy. Our overseas operations continue to be one of the segments with greatest potential as we broaden the global reach of our franchise to our licensing and our global service platform. This quarter we continued to push forward due to our strong and growing global franchise. Dragon Nest has been our most successful new IP and we are taking full advantage of the opportunities to present to grow this unique franchise across the globe. Last month we launched Dragon Nest in Indonesia and plan to launch it in Russia next month.

We also had majority stake of eFusion which is an important stake establishing our presence in Europe, so eFusion we expect to grow Dragon Nest across Europe the gaming sometime during the fourth quarter. In addition, we plan to launch Legend of Immortals in Vietnam and Korea once they complete further round of testing late this year.

I’d be interested to say that second game, Dungeon Striker will soon begin its second round of closed beta testing in Korea and is scheduled for launch in fourth quarter with a massive success in Dragon Nest we expect Dungeon Striker to deliver past and present Dragon Nest player with even more accelerating experience long way to new content to support it. With these adorable characters, high speed action sequences and unique skill customization system, we believe Dungeon Striker will become one of the most anticipated titles in Korea. After its launch in Korea we plan to launch this game out of other geographic areas to build on the momentum we already have from Dragon Nest, operating games overseas and licensing games to overseas operator have created a new long-term revenue stream for us. And we fully intend to capitalizing on this opportunity. We will continue to seek new investment opportunities as our franchise entering into a new market.

In summary, though we are facing challenges in rapidly changing industry, we are confident that our AAA strategy will continue to provide the long-term growth for our business. With that I’d like to conclude my remarks and turn the call to Richard. Thank you.

Richard Wei

Thank you, Xiangdong. As always our full earnings release and financial statements is available on our website as well as most major financial portals. I will now briefly review the highlights of our second quarter results and provide an outlook for the third quarter. We will take questions afterwards.

Given the second quarter of this year, our net revenues decreased 18.6% quarter-over-quarter and 14.4% year-over-year to RMB1.13 billion equivalent to US$179 million in line with our previous guidance.

As Xiangdong mentioned earlier in the call, we decelerated the monetization of Mir II and Woool to lengthen their life cycle and also delayed the launch of an expansion pack for Dragon Nest during the second quarter. In addition, Q2 was typically a good season due to fewer holidays as a result; net revenues from online games in China decreased 19.3% quarter-over-quarter and 16.6% year-over-year to $1.04 billion equivalent to US$165 million.

Average monthly active users or MAUs all games operated in China were 17.3 million compared with 19.1 million in Q1. Average monthly paying users or MPUs for games operated in China were 2.8 million in Q2 compared with 4.3 million in Q1. Monthly ARPU for all games operated in China were RMB90.3 compared with RMB99.9 in Q1.

Other revenues which primarily includes overseas revenue from games licensing, games operation and advertising were RMB90 million equivalent to US$14 million compared to RMB101 million in the first quarter of this year and RMB73 million in the second quarter of last year. The sequential decrease was mainly due to the sale of Mochi Media in the first quarter of this year.

Gross profit decreased 19.3% quarter-over-quarter and 11.9% year-over-year to RMB705 million equivalent to US$112 million. Gross margin was 62.4% down from 62.9% in the first quarter of this year and up from 60.6% in the second quarter of last year.

Operating income was RMB255 million equivalent to US$56 million a decrease of 18.7% quarter-over-quarter and 1.9% year-over-year. Operating margin was 31.4% in the second quarter flat from the previous quarter and up from 27.4% for the same period last year.

Non-GAAP operating income was RMB291 million equivalent to US$62 million a decline of 20.7% quarter-over-quarter and 10.6% year-over-year. Non-GAAP operating margin was 34.6% compared with 35.5% in Q1 and 32.1% in Q2 last year.

In line with our previous guidance, our non-GAAP calculation exclude impact of share-based compensation amortization of acquisition related intangible assets and the related income tax effects. Income tax expenses were RMB99 million equivalent to US$16 million compared with RMB106 million in the preceding quarter and RMB18 million in the year ago period. Effective tax rate for Q2 was 22.9% compared with 22.9% in Q1 this year and 20.6% in Q2 last year.

Income attributable to ordinary shareholders were RMB208 million equivalent to US$49 million representing a decrease of 8.4% quarter-over-quarter and an increase of 1.0% year-over-year. Earnings per diluted ADS were RMB1.10 equivalent to US$0.17 compared with RMB1.20 in the first quarter of this year and RMB1.08 in the second quarter of last year.

Non-GAAP net income attributable to ordinary shareholders totaled RMB237 million equivalent to US$53 million compared with RMB282 million in Q1 this year and RMB217 million in Q2 last year. Non-GAAP earnings per diluted ADS were RMB1.20 equivalent to US$0.19 compared with RMB1.36 in the first quarter this year and RMB1.30 in same period last year.

Turning to balance sheet and cash flow positions. The company’s cash and cash equivalence, short-term investments, restricted cash and time deposits, net of loans and dividend payable were RMB3.04 billion equivalent to US$480 million an increase from RMB2.66 billion as of March 31, 2012. The increase was primarily due to operating cash flow generated during the second quarter. Deferred revenue was RMB121 million equivalent to US$19 million down from RMB117 million in the previous quarter.

Now turning to guidance for the third quarter of this year. Our revenues in Q3 to decline by 4 to 5% sequentially and expect our non-GAAP operating margin which excludes the impact of share-based compensation, amortization of acquisition related intangible assets and the related income tax effects to be approximately 33%. The sequential decline is primarily a result of the sequential revenue decline and a potential increase in sales and marketing expenses during the third quarter. Share-based compensation in Q3 is projected to be similar to the Q2 level. We also expect to book approximately 35 to RMB40 million in government subsidies in Q3.

That concludes my discussion. I will now turn the call back to Ellen.

Ellen Chiu

Thank you, Richard. We will now take your questions. Operator, please go ahead.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question today comes from the line of Timothy Chan from Morgan Stanley. Timothy, please go ahead.

Timothy Chan - Morgan Stanley

I have two questions. The first maybe can you share with us on third quarter guidance. What are the major drivers for the decline in sales price stronger technology in third quarter? And I have got follow-up.

Ellen Chiu

In the second quarter base on to ensure a long-term and healthy life cycle gains. We proactively lowered or slowed down the amortization of Mir II and Woool and also have been working on including the games. Also the bigger update for Dragon Nest is going to be launched in third quarter. So, Dragon Nest also has seen softer second quarter revenue.

For Dragon Nest we have launched a new version of opening of the level up from to level 60 in July and as a result we increased the active user number, but the benefit to the revenue growth is not (inaudible) but that is more for long-term benefit. And also in August we put up expansion pack introducing the new character and we expect expansion pack to drive the third quarter revenue near the end of third quarter.

For AION we launched major expansion pack 3.0 version by end of first quarter, so we had pretty strong growth in the second quarter, but for in third quarter the expansion pack was launched close to the end of the quarter. So, it got limited contribution to the third quarter revenue. It will grow again in the fourth quarter.

Timothy Chan - Morgan Stanley

So, my follow-up question would be the acquisition (inaudible) may I know what the financial impact to the P&L?

Richard Wei

(Inaudible) is very small I don’t feel that there should be a meaningful change as a result of acquisition. It basically bought a small team that operate games in Europe and so the in Q3 it will pick up very small number of additional OpEx and once the company starts to launch Dragon Nest sometime in Q4, I don’t think there will be a drag.

Operator

Your next question today comes from the line of Dick Wei from J.P. Morgan. Dick, please go ahead.

Dick Wei - J.P. Morgan

First of all I just want to see if Shanda has any future strategy change for Shanda Games going forward, if you can discuss that will be great.

Ellen Chiu

We will continue existing corporate strategy, the AAA strategy, All-Star, All-Platform and All-Region and fill the allocation of resources. We will fully explore and urge the opportunity in the mobile internet area.

Dick Wei - J.P. Morgan

And we have seen pretty good cost control in the second quarter, wondering what is the latest headcount and also what are the expense trend going into next couple of quarter, any update on that will be good.

Richard Wei

At the end of Q2 total headcount was about 2300 was about over 600 coming from R&D. And so the total is down from about 24, 64 at the end of Q1. In terms of headcount for the rest of the year, I think it will be flattish, I don’t expect a big pick up in headcount.

Dick Wei - J.P. Morgan

Richard, so you said after 2 or 3 headcount was 1700 or?

Richard Wei

Q2 headcount was slightly over 2300 and out of that R&D was slightly over 1600.

Dick Wei - J.P. Morgan

And then what about the margin trend maybe into the next few quarters?

Richard Wei

Q3 should be down about flat to 1.6 percentage points from Q2 level. For Q4 I will say probably flattish from Q3, if we see a bigger pick up than what we are projecting then I have seen there will be some margin improvement.

Dick Wei - J.P. Morgan

And maybe last if you can just repeat your top gaming cost [based on Q2] I may have missed some of the numbers.

Richard Wei

Mir II in Q2 was 32% of total revenue and Woool was 17%, Dragon Nest was 13%, and AION was 12% which is equivalent our recent history we have not disclosed on percentage it was below 10%, but this time it was about 10%.

Operator

Your next question today comes from the line of Muzhi Li from Citigroup. Muzhi, please go ahead.

Muzhi Li - Citigroup

Just wanted to ask about the, if deletion of mobile version of the Woool how is that going to help the company to gain more traction from the light and non-core gamers. And I have a follow-up question on that.

Ellen Chiu

The mobile version of Woool is indeed expression of the (inaudible) and we leveraged the old brand and also utilizing a lot of the existing games game play to derive this title. And this title indeed has attracted a lot of those original (inaudible) game players as well as some of the mobile gamers.

Muzhi Li - Citigroup

And also I like to know that how other than the micro and also the mobile game, how does the company would deal with the matured NMO hardcore gamer market size, because it looks like that the existing players trending is real flattish and even sometime downward and honestly how the long-term strategy from the company?

Richard Wei

Let me clarify you are asking what the company is trying to do with the NMO business not on the mobile and micro client side, right?

Muzhi Li - Citigroup

Actually I don’t ask other than the micro-client and also other than the mobile game, how does the company to expand the limited growth potentials of hardcore gamers in NMO market?

Ellen Chiu

The online gaming the government is getting polarized, on one hand the quality of MNO games become higher and higher and the content is also getting richer, and on the other hand (inaudible) have games such as social game, web game and mobile games also emerging. We believe that in the new game genre the web and mobile games does do have a higher growth potential.

Muzhi Li - Citigroup

Lastly, just wanted to make sure that the new mobile version will be available on Android and iOS is that correct?

Ellen Chiu

Yes, correct.

Operator

Your next question today comes from the line of Thomas Chong from BOCI. Thomas, please go ahead.

Thomas Chong - BOCI

I have one question that relates to the others revenue, do we expect other revenue to be resume sequential growth as per after Mochi, any addition to management has any expectations on the revenue contribution of overseas revenue in the next few years?

Richard Wei

Q3 overseas revenue should is project to increase from Q2; Q2 was slow because of the [Mochi]. And then with the acquisition of eFusion I think Q4 also should see higher growth in revenue in Q4.

Operator

I got next question today comes from the line of Martin Bao from CICC. Martin, please go ahead.

Martin Bao - CICC

Actually my question is more related to the two new license to game, could you provide us some more colors on the two new licensed game after RIFT and Final Fantasy XIV?

Ellen Chiu

We have just gotten the government approvals for RIFT and we are at the final stage of localization for this game. We expect to start another round of testing in Q4 for RIFT. For Final Fantasy XIV the new version of the game just came out and we are doing the localization of the new version. We also expect to start a round of testing for the new version in Q4.

Martin Bao - CICC

Quick question regarding your web game strategy, as we have seen that our competitors are actively working to (inaudible) segments and what are our strategy going on for the web game.

Ellen Chiu

Two ways; one is we are overleveraged our current game franchises such as Mir II, Woool an Dragon Nest and to introduce the web version of those micro-client based games. And another is we will introduce gamers the good quality international game brand such as Championship Manager that we just launched and by introducing those new international titles we will introduce gamers new game play also new genre of games.

Operator

Your next question today comes from the line of Andy Yeung from Oppenheimer. Andy, please go ahead.

Andy Yeung - Oppenheimer

I have two questions today; the first question is the follow-up question on your product cycle and your product pipeline. So, wondering if you can give us some color on the top three games performance in the quarter and also in terms of your pipeline, expansion pack and new game licensing in third quarter and fourth quarter, what’s your monetization plan for those games?

Richard Wei

The three, four games, I think we mentioned in the call earlier, Mir II was 32% of total revenue, Woool was 17%, Dragon Nest was 13% and AION was 12%.

Andy Yeung - Oppenheimer

Right, we got the number, but it seems like decline was quite significant especially for Dragon Nest and Mir, both sequential basis on year-over-year basis, just wondering beside of your easing up on monetization what’s your user in those games?

Ellen Chiu

For Mir II and Woool because we proactively lowered the amortization insider game in second quarter. So, actually the infant number didn’t decrease, the revenue decline was caused by the ARPU decline. For Dragon Nest, the decline is mainly from the user decline, since we don’t have major expansion packs launched in the past quarter, but indeed we launched couple expansion pack in the third quarter which we believe will increase both at the user number and ARPU level in third quarter onwards.

The near-term or due to their long duration of our operations they have formed communities inside those games. So, indeed gamers are more interesting (inaudible) which also contribute to the foundation of the user’s loyalty. So, it will enhance the social function of games, spend gamers total network to increase the sequence. Also we will enhance the game structure by introducing a new careers; there has been no change to the structure as well as graphics for quite some time. So, therefore, on the content side we will continue to see put out a new careers as well as improve the graphics to attract new users. And we hope to stabilize and also grow the user base to those efforts for the long-term positive growth development for Mir II and Woool.

Andy Yeung - Oppenheimer

Just a quick follow-up on that then, when we look at your monetization for those game you have used up level of monetization in recent quarters, with all of this new expansion packs and changes in the game, when can we expect you where we able to turn up monetization again timing for that?

Ellen Chiu

As we mentioned the new version, the new expansion packs will have the user certify their new demand insider game and as such will increase our install base accordingly. As for the amortization we will increase gradually increase it by launching new expansion pack. For Mir II, Woool and Dragon Nest we have this kind of effort starting in Q3.

Operator

Final question today comes from the line of Mark Marostica from Piper Jaffray. Mark, please go ahead.

Mark Marostica - Piper Jaffray

With all of the activity in the game pipeline, I’d like to hear management’s view on what it believes, are the games that have particular promise in becoming the next 10% revenue contributors?

Ellen Chiu

As you know [AION] has become the title that exceeded 10% of our total revenue gain in second quarter. And through our All-Star strategy we also have many, many new pipeline titles such RIFT, Final Fantasy XIV also couple our in-house developed game which are also with very good quality. And we believe that they all have the potential to become the next game revenue contribution over 10% and this is also one of the important direction for our All-Star strategy to ensure launches for new game titles.

Operator

Ladies and gentlemen that does conclude the question-and-answer session for today; I’d now like to hand the call back to you presenters. Please continue.

Ellen Chiu

Thank you again for joining us today, if you have any further questions please feel free to contact us. Have a nice day.

Operator

Ladies and gentlemen that does conclude the conference for today. Thank you all for your participation, you may all disconnect.

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