NetEase Q2 2006 Earnings Conference Call Transcript (NTES)

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NetEase, Inc. (NASDAQ:NTES)

Q2 2006 Earnings Conference Call

August 14, 2006 9:00 pm ET

Executives

Brandi Piacente - IR

William Ding - CEO

Michael Tong - COO

Denny Lee - CFO

Analysts

Lu Sun - Lehman Brothers

Wallace Cheung - Credit Suisse First Boston

Safa Rashtchy - Piper Jaffray

Richard Ji - Morgan Stanley

Frank Shi - CLSA Limited

Dick Wei - JP Morgan

James Mitchell - Goldman Sachs

William Bao Bean - Deutsche Bank

Antonio Tambunan - Bear, Stearns

Tian Hou - C.E. Unterberg

Ming Zhao - Susquehanna Financial Group

Catherine Leung - Citigroup

Operator

Good day and welcome to NetEase fiscal second quarter 2006 financial results conference call. As a reminder, today's call is being recorded. For opening remarks and introductions, I would now like to turn the call over to Ms. Brandi Piacente, Investor Relations for NetEase.com.

Brandi Piacente

Thank you, operator. Today you will first hear from Mr. William Ding, Chief Executive Officer; and Mr. Michael Tong, Chief Operating Officer; who will discuss some of the financial and operational highlights for the second quarter end June 30, 2006. Finally, Mr. Denny Lee, Chief Financial Officer, will review the financials.

Before we continue, please note that the discussion today will contain forward-looking statements relating to future performance of the Company and are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities Litigation Reform Act. Such statements are not guarantees of future performance, and are subject to certain risks and uncertainties, assumptions and other factors. Some of these risks are beyond the Company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion.

Risks related to the fluctuation in the value of the renminbi with respect to other currencies could also adversely affect the Company's business and financial results. The Company does not undertake any obligation to update this forward-looking information, except as required by law.

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

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

Michael Tong for William Ding

Thank you for joining us today. I will begin with an overview of each of our services segments. In total, revenues for the quarter increased 8.6% quarter-over-quarter; and 38% year-over-year to $72 million, driven by strong sequential growth across all of our service categories.

Online game revenues for the quarter grew 7.9% quarter-over-quarter; and 41.4% year-over-year to $60.8 million. The continuing and growing popularity of Fantasy Westward Journey was the key driver of our growth for the quarter. Fantasy Westward Journey achieved record peak concurrent user metrics of approximately 1.3 million for the second quarter. During the same period, Fantasy Westward Journey achieved average concurrent users of 494,000. In addition, Westward Journey Online II achieved peak and average concurrent users of approximately 561,000 and 197,000 respectively for the second quarter of 2006.

Our newest expansion packs with rich content updates for Fantasy Westward Journey is planned for release by the end of this year, which we expect will contribute to the strength and bolster the popularity of this leading game, which remains the number one online game in China.

Additionally, we are in the process of revamping the game engine for our original and most mature game, Westward Journey II, which we believe will spur future growth in player usage and enhance its longevity. Effectively, we are going to provide a new game with new playing features, content and artwork under a 2.5D environment, which we believe will have a significant impact on the continued success and longer life cycle of Westward Journey II. We expect to initiate internal closed beta testing of the upgraded version of this game in early ’07.

Overall, these comprehensive game enhancements, coupled with the marketing leverage we have from our portal are key strategies for expanding the lifecycles of our original online games.

Our new 2.5D game, Datang, was in open beta testing for approximately one-and-half months during the second quarter and achieved solid results during the period. Datang was commercially launched on July 19th and market response has been satisfactory. We still have many amendments to this game to look forward to, and we will continue to build on its initial success and increasing its popularity in the markets by regularly adding new content and playing features, including the new cube system just released in August, and by signing up additional promotional partners as we move ahead.

We are very enthusiastic about our next generation 3D game, Tianxia 2, which is currently in closed beta testing. Tianxia 2 remains on track and we plan to commence open beta testing by the end of this year. We look forward to solid progress in the remaining parts of ’06 as we execute on our marketing, customer services and product development initiatives for this game.

Our online game team is stronger than ever, and we believe this is the best in this industry. We have picked internal resources for research and development, game development and marketing, a strong and stable platform for the future growth of our online game business.

Turning to our advertising services segment, advertising services revenue increased 11.7% quarter-over-quarter; and 28.7% year-over-year to $8.6 million. The primary drivers of our advertising services revenue growth were the traditional seasonal increase in advertiser spending. During the second quarter, we drove overall increased advertising placements in response to our enhanced web content.

World Cup activity also brought increased traffic to the NetEase.com portal during the second quarter. World Cup presented us with a great opportunity to showcase our improved content channels, and new services for Internet users to a broad audience. In addition, our new blog services are already under closed beta and is planned to be released in the third quarter.

We have an extremely large and loyal user space, a massive interactive marketing platform for advertisers. During the second quarter, the NetEase family of websites drew average daily page views of 702 million, making us one of the most popular destinations in China and on the World Wide Web.

Turning to the wireless category, revenues from the wireless value-added services and other also showed solid quarter-over-quarter growth of 16.3%. Revenues from this segment increased to $2.6 million from $2.2 million for the first quarter of 2006, and $2.4 million for the second quarter of 2005.

Let me now turn to Denny for a more detailed discussion of our financial performance for the second quarter.

Denny Lee

Thank you, Michael. I will now provide an overview of our financial highlights for the second quarter using numbers and percentages based on U.S. dollars. Please note that in order to provide a meaningful comparison of NetEase’s current operating results to those periods prior to the Company’s adoption of FAS-123 R, which took effect this year, our presentation includes non-GAAP results for the second quarter. A reconciliation of the non-GAAP financial measures to the U.S. GAAP results are provided in the unaudited financial information included in today’s earnings release.

Once again, total revenues increased to $72 million for the second quarter of 2006, representing an increase of 8.6% from the previous quarter, and 38% over the second quarter of 2005.

Breaking down into revenue categories: online game revenues increased to $60.8 million for the second quarter of 2006, representing a 7.9% quarter-over-quarter increase and a 41.4% year-over-year increase. Revenues from the advertising services increased 11.7% quarter-over-quarter and 28.7% year-over-year to $8.6 million. Wireless revenue increased to $2.6 million for the second quarter of 2006, from $2.2 million for the first quarter of 2006 and $2.4 million for the second quarter of 2005.

GAAP gross profits for the second quarter of 2006 was $57.2 million. Non-GAAP gross profit was $57.8 million, representing an 8.6% increase over the previous quarters. Non-GAAP gross profit of $53 million for the first quarter of 2006. Second quarter non-GAAP gross profit represents a 31.3% increase over non-GAAP gross profit of $39.5 million for the corresponding period a year ago. Non-GAAP financial measures exclude the effects of certain non-cash, share-based compensation expenses.

Total GAAP gross margin was 82.8% for the second quarter. Total non-GAAP gross margin for the second quarter was 83.5%, compared with non-GAAP gross margin of 83.6% for the previous quarter, and 83.2% for the same quarter last year.

GAAP gross margin for the online game business for the second quarter of 2006 was 90.7%. Non-GAAP gross margin for the online game business for the second quarter of 2006 was 91% compared with non-GAAP gross margin of 90.7% for the previous quarter and 90.2% for the second quarter of 2005.

GAAP gross margin for the advertising business for the second quarter of 2006 was 49.8%. Non-GAAP gross margin for the online advertising business for the second quarter of 2006 was 53.3%, compared with non-GAAP advertising gross margin of 55.3% for the preceding quarter, and 62.1% for the second quarter of 2005, primarily due to an increase in salary and other benefits paid to our content editors.

GAAP gross margin for wireless value-added services business for the second quarter of 2006 was -2.3%. Non-GAAP gross margin for the wireless segment was 1.9% in comparison to -7.1% for the preceding quarter, and 18.4% for the same quarter a year ago.

GAAP operating expenses for the second quarter of 2006 totaled $16.8 million, or 23% of total revenue. Total non-GAAP operating expenses for the second quarter of 2006 were $14.1 million compared with $11.5 million for the preceding quarter, and $9.7 million for the same period last year. The increase in non-GAAP operating expenses, in comparison to the preceding quarter, was primarily due to a one-time write-off of $1.4 million in software costs for the Company’s licensed online 3D game, Fly for Fun.

As a result of the foreign currency translation from currency other than the Renminbi into Renminbi in accordance with applicable accounting standards, we reported a $6,000 foreign exchange loss in the second quarter of 2005 [sic – see press release].

GAAP net profit for the second quarter totaled $39.3 million. Non-GAAP net profit for the second quarter totaled $42.6 million, a 6.5% increase over the preceding quarter’s non-GAAP net profit of $39.9 million; and a 40.2% increase over non-GAAP net profit of $30 million for the second quarter of 2005.

GAAP basic and diluted earnings per ADS was $0.30 and $0.28, respectively, which includes the impact of approximately $3.3 million, or $0.02 per ADS, in non-cash, share-based compensation costs. This compares to $0.28 per basic ADS and $0.26 per diluted ADS for the first quarter of 2006; and $0.23 per basic ADS and $0.21 per diluted ADS for the second quarter of 2005.

As of June 30, 2006 total cash and time deposit balance was $451.8 million. Cash flow generated from operating activities decreased to approximately $37.1 million, compared to the previous quarter’s $51.4 million, primarily due to the repayment of option proceeds held on behalf, by the Company, to employees and the seasonal increase in accounts receivable balance in the second quarter of 2006.

Finally, for an update on our share repurchase program that we announced on May 18, we repurchased approximately 2.4 million of our issued and outstanding ADS for an aggregate purchase consideration of $50.3 million, including transaction costs. The weighted average number of ADS outstanding diluted decreased to 141.5 million shares for the second quarter of 2006 as a result of the share repurchase, which was funded from available working capital. We are pleased to have completed our share repurchase, that underscores our confidence in the long-term value of NetEase and returns such value back to our shareholders.

Now, I would like to comment on our financial guidance for the third quarter ending September 30, 2006. Please note that the following outlook statements are based on current expectations. These statements are forward-looking and actual results might differ materially.

We expect total gross revenues to be between $73.2 million and $75 million for the third quarter, with online games services revenue to be between -1% to a 1% increase quarter-over-quarter. Advertising services revenue to increase by 25% to 28% quarter-over-quarter, and wireless value-added services and other revenue to be flat, to a decrease of 10% quarter-over-quarter.

Net profit for the third quarter is expected to be between $39 million and $40.5 million. These estimates include the effect of share-based compensation expenses of approximately $3.3 million. Please note that such share-based compensation expenses are only based on our best estimates as of today, and the actual expenses may differ from the estimates.

Also, we caution that we cannot predict the future exchange rate of the RMB versus other currencies, and therefore cannot accurately estimate the effect of any changes in exchange rates on our financial results. Accordingly, our guidance assumes no change in exchange rate in the third quarter of 2006, and hence adopted the same exchange rate as of June 30 of this year of $1 to RMB7.9943. Our actual results could differ, however, from our guidance as a result of fluctuations in the RMB exchange rate.

We will now be happy to take your questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Lu Sun - Lehman Brothers.

Lu Sun - Lehman Brothers

Good morning. Thank you for taking my question. I have two questions. The first one is on your online advertising business. What is the driver behind very strong growth in the third quarter, and the relatively weak growth in the second quarter? Are you seeing any contracts from new customers going into the second half of the year? Do you expect margins to improve? Then I have two follow-ups. Thanks.

Michael Tong

It is simply because of different season and also different companies have different seasonal effects. If you look at last year’s third quarter, we also grew very strongly, because most of our customers are more based on IP and FMCG where the third quarter there is more activities from the advertisers. It is simply just that, actually.

Operator

Our next question comes from Wallace Cheung - Credit Suisse First Boston.

Wallace Cheung - Credit Suisse First Boston

Good morning. Thanks Michael and Denny. A great quarter. I wanted to ask about the impact of some events that happened in July and how does it impact your third quarter on the games guidance? In particular, the World Cup as well as the in-game protests that have been spreading around in Fantasy? Thank you very much.

Denny Lee

I think if you look at our guidance, Wallace, I think for the World Cup it is over and it is obviously a one-time effect between the end of June and early July and it is spread over two quarters. You also asked about the in-game protests. That happened in the beginning of July where some of the players mistakenly believed that some of the graphics were Japanese-related, but they are actually not. It was totally unfounded. There were some protests inside the game, which also affected players who were playing the games and the revenue numbers.

That is why you can see the guidance that we have given out for the online game business is a very conservative number. We do see such kinds of protests are over, as we see, in August. We think that both games have been stabilized from these two effects starting in August, so it should be a one-off event.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Michael Tong

Operator, I think we can let them follow-on with questions if they don’t understand our answers or if they have follow-on questions.

Operator

Certainly.

Safa Rashtchy - Piper Jaffray

Hi everyone. Could you give us some insight into how you expect Datang to contribute in Q3? Also, what kind of growth rate do you expect for Fantasy and Westward Journey II? You mentioned that the effect of the World Cup and the protests are over. Could you give us some more color? Are you actually seeing growth again? What kind of pattern do you expect for those two games? And again, the contribution from Datang.

Michael Tong

On Datang, the game went into commercial on the 19th of July, and after commercialization of this game we achieved peak concurrent users of a bit over 30,000 peak concurrent users. Obviously that is satisfactory, but not very good. What happens to this game is that we are still building up the content of this game to give more content to the users. Also, changing some of the game play right now. We are still confident about this game and we are expecting, with the new content which includes a new system that has just been released and also more marketing efforts, we continue to see more confidence in this game.

For Fantasy Westward Journey, the guidance that we have given out for the total of online games is -1% to 1%, and that is mainly a breakdown of Fantasy Westward Journey growing around low single-digits. Then for Westward Journey II, a bit of a negative of single-digits as well.

So what happens, of course we have already mentioned in July that there were two events that resulted in some negative events – the World Cup and also the in-game protest. As we see in August, those have stabilized and for September, because September is usually a school period, so we want to keep ourselves more conservative on these numbers.

Especially for Westward Journey II, the numbers in late June or July are also down because there is another event that happened. We changed some of the game play with Westward Journey II for the purpose of actually paving the way for our new game engine that we have mentioned in our script; the new game engine with the new content and the new graphics that is basically a new game for Westward Journey II. Paving the way for that, we actually changed some of the game play in Westward Journey II during June and July. That actually also resulted in some of the drop in the number of users, because they are not used to the game play as yet. We are also seeing stabilizing of this product in Westward Journey II.

Safa Rashtchy - Piper Jaffray

So based on this, could you give us some preliminary indication of how you expect the games to actually trend in Q4? I am not asking for guidance, I just want to see if you expect them to pick up, if you had some expansion packs that would be coming up, or should we expect a more conservative and gradual growth for the two games?

Denny Lee

I think it would be too early to say the numbers or the kind of growth in quarter four for both games. The way I think about it is, as we mentioned, for Fantasy Westward Journey we are going to have a new expansion pack in the fourth quarter. Also, we are already paving the way for a new engine for Westward Journey II which is going to have the closed beta in early ’07. So we are very confident about the continued popularity of both games.

Safa Rashtchy - Piper Jaffray

Thank you.

Operator

Our next question comes from Wallace Cheung - Credit Suisse First Boston.

Michael Tong

Wallace, did I answer your question?

Wallace Cheung - Credit Suisse First Boston

I think Safa has already posed my questions.

Michael Tong

Okay.

Wallace Cheung - Credit Suisse First Boston

I will go back to the queue. Thank you.

Operator

Next we will hear from Richard Ji - Morgan Stanley.

Richard Ji - Morgan Stanley

I have two questions. The first is regarding competition. Especially, can you comment on the new trend of free-to-play games and how that trend is going to impact your future game design? Then I have a follow-up.

Michael Tong

Of course. On the free-to-play based games, obviously we have not tried on any of our games, if we are going into the free model, but we are definitely paying close attention to the market and also paying close attention to how these games are being operated by other competitors. Obviously we are very close to the market and we continue to learn from them. If it happens to some of our games, that is in the future.

I have to make it very clear. The way we think about free games, it would only happen if we designed from the very beginning that this game was going to be a free game, otherwise we don’t think we would do it. In the future, if we have games that we think are suitable using this model, then we would have free games. We don’t think that is going to happen to any of our existing games.

Richard Ji - Morgan Stanley

My second question is regarding your non-gaming operation. Especially I am interested in your plans to monetize your casual game service and also how you are going to monetize other services, including the email community, et cetera.

Michael Tong

For casual games, obviously our focus has been on the release of Datang and also the release of Tianxia 2 and for casual games, we do have some new initiatives. We are going to have a new platform coming in these two months – actually at the end of this month. Obviously for casual games, we intend to make money by way of selling virtual items. Anyways, it is a very small part of the business right now. For email, I think it is still too early to say. I think the simplest thing to say is still through advertising. That actually, by just saying advertising, it actually means a lot for us because there is a lot of technology that we need to work on to understand the demographics better, to educate the advertisers on the performance of advertising on email is actually a lot of work and all of this is taking time. We are working on that.

Richard Ji - Morgan Stanley

Thank you.

Operator

Next we will hear from Frank Shi - CLSA Limited.

Frank Shi - CLSA Limited

Hi guys. Can you talk about your portal business strategy? Right now we see Sina and Sohu competing against each other for premium content. Is there anything that you guys are doing differently to enhance your position in the portal business? Thank you.

Michael Tong

For the portal, I think competing for premium content is one way of doing it. We will be part of it, but we will not be as aggressive as our competitors. As you see the cost of content that we pay is obviously less. The way we have been doing that is to make sure and increase the quality of our content, the quality of our advertisers, and also be able to use technology to integrate together well with our portal by introducing different kinds of new services as well; also by integrating with our current applications, such as the emails, and so on and so forth.

I think overall, we will not simply just put up more cost on buying a lot of premium content, but we have different strategies through both people and technologies. We believe this is the most reasonable way of competing in this market right now.

Operator

Our next question comes from Dick Wei - JP Morgan.

Dick Wei - JP Morgan

Good morning, I just have a quick question on your longer-term pipeline, like Westward Journey III and other games in 07/08. What is the development progress for those games in the pipeline? Thank you.

Michael Tong

I think the simplest way to answer that is we currently have a total of four projects on hand, which are both related to either MMORPG or MMORPG-like games. On average, I would say the development process of these four games span between three months to about 15 months, in terms of the development on each of these games. Some of the games have been developing for three months and some have been developing for around 15 months, but I think it is still early to say the release time for these games. I would say that it is just too early to say that.

Dick Wei - JP Morgan

I have a follow-up to that. It seems like towards the end of this year or early next year, there are a couple of light upgrades and game launches. Will you be allocating more people from those longer-term games to these existing upgrades in Tianxia and Datang? I just wonder if there are any delays in these longer-term games.

Michael Tong

We have not set the exact time for these games, so I think it is just too early to say if those games are going to be late. To give you a clearer picture of what is happening is in the fourth quarter, we are going to have a new expansion pack for Fantasy Westward Journey. By the end of this year, we are going to have the open beta for Tianxia 2. Early next year, we are also looking at expansion pack for Datang, and then later on, we also obviously have a new game for Westward Journey II players; we call it Westward Journey 2.5. Then, going forward, obviously we are looking at new expansion pack for Tianxia and also a new expansion pack of all the other games as well. Probably by the end of ’07, we are looking at new betas for totally new games.

That is how I would give you a summary of our pipelines. We have different teams. We have a total of over 700 R&D people working on a lot of these. We think we will continue to hire more people to work on these. Right now, that is just the strategy in the pipeline.

Operator

Moving on, we will go to Lu Sun - Lehman Brothers.

Lu Sun - Lehman Brothers

Thank you for taking my follow-up. Actually, I just want to ask about the status of Tianxia. What are the current areas for improvement do you think that you need to accomplish before launching the game for open beta?

My second follow-up is on your traffic growth for the portal. You finished at the 700 million number. How does that compare to the previous quarter and year? Do you see any marked improvement in this business going forward? Thank you.

Michael Tong

Let me answer the Tianxia question first. Tianxia, we started our closed beta in March ’06. So far, we have released around 6,000 accounts, and obviously they are in high demand. We have released twice these accounts, the internal beta accounts. The response for the games continue to be great.

I think for the area of improvements, it is just different kinds of minor things that we are improving. Making sure that the game is bug-free and all that. There are no particularly difficult points, such as a technical point or such as the game play or the graphics, but it is just aggregates of all the minor things that we are improving. That is why we are very confident about the release time of this game, which is by the end of this year for the open beta.

For the traffic question, for June, we had 701.9 million. Actually, in March, we had 719.5 million daily average page views, so both numbers compared to last year, went up by more than 40% on average, if compared to last year’s similar quarter’s figures.

I think it is a general understanding of the users, continually, that we have been providing the best services, both technologically, including the e-mails and other related community products on our web; and also, the improved contents that we have been working on for more than a year. I think it is just a general result of all of this together.

Operator

Our next question comes from James Mitchell - Goldman Sachs.

James Mitchell - Goldman Sachs

I just wanted to check, with Datang, did you say it had dropped from 160,000 peak users to about 30,000 peak users? Then, as a follow-on, given Datang’s experience, do you intend to spend more on marketing your next title, Tianxia when that goes into open beta and commercial launch? Thank you.

Michael Tong

Right. I think for Datang, the problem with Datang is not simply with the marketing of the game. We continue to have a lot of ways of doing marketing for our games.

For Tianxia, I think simply because the game that we are working on is a very different title, it is the development time, the effort given, and the expectation that we are having with this game, naturally we are going to put more marketing effort in Tianxia to comparing to Datang; but it is not really a function of the results of what happened in Datang.

James Mitchell - Goldman Sachs

Great. Maybe just a not very related follow-up, but just on the Westward Journey 2 to Westward Journey 2.5 transition, would that involve a shift from turn-based combat to real-time combat?

Michael Tong

It will still be turn-based.

Operator

Next we will hear from William Bean - Deutsche Bank.

William Bao Bean - Deutsche Bank

Just in terms of Westward Journey 2 to 2.5, are you basically rolling out a new game and trying to move people over, or am I mischaracterizing that?

Michael Tong

You are actually quite correct. Westward Journey 2.5 is actually a new game; 2.5 is actually not a very good way to describe it, but this is our codename right now. It is a new game with totally new engine, totally new client side and new game play, new characters, new graphics -- so it is a new game.

What is different is that the user data in Westward Journey will be transferred to Westward Journey 2.5 and we keep the old users’ data. We think that is the best way to continue to keep the users and also to generate new interest for the users.

William Bao Bean - Deutsche Bank

Can you tell me some of the main differences?

Michael Tong

It is just basically a new game. Even a lot of the game play, the graphics, if you have some time, we can show you but it is just a totally new game, actually.

William Bao Bean - Deutsche Bank

Okay. Are there any changes for the Tianxia launch in the tier-one, tier-two cities? Or are you going to continue to do what you have done there before?

Michael Tong

Tianxia launch will continue to be -- do you mean the open beta?

William Bao Bean - Deutsche Bank

No, I mean in terms of marketing in the tier-one to tier-two cities. Do you intend on rolling out any new approaches versus your approach in the tier-three through six cities for the Tianxia 2 release?

Michael Tong

Actually, our strength has been all throughout the country, so it is not just the tier-two cities, but we are also very strong in some of the tier-one cities, such as Xinjiang province and Jiangsu province, we are also very strong as well.

I think the only difference is that for Tianxia 2, I think it is just the combination of home users and also the tier-one cities will be just a bit higher, but our network has the strength in both areas as well, so it does not make much of a difference.

William Bao Bean - Deutsche Bank

Okay, a question on CapEx. Can you just give us a sense of the trends there? Is that a big pick-up in the quarter? Should we continue to see that as you get ready for the launch?

Denny Lee

The CapEx increase in the second quarter was mainly due to the increase in the server capacity and for our services, including both online games, Datang, new games, and also our other portal services, like email, et cetera.

Also, in the same quarter, we have incurred some renovation costs for our new offices in Beijing and also in Guangzhou, that also accounted for the increase in the CapEx.

For the whole year, in 2005, our total CapEx was around RMB92 million, for the whole year last year. This year, we are planning for around RMB160 million for the whole year, including all the computer equipment, servers, laptops, and also some of the renovation costs, et cetera.

Operator

Now we will take a question from Antonio Tambunan - Bear Stearns.

Antonio Tambunan - Bear Stearns

Actually, William asked most of my questions. I do not want to beat a dead issue, but I am just kind of curious. Michael, you did mention that you are transferring the account users from Westward Journey. Now, is that just the users and all the users have to start at a level one, or are they keeping their accounts as well as the character attributes, so that for those users, even though the graphics are new, they are going to feel like they are continuing on, or is everyone a level 1 again?

Michael Tong

Obviously it is not. We keep the users’ data, so we keep their levels. It is going to be the same. In other words, maybe some communities, the abilities and everything will be the same.

Antonio Tambunan - Bear Stearns

The other part of the question too, back at ChinaJoy, because of the number of games entering the market, a lot of people said that a game’s success, assuming that it is designed okay, is increasingly becoming a function of marketing spend. Do you guys agree with this, or is NetEase in particular shielded from extraordinary marketing spend because of your existing platform? Is marketing spend therefore more of a function for smaller companies?

Michael Tong

I think it is the function of marketing spend for smaller companies, but it is not a function of marketing spend for us, because, as we have explained many times before, our marketing spend has been comparatively small in terms of dollars, but our power the marketing continues to be huge, given our company is a portal and also the user space that we have in our game business and all the networks that we also have in our business.

Operator

Next we will hear from Tian Hou – C.E. Unterberg.

Tian Hou - C.E. Unterberg

Two quarters ago, when you guys were on the conference call, you guys mentioned about the lifecycle of a game. You mentioned something like the two existing games, they are towards the later stage of their life, so the games are supposed to naturally in terms of growth, grow slower and eventually going down.

However, from last quarter, we saw a different trend, and from what you just said today on the call, and it seems like you do not agree with that view anymore. I just wonder, what do you think about the lifecycle of a game for your existing two games?

Michael Tong

There is a life cycle for the product anyway, but it seems that we have been doing well and we continue to extend that longer and longer. Frankly, it is hard to forecast exactly when this peak or exactly when this whole lifecycle is going to be, but we have been continuing to prove ourselves in extending the lifecycle, especially compared to our competitors.

I think it is just better not to say exactly when our forecast is, but we continue to prove ourselves in getting results.

Tian Hou - C.E. Unterberg

So based on your success experience from last quarter, what is the medicine for turning an old game to a younger game? What did you exactly do?

Michael Tong

I think it is just the assumption of continued effort in giving more content which is hospitable and to the taste of our users, continue to understand what the players need, continue to innovate with new content; it is just a function of that, actually.

Tian Hou - C.E. Unterberg

For the Westward Journey 2 and Westward Journey 2.5 version, are they similar content, or content-wise are totally different?

Michael Tong

They are totally different. It is basically a new game.

Operator

Now we will take Ming Zhao - Susquehanna.

Ming Zhao - Susquehanna Financial Group

Thank you for taking my questions. I have a question on the advertising business. It seems like your competitors have put very strong numbers during the second quarter, benefiting from the World Cup event, whereas your advertising revenue guidance for the third quarter is much better than those guys. Could you comment on the seasonality and what you saw during the World Cup? Was that good for your advertising business? Then I have a quick follow-up.

Michael Tong

The World Cup I would not say it was especially good for our advertising business. It did move some of the budget of our advertisers to an earlier period, and also it is a way of showcasing our content that has improved a lot, and also showcasing our advertising performance for our advertisers; it has been very good.

I would not say that it gave us a lot of advertising dollars, as you can see from the results. For the third quarter, as I have explained, the third quarter is simply that for us, because the base of our advertisers is different from that of our competitors, so the different seasons, and different quarters have different growth compared to our competitors as well. Our third quarter has always been strong. That happened last year and that is happening this year as well.

Operator

Next we will take a question from Catherine Leung with Citigroup.

Catherine Leung - Citigroup

Thank you for taking my question. I have one question about Datang. Firstly, can you share with us, where are you seeing the players for Datang come from? Is it players from other games and NetEase game players trying this game out, or is it new game players in the market?

Also, is the performance after the commercialization of the game within your expectations, based on one-and-a-half month open beta of the game?

Lastly, can you give some more color, what are the main areas in the changes that you are making to the game, and how significant these changes will be? Thank you.

Michael Tong

Sure. The gamers actually come from everywhere. It is just a reflection of the market. We did some calculation on the overlap of the gamers that have ever played our other games or are they totally new gamers, and that is a very small number. If I remember right, it is under 20% who are overlapping with users who have ever played our other games.

Given the base of the two games, which is such a huge base, under 20% is actually a very good number. The good thing is that out of this 20% of these players, actually most of them are churned players in our other games. I mean, these are gamers who have played Westward Journey or Fantasy Westward Journey, but who are already churned anyway. It does not really affect our active users in the old games, or in our existing games.

For the areas that we are working on, it mainly includes the game play and the balancing of the characters and different professions. I would not say, since adding more new maps on, new characters, but it really is just the game play, the attributes, the calculation, and the balancing of those different professions. These are the areas that we are working on right now.

A new system has just been released a few days ago and we are hopeful that this is going to bring more popularity to Datang as well.

Operator

Now we will go back to Wallace Cheung - Credit Suisse.

Wallace Cheung - Credit Suisse First Boston

A question on Datang. Basically, if you always refer to the industry statistics, saying after the commercial launch then the peak users were up by 40% to 60%. But given the fact that your at 1,000 PCU versus 160 during the open beta test, it seems performance is actually lower than the industry performance.

I think since management is still maintaining its relatively successful review or confidence in the future, can you comment on why the drop is relatively higher than the industry average? What kind of experience have you gained that you can make sure in the future, you can drive that Datang to grow further? Thank you.

Michael Tong

I think you are right. The drop-off rate is actually less than satisfactory, to be more clear. I think, as I have just mentioned, we are working on a few areas, including the balancing of the difference professions. We have just released a new guild systems. We believe that with the new content, we will be able to drive the users and the popularity back to the game. I think it is still a function of how we work on content and continue to revise the game play.

Wallace Cheung - Credit Suisse First Boston

Just as a final follow-up, so within your first quarter guidance, how much growth that you are attaching to it? What level, or what kind of general revenue do you expect from the Datang?

Michael Tong

A very small and minor percentage to the total revenue base. We tend not to give you exact assumptions, but the way we have been working on this, estimates of our guidance is just almost like extending what is happening right now to the next six weeks.

Operator

Now we will go to Richard Ji - Morgan Stanley.

Michael Tong

Okay, and this will be our last question, right?

Richard Ji - Morgan Stanley

For your 3Q guidance, you obviously incorporated some of the one-time impacts, including, as we mentioned before, in-game protests and World Cup. Can you help us to quantify in terms of percentage, how much impact to your guidance that has incorporated for 3Q?

Denny Lee

We’ll put it this way. I think when we estimate our online game guidance for this quarter, Q3, we have already taken into consideration the actual results for the one-and-a-half months which have already passed. As Michael already explained this, there are some events or incidents happened during July, which impacted our revenue growth in July, which is the summer season which is supposed to be a busy season. On the other hand, we have seen that those incidents are likely to be one-time, because we have seen some return back of the growth rate in both of our games.

In our projections for the third quarter, we have taken this into account, and actually because you as note in September, normally it will be a low seasons for online game industry because of the students going back to school. We have been using the same experience as last year’s in our projections.

Operator

That concludes the question-and-answer session today. At this time, I will turn the call back over to Brandi Piacente for any closing or additional remarks.

Brandi Piacente

Thank you once again everyone for joining us today. Please feel free to contact us any time if you have any further questions. Thanks.

Operator

That does conclude this conference call. We thank you all for joining us. You may now disconnect.

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