Shanda Interactive Entertainment Ltd. Q2 2008 Earnings Call Transcript

Sep. 3.08 | About: Shanda Interactive (SNDA)

Shanda Interactive Entertainment Ltd. (NASDAQ:SNDA)

Q2 2008 Earnings Call

September 2, 2008 9:00 pm ET

Executives

Maggie Yun Zhou - Investor Relations Manager

Tianqiao Chen - Chairman of the Board, Chief Executive Officer

Alan Qunzhao Tan - President and Chief Technology Officer

Grace Wu - Chief Financial Officer

Analysts

Dick Wei - JP Morgan

Alicia Yap - Citigroup

Tian X. Hou - Pali Capital

Eddie Leung - Merrill Lynch

Richard Chao – Alliance Bernstein

Jenny Wu - Morgan Stanley

Paul Keung – Oppenheimer

[Lin Ho] – Goldman Sachs

Wendy Haung

Anthony Gikas - Piper Jaffray

Operator

Welcome to Shanda Interactive Entertainment’s 2008 second quarter earnings conference call. The conference call will be recorded and available for replay in its entirety. A copy of Shanda’s second quarter 2008 announcement can be found and downloaded from its corporate website, www.snda.com. (Operator Instructions)

I would now like to turn the call over to Ms. Maggie 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 second quarter 2008 results conference call. Here with us today are Mr. Tianqiao Chen, our Chairman and CEO; Mr. Alan Qunzhao Tan, our President and Chief Technology Officer; and Ms. Grace Wu, our Chief Financial Officer.

Before we begin, I would also like to remind you that management’s comments during the call will include forward-looking statements that are based on our current expectations and are intended to qualify for the safe harbor from liability for such statements established in the U.S. Private Securities Litigation Reform Act of 1995. All statements 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 Shanda Interactive Entertainment’s second quarter 2008 press release.

In addition, please note for discussion purposes, all numbers were translated into U.S. dollars based on the exchange rate of RMB 6.8591 per U.S. dollar. With that, I would like to turn the call over to our Chairman and CEO, Mr. Tianqiao Chen.

Tianqiao Chen

Thank you, Maggie. During the second quarter, Shanda continued to make significant progress towards the company's development as a global entertainment media company through the execution of the 3C strategy of content, community and commerce. Despite the impact of the devastating earthquake, Shanda achieved it's tenth consecutive quarter of growth since initiating our CSP model in late 2005 with revenue reaching $122.1 million in 2Q08, a 7.4% increase from 1Q08. This exceeds our prior guidance of zero to 5% growth.

Shanda's ability to maintain quarter-on-quarter growth and to successfully execute our 3C strategy is attributable in large part to our employees. The dedication and commitment of our employees and their ability to strategize, innovate and execute are the backbone of our success. In recognition of this contribution of our employees to our continued growth and development, we applied both general and merit-based salary and benefit increases in 3Q08, at approximately an average rate of 20%. We have recruited and retained -- and aim to continue to attract -- the best talent to Shanda by offering the most competitive compensation package.

In July 2008 the company also announced the establishment of Shanda Literature, or SDL, in addition to our current two business units -- Shanda Online and Shanda Games -- to further enhance the company’s 3C strategy of content, community and commerce. Shanda Online operates the company’s integrated ecommerce system and virtual community platform. Shanda Games will operate our online games and will continue its balanced portfolio approach and innovative multi-channel sourcing strategy which together support a diverse offering of games targeting a broad user base.

Shanda Literature serves as a leading online publisher of original user-generated literary world in China with three different literary platforms -- qidian.com, jjwxc.com and hongxiu.com -- which represents the smallest portion of our overall revenues, but have a dominant position in the Chinese online original literature market.

While online games continue to remain our primary content offering, we are also exploring other growth opportunities by leveraging the advantage of our community and the platform.

As we have emphasized many times in the past, content attracts users; community and commerce help retain users and monetize the user base and in turn attract more users. Shanda’s operating platform will continue to integrate our various online communities such as the online game communities and the online literature communities; leverage the advantage of the Web 2.0 community and achieve sustainable and scalable long-term growth.

Last but not least, as Shanda continues to evolve as a global entertainment media company, we remain committed to explore various opportunities to converge the real world and the virtual fantasy world experience for our users.

Now I will turn the call over to Alan, our president and CTO.

Alan Qunzhao Tan

Thanks, Tianqiao and welcome, everyone. Despite the seasonal weakness in casual games and the three-day games service suspension during the national mourning period in May, Shanda achieved another quarter of solid growth for the second quarter of 2008.

Online game revenues grew 47.7% year over year and 6% quarter on quarter to a record high of $117 million, as a result of the successful execution of our diversified portfolio strategy, which is further enhanced by our unified [strengths]. During the second quarter we continued to post growth of our existing titles by releasing a total 43 expansion packs for our games portfolio. We also organized customized in-game promotions targeting each game, and had various online and offline activities to enhance user interaction and communication.

In terms of new games, we launched a full commercial service for Might and Hero, a web-based RPG in June and received encouraging user feedback. In addition, three MMORPGs and one casual game, namely [inaudible], Tales of Dragon, The Conqueror and X-Up, entered into beta testing during the second quarter.

Net revenues from our MMORPGs in the second quarter rose 8.5% quarter over quarter and 47% year over year to $101.3 million. As a result of growth in existing titles, we continue to launch content upgrades, as well as a partial contribution from new titles.

Active paying accounts for our MMORPGs grew 3.1% quarter over quarter to a record $4.2 million in the second quarter of 2008. Note the ARPU for MMORPGs increased 5.2% quarter over quarter to RMB 54.7 in the second quarter.

Our casual game revenue declined 7.8% quarter over quarter to $15.7 million, increased 52.1% year over year. The sequential decline in casual game revenues is primarily due to seasonality in casual games for which the first quarter of each year is usually heightened with the winter holidays and the Chinese New Year. Active paying accounts for casual games declined 14.1% quarter over quarter to 1.65 million, yet ARPU for casual games increased 7.4% quarter over quarter to RMB 21.8.

Looking into the third quarter, we expect continued growth in our existing games portfolio from the planned releases of expansion packs and value-added services, and a full quarter contribution of Might and Hero. In terms of new games, we have started open beta testing of Castle of Dragons in July and expect to launch open beta of X-Up in September. Also in the third quarter we commenced closed beta testing of Dead or Alive online and expect to conduct open beta testing of Changchun Online during the fourth quarter.

As of the end of August, we are operating 12 MMORPGs, nine casual games, two [inaudible] game packs and one [inaudible]. In addition, there are 11 MMORPGs and six casual games in the [Alliance] pipeline that will also be released in the next 12 to 18 months.

Now I will hand the call over to our Chief Financial Officer, Grace Wu.

Grace Wu

Thank you, Alan. During the second quarter both our net revenues and operating income achieved record highs of $122.1 million and $48.9 million respectively, a solid 7.4% and 7.5% quarter over quarter growth, despite a weak season for casual games and the impact from the three-day suspension of game services.

Other revenues in Q2 increased 67.4% year over year and 55.9% quarter over quarter to $5.1 million, recovering from seasonal weakness in Q1. Gross profit was $88.9 million in the second quarter, compared with $79 million in the preceding quarter and $55.3 million for the same period in 2007.

Gross margin for the second quarter of 2008 was 72.8%, compared with 69.5% in the first quarter and 67.2% a year ago. The sequential growth in gross margin was primarily due to the decrease in other cost of services related to impairment charges.

Income from operations was $48.9 million, up 17.5% quarter over quarter and 37.4% year over year. Operating margin remained relatively stable in Q2 at 40.1% compared with 40% in 1Q08 and compared with 43.3% in 2Q07.

Development expenses increased 4.6% quarter over quarter in Q2 to $9.9 million. Sales and marketing expenses increased by $2.8 million to $11.5 million sequentially, approximately 32.9%, mainly from an increase in marketing and promotion expenses. We expect sales and marketing expenses to continue to increase in 3Q08 due to a series of marketing campaigns and promotional activities related to ChinaJoy and student summer holidays.

General and administrative expenses increased by $3.2 million quarter over quarter to $18.6 million, primarily attributed to provision expenses, auditing-related expenses and staff-related expenses.

Share-based compensation in Q2 was $2.2 million, similar to that of our first quarter of 2008 and year ago. Net non-operating income for the second quarter was $0.8 million compare to $0.8 million in the first quarter of 2008 and $30.6 million in the second quarter of 2007. The year-over-year decline was mainly due to a one-time capital gain of $25.9 million recorded in 2Q07 which was generated from the sale of SINA shares. Non-operating income from government subsidiaries was $0.8 million in 2Q08. This compared with $0.3 million in the first quarter of 2008 and $2 million in the second quarter of 2007. Our receipt of government financial incentives is subject to a time lag and government administrative practices. We expect we will continue to receive government subsidies in the remainder of 2008.

Income tax expense for the second quarter was $8.9 million compare with $4.2 million in 1Q08 and $5.6 million in 2Q07. The sequential increase in income tax expenses primarily resulted from a tax benefit of $2.9 million which was recognized in 1Q08 to reflect the new income tax law that came into effect as of January 1 2008.

Effective [inaudible – break in audio] that unified the enterprise income tax payable by domestic and foreign investor enterprises at 25%. Prior to the adoption of the new law, a number of the company’s subsidiaries and [VIEs] were entitled to various preferential tax treatments. The company’s subsidiaries and [VIEs] are currently in the process of applying for the new high-technology enterprises tax treatment pursuant to the working guidelines for assessment of new high-tech enterprises issued by the Chinese tax authority on July 8 2008.

The company reported its income tax provision at the statutory income tax rate of 25% at this moment, except for certain subsidiaries of the company that are subject to a tax holiday. We expect to reverse any excess tax provisions in subsequent periods as and when the subsidiaries and [VIEs] are deemed to qualify as new high-tech enterprises, or are entitled to other tax incentives which the company expects will be partially offset by the expected reduction to our deferred tax assets recorded at a lower preferential tax rate.

Net income in Q2 was $40.8 million compared with $42.1 million in 1Q08 and $60.6 million in 2Q07. Diluted earnings per ADS were $0.56 in 2Q08 compared with $0.58 in 1Q08 and $0.84 in 2Q07.

Non-GAAP net income, which excludes share-based compensation and the impact of the disposal of SINA shares was $43 million in 2Q08, compared with $44.4 million in Q1 and $37 million in 2Q07. Non-GAAP diluted earnings per ADS were $0.58 in Q2 compared with $0.60 in 1Q08 and $0.50 in 2Q07. The effective tax rate was 17.9% in 2Q08 compared with 9% in 1Q08 and the adjusted effective tax rate of 13.8% in 2Q07, which excludes the one-time capital gain from the sale of SINA shares that was non-taxable in 2Q07.

The sequential increase in the effective tax rate of 2Q08 was mainly due to the recognition of $2.9 million tax benefit in Q1 explained earlier. Excluding the $2.9 million income tax credit included in 1Q08, the effective tax rate for that quarter would have been 15.2% compared to 17.9% in Q2. We expect the effective tax rate for 2008 to be in the range of approximately 18% to 25%.

For the first six months ended June 30, 2008 consolidated net revenues grew to $235.8 million, up 47.5% year over year. Operating income amounted to $94.4 million, up 38.2% year over year. Net income was $82.9 million compared with $126.1 million for the same period last year.

Non-GAAP net income was $87.4 million, up 27.8% year over year. Diluted EPS per ADS were $1.12 and Non-GAAP diluted EPS were $1.18 for the first half of 2008 compared with diluted EPS of $1.72 and non-GAAP diluted EPS of $0.94 a year ago.

Turning to our balance sheet, cash and cash equivalents as of June 30 2008 totaled $378.4 million and $514.9 million including short-term investments and marketable securities. Deferred revenues increased 5.2% quarter over quarter to $62.2 million in the second quarter of 2008.

Before I turn to 3Q08 guidance, we caution that we cannot predict the future exchange rate of RMB against the US dollar and therefore cannot accurately or with any degree of certainty estimate the effect of any change in exchange rates on our financial results.

Accordingly, in giving our financial targets below, we assume no change in exchange rate for 3Q08 and have adopted the same exchange rate of $1 per RMB 6.8591. Our actual results could differ from our financial targets for various reasons as stated in the safe harbor notice in the press release, including changes in the exchange rate. Now based on the company’s current operations, we expect our consolidated net revenues for the third quarter of 2008 to increase by a rate in the range of 6% to 9% quarter over quarter and our operating margin for the third quarter is expected to be similar to the level of 2Q08.

That concludes my financial discussion. I will now turn the call back to Maggie Zhou. Thank you, Maggie.

Maggie Yun Zhou

We are now ready for questions. Operator, please go ahead.

Question-and-Answer Session

Operator

Your first question comes from Dick Wei - JP Morgan.

Dick Wei - JP Morgan

With the higher salary expenses and potentially sales and marketing expenses for the third quarter and the beyond, what kind of longer term margin trend does the company see?

My second question is on the overall game development in China, any new trends that you see in the market, particularly for example if the real-time strategy games have gotten more popular and your view on Company of Heroes, for example. Thank you.

Grace Wu

Allow me to answer your first question regarding long-term margin trends. We usually have a salary and benefit increase every year, it usually takes effect in the third quarter and also we did that in 2008 as well. This definitely has an impact on margins; approximately 1%.

However, it is always our commitment to try to offset these type of expenses with our scale efficiency so hopefully we can manage the long-term margin in a similar range, but of course, given the short period of time it might fluctuate a little bit. Longer term we still hope to keep the operating margin in a stable range.

Maggie Yun Zhou

Dick, can you please repeat your second question again?

Dick Wei - JP Morgan

I was curious on the company’s thoughts of on new game development in China. Any new trends in China in terms of a game type that is more popular or any interesting development? For example, are real-time strategy type of games getting more popular or not? Thanks.

Tianqiao Chen

(Translation)

Thank you, Dick for your question. I will interpret Mr. Chen’s answer. The China online game market is developing. We will see that; there will be more and more different types of games coming out.

For example, at the current stage, we work with the traditional game developers to develop the online version of single-PC games such as Dead or Alive Online and Company of Heroes Online. We’re very positive on the future of the different types of games.

In addition, we believe that based on our portfolio strategy we are able to provide users a very diversified experience and are very optimistic about that.

Operator

Your next question comes from Alicia Yap – Citigroup.

Alicia Yap - Citigroup

Regarding your 3Q guidance, how much have you factored in from the contribution of Changchun and other new games? How much will the guidance actually continue to come from the growth of existing games?

Grace Wu

As Mr. Tan explained during his part of the presentation, Changchun Online had a closed beta testing in the third quarter and the open beta testing will commence in Q4. Therefore the contribution for Q3 from Changchun will be relatively limited. We take in all the different considerations for our current game portfolio and the current operations to provide our Q3 guidance which was 69% quarter-over-quarter growth. Thank you.

Alicia Yap - Citigroup

Does that mean that the Changchun closed beta testing is not currently charging people, or am I mistaken on that?

Tianqiao Chen

(translation) Currently we are in a limited closed beta testing period and we have launched some tests for commercialization but at this stage it is very minimal.

Grace Wu

We are actually still using this closed beta testing to explore the potential user appetite to figure out the best model for this game. Therefore right now in the third quarter the relative commercialization is very limited. I wouldn’t call it commercialization, it’s really a logic testing.

Alicia Yap - Citigroup

How is the game actually performing and whether the performance so far has met your internal expectations? Was there any particular reason to launch a free service for Changchun? Is that mainly just to test the reception for the battlefield game play?

Grace Wu

I’m sorry, Alicia, we missed the last part of the question. You were breaking up there.

Alicia Yap - Citigroup

My second question is on your expectation for Changchun and is there any reason for you to launch a free service for the game? Was that mainly just to test the reception for the battlefield game play?

Tianqiao Chen

(Translation) Changchun commenced beta testing in July and during this period we expect to view the feedback and listen to suggestions and then build in adjustments according to user demand. We expect to start open beta of the game in the fourth quarter of ‘08. The launch of free service is [inaudible].

Alicia Yap - Citigroup

From last week’s earthquake, can you see any material impact for your game business in terms of the affected provinces?

Tianqiao Chen

(Translation) We see very minimal impact.

Operator

Your next question comes from Tian X. Hou - Pali Capital.

Tian X. Hou - Pali Capital

Regarding the new game content, in the market there are so many new games coming out. What is the differentiation point between Changchun and other games in the market?

Tianqiao Chen

(Translation) From the game itself, the game is a particular game and has a big history background, has a very special player system and also we feel very good recognition.

Tian X. Hou - Pali Capital

In the markets we read some surveys among CEOs of game companies. One common feeling among the game company CEOs is [inaudible] and you guys constitute an international corporation? I just wonder, what do we think in that front?

Grace Wu

I am sorry Tian, we missed your question. You mentioned there were some surveys for the game company CEOs?

Tian X. Hou - Pali Capital

(Translation not provided)

Tianqiao Chen

(Translation not provided)

Tian X. Hou - Pali Capital

The last question is about the sales and marketing expense. What do you expect the sales and marketing expense to be in Q3? It seems like a pretty high increase in the second quarter. Do you expect to see a similar type of increase? How should we model this type of expense?

Grace Wu

Generally Q3 is pretty much the peak season for us to focus on our marketing campaign because of ChinaJoy, the student summer holidays, so we expect to see a similar trend of a quarter-over-quarter increase for Q3 this year as well. So we do expect to see an increase in marketing expense growth in Q3.

Operator

Your next question comes from Eddie Leung - Merrill Lynch.

Eddie Leung - Merrill Lynch

Related to regulations, if the government implements a rating system on online games, what could be the impact on your various games?

Tianqiao Chen

(Translation) As a fast-growing industry, the online game industry was supported by the Chinese government and the government wants to regulate the industry in a healthy direction. As a leader in this industry, Shanda is always working closely with government. For the ratings system you mentioned earlier, long-term Shanda will also work closely with the government.

Eddie Leung - Merrill Lynch

Do you expect it will be a positive trend to your game revenues or a negative or neutral?

Tianqiao Chen

(Translation) I think that any regulation targeted at the long-term healthy growth of the industry will help the industry to prosper in the long term. As a leader in this industry we are also able to benefit from the growth from that industry.

Eddie Leung - Merrill Lynch

Grace, could you elaborate more on the increase in minority interest on your balance sheet?

Grace Wu

The minority interest quarter over quarter reflects the different [inaudible] we reported on a consolidated basis for the whole group. We are engaging in various divisions lines, so this is actually a combination reflecting the different investments we have. Mainly the difference this quarter I would think actually are subsidiaries in Korea which we own 51%. That will reflect the difference based on the consolidation on the top line.

Operator

Your next question comes from Richard Chao – Alliance Bernstein.

Richard Chao – Alliance Bernstein

First of all, congratulations on the excellent results, everybody. I have several questions. First regarding the gross margins in the second quarter if you can give me some highlights on why there was the strength here?

Second of all, I would like to ask about your new game launch in the fourth quarter. Also how much did it make on the in-game advertising in the second quarter? Thanks.

Grace Wu

Allow me to answer your first question regarding the gross margin. We do have an enhancement in gross margin for 2Q08 which mainly reflects that in Q1 we recorded an impairment charge about RMB 1 million that quarter. In Q2 we are free of that burden, so that had some contribution to gross margins.

And I will ask Mr. Chen to answer your second question.

Tianqiao Chen

(Translation) Currently we have 11 MMORPGs games and six casual games in the pipeline. As Mr. Tan expressed earlier in the conference call, during the third quarter we are going to launch the open beta testing of Tales of Dragon, we have already commenced open beta testing and also X-Up, the casual game, we are able to launch open beta in a few days. Also we have commenced the Changchun Online closed beta testing and also commenced the closed beta testing for [inaudible] Life Online in the third quarter.

Going forward, we don’t have much to disclose at the moment.

Grace Wu

We hope to update you in our third quarter conference call.

Richard Chao – Alliance Bernstein

If you can comment on the in-game advertising revenue in the second quarter?

Grace Wu

We actually see pretty healthy growth of in-game advertising revenue quarter over quarter but that was still a very, very small portion of the overall business still. We do see a pretty good growth rate there and we expect to see the trend continue in the following quarters.

Operator

Your next question comes from Jenny Wu - Morgan Stanley.

Jenny Wu - Morgan Stanley

What percentage of total active accounts are paying for your games in the second quarter?

Tianqiao Chen

(Translation) The commercial rate of active paying accounts is around 8% to 9% at this moment.

Jenny Wu - Morgan Stanley

My second question is regarding the game contribution. In the second quarter which game contributed the most for revenue growth? What is the revenue contribution for your newly launched games?

Grace Wu

I apologize we can not disclose the detailed performance of our portfolio. We see pretty good growth in the second quarter from our existing portfolio and very encouraging growth trends for our newly launched titles.

Jenny Wu - Morgan Stanley

On your [inaudible], so far what’s the revenue contribution from this new business line?

Grace Wu

Again, as Mr. Chen mentioned in his presentation, currently it is still a very small portion of our overall business. The revenue of the business unit is considered part of other revenues in our financial statement. We do see very encouraging growth trends overall in this business. We also announced a very strong management team to lead this business unit which was in place in July this year. Therefore, in the next quarters we expect to see a very strong management team to lead this newly established unit.

Jenny Wu - Morgan Stanley

When do you expect it to become a material revenue contributor? Will it contribute more than 5% of total revenues?

Grace Wu

We are very positive of all of our business lines and therefore we expect to see healthy growth in all of them. That’s why it’s very difficult to predict when you have a very high contribution to revenue. We are very optimistic about SDL as well as how we are positive about our future growth trend for ITA and other businesses.

Jenny Wu - Morgan Stanley

Can you give us some color on your potential approaches to monetize the business? What percentage of the orders are paying now? Thank you.

Grace Wu

Currently it is still charged by the subscribers and also the number of characters. However, we also see different revenue models for SDL to license its copyright to different businesses such as movies, online games and books. We have now a very strong management team in place and we expect them to develop a new business revenue model for us, but due to some business competition we cannot discuss too much at this moment.

Jenny Wu - Morgan Stanley

What percentage of the orders are paying now?

Grace Wu

At this moment, we cannot disclose that number due to the business activity.

Operator

Your next question comes from Paul Keung - Oppenheimer.

Paul Keung - Oppenheimer

I have a question on casual games revenue this quarter. In previous years the seasonal decrease in 2Q was much greater. Can you comment on why the casual games business in Q2 this year did not drop as much as in previous years? Was it more of the new game launch that is performing better than before or better monetization from older games?

Tianqiao Chen

(Translation) On the casual game side we implemented a portfolio strategy, particularly during the first quarter and second quarter we have launched a couple of new games. In addition to the contribution from new games, we continue to launch content upgrades and expansion packs for our existing games and launched in-game promotions in the game community. All of this helped us in the causal games business.

Paul Keung - Oppenheimer

Is there any one game that’s responsible for a large percentage of the growth in Q2?

Tianqiao Chen

(Translation) Several games in the second quarter we see really strong performance, but due to business confidentiality we did not disclose that detail. Thank you.

Paul Keung - Oppenheimer

Can I ask a follow-up question on Haofang Network? How much is Haofang Network contributing to Shanda in terms of both users and in terms of revenue? Can you comment on how Battle.net from Blizzard and Starcraft II will affect your network once that launches?

Tianqiao Chen

(Translation) Haofang is the leading esports; it’s the largest esports platform globally with a very large user base and advanced esports operation expertise. We are very proud to be the major shareholder of the company. In terms of the revenue side, we still see very minimal contribution on the revenue side. We are very confident in the future growth of that.

Operator

Your next question comes from Eddie Leung - Merrill Lynch.

Eddie Leung - Merrill Lynch

Questions on the seasonality in the third quarter, because we just had the Olympic Games, I am wondering could you also comment on the impact of the Olympic Games on your casual games as well as on your MORPG? Did you see a big difference between the impact, or pretty much are similar? Thanks.

Tianqiao Chen

(Translation) We saw very limited impact from the Beijing Olympic Games both on casual games and MORPG games. For casual games particularly we have done a lot of promotions in accordance with the Beijing Olympic Games. Thank you.

Operator

Your next question comes from the line of [Lin Ho] – Goldman Sachs.

Lin Ho – Goldman Sachs

First of all on Q3 can you give us a little bit of color of how your game operation is trending so far into Q3? What do you expect will be the major driver for growth? Is that going to be growth in users or growth in ARPU? I understand that there is going to be a seasonal rebound in the casual game trends.

Tianqiao Chen

(Translation) So far in the third quarter we see all the games performing on track. We also focused both growth through active paying accounts and ARPU and we believe that with the launch of the new company as well as the launch of new in-game promotions that APA and ARPU both have large potential to grow in the future.

Lin Ho – Goldman Sachs

Can you give us a little bit of an update on timing related to [inaudible]? Secondly, I was just wondering if you can comment on the future outlook or growth for console games in the China gaming market. Thank you.

Tianqiao Chen

(Translation) We are trying to introduce [inaudible] at the end of this year or next year and we will also launch the [inaudible] model based on the user feedback.

As for console game prospects in the China markets, at the current stage we have already cooperated with some of the console game developers to co-develop the online version of console games and we will closely monitor the opportunities in the China markets.

Lin Ho – Goldman Sachs

If I’m not mistaken I remember there was some sort of regulation related to console games, specifically the console launches, in China. Is that still ongoing or are there some changes on the policy front?

Tianqiao Chen

(Translation) Actually we work very closely with the government about the regulation. If we sense any significant change we’ll know that.

Operator

Your next question comes from the line of Wendy Haung – [inaudible].

Wendy Haung

I just want to confirm with you that you mentioned Changchun will be open beta testing in the fourth quarter. Should we expect that’s a fully commercialized quarter for Changchun?

Tianqiao Chen

(Translation) We haven’t worked out the detailed timetable for Changchun Online yet. There might not be full commercialization of the game, there is still uncertainty there.

Wendy Haung

You mentioned that you have some overseas revenue. Could you tell us your overseas revenue as a percentage of total revenue? I think those probably weren’t disclosed in the quarter results.

Grace Wu

Right. We just started the overseas licensing business, hence at this moment it’s still a relatively small portion to our very, very large scale in China. Therefore we haven’t disclosed the percentage of that. But once it becomes a very meaningful contribution, we’ll disclose the breakdown of the overseas contribution.

Wendy Haung

So it’s less than 1%.

Grace Wu

I cannot disclose that at this moment.

Wendy Haung

Finally, could you give us some updates on the Actoz side. How do you see its impact on your financials as well as operations so far?

Grace Wu

Right. We started consolidation of Actoz on our financial statements to the group financial statements from third quarter last year once we took the majority stake in Actoz, over 51% we were required to consolidate financials. We include Actoz revenues in top line and we subtract the difference in minority shareholder interest in our non-operating items.

But Actoz itself is a publicly listed company in Korea so its financial statements are available to the market, you can take a look. Mainly the difference to us is actually on the cost of service part we are able to combine Actoz contribution which has eliminated the double counting of the licensing charges for the games developed by Actoz while in operating expenses we actually have to incur additional costs for the R&D staffing and also the [inaudible] expenses in Korea which are higher than China. So I think after operating margin, the net-net effect is pretty much neutral.

Wendy Haung

On the gaming operation side, are there any improving synergies impact from Actoz?

Grace Wu

Yes. One of the reasons why we took majority stake in Actoz is because they have fabulous R&D engineers who have a different developer’s mind with a different cultural background so it does add diversity to our game portfolio and also significantly enhances our R&D talent.

Operator

Your final question comes from Anthony Gikas - Piper Jaffray.

Anthony Gikas - Piper Jaffray

As it relates to the gross margin you talked about there being a reduction of this other cost of services expense. Is that a permanent expense reduction on that line item?

What have you seen with gaming trends post-Olympics? Have you seen a measurable uptick in user activity?

Could you give us the cash flows from operations during the quarter?

Grace Wu

Allow me to answer your first question. You mentioned about the cost of service difference. We provided an explanation actually in Q1, we took an impairment charge related to some of the titles in our game portfolio, which amounted to probably about RMB 10 [points]. In the second quarter, we did not have that impairment provision and therefore the cost of service was lower.

We continue to monitor the portfolio of our titles and we take a provision charge whenever it is necessary or we believe it would be a prudent approach, as the company always takes a prudent approach to evaluate our portfolio and the potential charges. So it is one-time in Q1 and we don’t have such charges in Q2.

I hope that answers your question.

Tianqiao Chen

During the Olympics period we saw a very limited impact from these events and after the Olympics we also see game performance on track.

Grace Wu

Would you repeat your third question?

Anthony Gikas - Piper Jaffray

Could you give us the cash flow from operations during the quarter? With the pretty sizeable cash position that you have, could you maybe just talk about use of that excess cash going forward?, Is it share repurchases, company acquisitions, intellectual property acquisitions?

Grace Wu

We disclose our cash flow statements on an annual basis and hence we do not have quarterly cash flow statements. But as you know the business model we have healthy EBITDA trends and therefore we also see a very healthy cash flow from operations continue to contribute to our cash balance.

Operator

This concludes the question-and-answer session. At this time, I will turn the call back over to Ms. Maggie Zhou for closing remarks.

Maggie Yun Zhou

Thank you everyone for joining the conference call today. Please feel free to contact us if you have any further questions. Have a good day.

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