NetEase, Inc. (NASDAQ:NTES) Q1 2019 Results Conference Call May 15, 2019 9:00 PM ET
Margaret Shi - IR Director
William Ding - Chief Executive Officer
Charles Yang - Chief Financial Officer
Hilton Hui - Co-President of NetEase Games
Conference Call Participants
Eddie Leung - Bank of America Merrill Lynch
Natalie Wu - CICC
Hillman Chan - Citibank
Alex Poon - Morgan Stanley
Alex Yao - JPMorgan
Good day, and welcome to the NetEase First Quarter 2019 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Margaret Shi, IR Director of NetEase. Please go ahead, ma'am.
Thank you, operator. Please note the discussion today will contain forward-looking statements relating to the future performance of the company and are intended to qualify for 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.
A general discussion of the risk factors that could affect NetEase's business and financial results is included in certain filings of the company with the Securities and Exchange Commission, including its annual report on Form 20-F. The company does not undertake any obligation to update its forward-looking information except as required by law.
During today's call, management will discuss certain non-GAAP financial measures for comparison purposes only. For a definition of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results, please see the 2019 first quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. In addition, an investor presentation and a webcast replay of this conference call will be available on NetEase's corporate website at ir.netease.com.
Joining us today on the call from NetEase senior management is Mr. William Ding, Chief Executive Officer; Mr. Charles Yang, Chief Financial Officer; and Mr. Hilton Hui, Co-President of NetEase Games.
I will now turn the call over to Mr. Yang, who will read the prepared remarks on behalf of Mr. Ding.
Thank you, Margaret, and thank you, everyone, for participating in today's call. Before we begin, I would like to remind everyone that all percentages are based on renminbi.
2019 began on a strong note with robust financial growth and our core businesses strategically aligned for future success. Our total net revenues grew by 30% year-over-year for the first quarter and we more than doubled our non-GAAP net income to CNY 3 billion on an annual basis.
Our online games revenues grew by 35% as a result of continued strong performance from our flagship titles and our successful diversification initiatives. Beyond online games, we realigned our resources to be more focused on our e-commerce, music and online education divisions, which we believe will improve our profitability in the longer run.
Over the last few years, we have been steadily amassing a portfolio of high-quality games that span a diverse universe of game types. This has allowed for exceptional stability within our online games segment and enabled us to better navigate the fluid market without having to rely solely on new game introductions.
Combined with the time-proven longevity of our games, we delivered another quarter of sequential growth based on just our existing titles. This is the fourth consecutive quarter that we have exceeded CNY 10 billion in quarterly online games revenue. We delivered this result amid a challenging industry environment, with fewer new games being approved for a market release in China. With our promising pipeline of upcoming new titles in China and abroad, we are confident in our ability to sustain this growth trend in our online games division.
Our legacy titles such as Fantasy Westward Journey series, New Westward Journey Online series and Tianxia III continued to grow in the first quarter. Quarterly revenue for Fantasy Westward Journey Online keeps breaking new record, hitting another all-time high this quarter. Revenue from New Westward Journey Online II also rose steadily, reaching a new high this quarter in recent years. These are prime examples of our ability to create sustainable games that remain relevant over extended period of time.
This is a goal for each one of our games and is becoming more apparent for our newer titles as they move into their third or fourth year of operation. For example, our 2015 launch, Invincible, continues to deliver new records in terms of revenue and number of active users quarter-after-quarter. And Onmyoji, our 2016 launch, has topped the iOS grossing chart in China multiple times in recent quarters.
Despite all the hype in the online game market, our efforts to create innovative and interesting content updates for our core base of users is consistently rewarded with longevity and loyalty from our game players. In the spirit of Chinese New Year, we introduced new features and activities for a number of our games that promote our Chinese heritage. These were very well received by our players. For example, in Justice, we introduced Song dynasty-themed Chinese New Year celebration, allowing users to experience Asian customs and traditions within the game.
These additions quickly gained wide recognition from the user community and central government media outlet, including CCTV and Xinhua News Agency. With Invincible, players often use classical Chinese language to communicate, particularly for declaring war and conducting other actions within the game. In Minecraft, we released new update enabling players to build classical architecture such as the Beijing Palace Museum and restore historical relics, including the Old Summer Palace. With these updates in place, Minecraft's monthly and daily active user numbers reached new highs during the Chinese New Year and bringing the game's total number of registered users to more than 200 million.
One of the benefits of having a broad portfolio of self-developed games is that we can explore the full potential of our full spectrum of IP, many of them are in-house developed. Based on its huge fan base, we tested this strategy on Onmyoji. The first spin-off of Onmyoji was its MOBA game version, Onmyoji Arena, which gained meaningful traction from users and helped reinforce the Onmyoji franchise.
We are currently working on another new game based on Onmyoji's IP presently known as Project SSR. This collectible card game, with storyline set on a mysterious ship, will offer a new and more casual experience compared with our previous Onmyoji titles. Based on Onmyoji IP, we now have merchandise, music, fan art, a musical stage production and a cartoon series. We are continuing to build on Onmyoji's popular brand, offering many other Onmyoji-based pan-entertainment formats.
We keep looking for ways to improve our R&D process, increase efficiency and address the market with innovative new games. While it is impossible to predict with absolute certainty which games will be the next industry blockbuster, over the course of the last two decades of operation in online games, with one of the world's largest teams of in-house game developers and comprehensive infrastructure, we have a fairly good understanding of what game players want by implementing an even more rigorous evaluation process and demanding even higher quality content during the R&D stage. We are confident we can continue to bring blockbuster titles to China and global game player communities with lasting IP that stands the test of time.
Turning to our overseas market. We continue to make headway to deepen our presence in key international markets such as Japan and the U.S. Knives Out remains a popular title in Japan and again topped the grossing chart a few times in March and May following the introduction of Battle Pass and our collaboration with King of Fighters. Identity V is another fan favorite in the Japanese market, growing steadily since its launch there. With the release of its new character, Axe Boy, Identity V made Japan's top five iOS grossing chart for the first time in April.
More recently, Night Falls: Survival, our cooperative survival RPG; and Cyber Hunter, our new open world battle royale game, both reached number one on Japan's download chart shortly after their launches in April. We follow a three-tiered approach with our international expansion strategy. First, we will continue to invest in global talent and overseas game studios that complement our internal R&D know-how to create proprietary games that are suitable for global audience. Second, we work with many of the world's best game companies to help transform some of their most well-known PC or console IP into mobile sensations such as Diablo and EVE.
Third, we have partnered with some of the world's most successful IP owners to create games based on their iconic characters and storylines. More news will be revealed at our May 20 game day event next Monday. We will also be showcasing more upcoming game titles in our pipeline, including BuildTopia, Love is Justice, Sky, Fantasy Westward Journey 3D, Xuan Yuan Sword: Dragon upon the Cloud and Ages of Isle.
Now moving on to our other businesses. Our heightened emphasis on our core businesses allows us to sharpen our focus on areas where we see the most potential for sustainable and long-term growth. During the first quarter, we made a series of structural optimizations to hone these core growth segments, deescalate inefficient segments and increase our investment in areas that improve our competitive edge. Our profitability improved as a result.
Take e-commerce as an example. We successfully enhanced our warehouse logistics operations, adjusted our marketing strategies, improved our product navigation and optimized our pricing. Kaola hopes to capture additional spending from loyal customers by offering authentic and cost-effective products from around the world. Compared with last year, the number of Kaola membership has almost doubled, with average spending per user steadily improving. We will continue to add more membership benefits as more and more of our brand partners become aware of the value of these VIP members.
For Yanxuan, we are determined to build a national brand that is deeply embedded in people's mind when they look for premium quality and affordable price. Over the past three years, we have accumulated a large community of Yanxuan fans. In April, we introduced a new cashback incentive program to encourage user engagement. Moreover, we launched a series of interactive activities online and offline to help Yanxuan fans gain a deeper understanding of the entire production process.
For music, we continue to position ourselves as the gathering place for original Chinese singers and a nursing ground for original music and independent artists in China. The number of paying subscribers on our platform more than doubled year-over-year and continues to grow healthily on a quarter-over-quarter basis, underpinned by our strong growth in MAU and DAU. In January, we hosted the NetEase Cloud Music Original Artists Ceremony 2018 and we launched the third season of our talent hunt program where we discover and help promote new independent musicians in China.
Based on our excellent operational capability and distinguished music community atmosphere, we have helped create a great deal of popular original music which has been played billions of times on our platform. Our users are typically young, edgy and have very diversified tastes in the music they listen to. In addition to original music, we try to satisfy our users with music from all over the globe. In April, we added popular Japanese music to our platform through our partnership agreement with Nippon Columbia, Japan's premier record label company.
For online education, Youdao is a leader in China's learning and online education sector with a decade-long cultivation. Youdao now attracts a diverse and engaged user base comprising over 800 million users and offers a suite of technology-driven learning and education products and services. With the comfort and trust these users have gained from our products and services, NetEase Youdao has become a household name in China's learning and education space and our users are willing to try out other products we offer as they move on to different stages of learning or even select suitable products for their children.
This brand recognition has led to higher conversion rate and rapid growth in Youdao's online course offerings. K12 continues to be the primary growth engine for Youdao where we offer online courses via after-school curriculum tutorials as well as extracurricular courses in STEAM subjects such as coding. Youdao online courses focus on creating differentiated, reliable and effective learning and educational content to our users.
We achieve this by adapting our sophisticated technology to an online learning environment and application. For example, our proprietary smart pens are able to grade homework and give feedback to our students simultaneously as they use them to write on paper. This technology greatly enhances teaching efficiency and help us accumulate a large amount of relevant data which we utilize to further improve our teaching content.
NetEase has come a long way over the last few years. Mobile and PC games remain the crux of our business with e-commerce, music, online education and media following closely behind. These are the core areas that we have identified as content in an ever-evolving online world. This is where we will focus our efforts to continue to grow our business and this is where we provide our users a variety of best-in-class content and services under one NetEase brand appeal.
As we nurture these nongame businesses to their full potential, adapting with the intellectually curious Internet population, we believe we will be very well positioned to remain at the forefront of the evolution, shaping trends and bringing new online ideas to our growing community of users around the world. 2019 is off to a strong start and we are excited to continue on this trajectory. This concludes William's comments. I will now provide a brief review of our first quarter 2019 financial results. Given the limited time on today's call, I will only be presenting some abbreviated financial highlights. We encourage you to read through our press release issued earlier today for further details.
Our total net revenues for the first quarter were CNY 18.4 billion or $2.7 billion, representing approximately 30% increase year-over-year. Net revenues from online games grew for the fourth consecutive quarter, reaching CNY 11.9 billion, representing an increase of 8% quarter-over-quarter and 35% year-over-year. The sequential increase was driven by steady performances from a number of our legacy titles. The year-over-year increase was primarily driven by new game launches in China and abroad, including Knives Out in Japan, Identity V, Justice and Night Falls: Survival. Mobile games accounted for approximately 72% of net revenues from our online games in the first quarter.
The first quarter is typically a slow season for e-commerce and advertising, which explains the sequential decline in net revenues from these business segments. Net revenues from innovative businesses and others declined sequentially due to reduced revenues from noncore businesses as a result of the reallocation of our resources to our core business areas and a decline in Cloud Music and CC live streaming due to seasonality.
Gross margin was 44.1% in the first quarter compared with 38.6% in the preceding quarter and 42% for the prior year period. Gross margin for our online games services for the first quarter improved slightly to 63.7%, which is largely stable. As a reminder, our gross margin for games typically fluctuates quarter-to-quarter within a narrow bandwidth based on the revenue mix of mobile, PC, self-developed and licensed games.
For e-commerce, we aim to maintain our gross margin in the high single digits on an annual basis. For the first quarter, our e-commerce gross margin was 10.2% versus 4.5% and 9.5% in the prior quarter and for the first quarter of 2018, respectively. The sequential increase was because the fourth quarter last year is seasonally the largest promotional quarter of the year.
Gross margin for innovative businesses and others was negative 13.1% versus negative 5.2% and negative 9.9% in the prior quarter and for the first quarter of last year, respectively. This was mainly due to reduced revenue contribution from noncore business divisions. For Cloud Music, on a year-over-year basis, gross profit margin is improving due to scale effect. The quarter-over-quarter decline was mainly due to seasonality on advertising and increase in content purchase costs.
For the first quarter, total operating expenses were CNY 4.7 billion, down 14% and 1%, respectively, compared to the prior quarter and first quarter of last year. We continue to see operating leverage as we benefit from economies of scale and improved operational efficiencies.
Selling and marketing as a percentage of net revenue was 9.2% in the first quarter, consistently coming down from 2018 levels. E-commerce-related shipping and handling expenses included in selling and marketing expenses as a percentage of e-commerce revenue was 8.4% in the first quarter compared with 8.7% in the same quarter last year. R&D expenses were maintained at around CNY 2 billion level, reflecting our continued commitment to investing in content creation and product development, which is what defines us as a technology company.
Operating income for the first quarter was increased by 52% quarter-over-quarter and 182% year-over-year to CNY 3.4 billion. Effective tax rate for the first quarter was 34%. Non-GAAP net income attributable to our shareholders for the first quarter totaled CNY 3 billion or $450 million, representing an increase of 28% quarter-over-quarter and 126% year-over-year.
Our non-GAAP diluted earnings per ADS were CNY 23.34 or $3.48 for the first quarter of 2019. Our cash position remains steady and strong. As of March 31, 2019, our total cash and cash equivalent, current and noncurrent time deposits and short-term investment balance totaled CNY 51.9 billion compared with CNY 50.1 billion as of December 31 last year. For the first quarter of 2019, we plan to pay a dividend of CNY 0.69 per ADS, representing 25% of the net income attributable to our shareholders.
Thank you for your attention. We would like now to open the call to your questions. Operator, please go ahead to Q&A.
[Operator Instructions] We will take our first question from Eddie Leung from Bank of America Merrill Lynch.
Just I have a question on an industry phenomenon. We have seen a group of Internet companies talking more and more about focusing on time spent of ad users. So just curious if NetEase thinks about these problems? Do you think time spent is the most important metric internally for a lot of your business unit? If not, why? Especially given your experience in running PC games, which you are, again, one of the first Internet applications facing the challenge of time spent diluting by other applications. So it would be great to hear from you guys in terms of these industry dynamics.
Thank you, Eddie. I will translate the question for William and the other management team. [Foreign Language] Okay. Eddie and everyone on the call, for the benefit of the broader population, I'll briefly translate William's comment that he made in Chinese. Well, first of all, we don't think this is a question can be answered by one generalized answer. Definitely time spend is an important factor, but this should not be the only or so important factor that is applicable to all the different verticals.
For us, what we think are the most critical factors to our success is the -- back to the essence of a content, whether you are providing a unique and differentiated experience to the users that differentiates your products versus of a competitor. So to us, we really think that's the core, that's the essence that's been attracting users coming back with higher frequency of using our products and services. So if we were to summarize this broad macro question, it is the frequency of user revisiting and unique and differentiated experiences that we will prioritize when we think about the NetEase products and services.
[Operator Instructions] We'll take the next question from Natalie Wu from CICC.
Congratulations on a very solid result. My question is related to the innovative business and others, including Youdao education, Cloud and others. Just wondering what the scale of the investment are you preparing for this business this year. And specifically for online education, even that it is actually quite difficult to reach a flexible level by simply utility app category direction for online K12 after tutoring -- after-school tutoring, especially those primary school costs is related, so just wondering what differentiation or unique positioning NetEase has in the competition with other industry leaders, say New Oriental and TAL et cetera. And what the resources NetEase would allocate on the group level to facilitate a better development of this business? And also, a housekeeping question. Can you update us about the overseas revenue contribution this quarter?
Okay. Let me translate again. [Foreign Language] So Natalie, in terms of specifically on Youdao, the one positioning that we would like to emphasize is that our core Youdao business is only focused on online teaching and learning, so we are not tapping into offline, and the primary focus is K12 segment of the population. One very unique advantage of NetEase as a technology company and Youdao that has been cultivating its online education resources for over a decade is that we have very, very strong technology-backed proprietary hardware AI technology such as our smart pen smart device. That's one thing that many other online education or offline educations do not have as strong as us.
And also in terms of traffic support, at a group level, we are dedicating a lot of traffics from various business segments to contribute and support the growth of Youdao. Many of our users are now in the age of their parenthood, so it's not only them and it also extends beyond to their children that can be a potential beneficiary of our Youdao product and services.
And last but not least, a very important factor around all these educational assets is NetEase brand appeal. That brand appeal itself is now being widely recognized as a household name in the teaching and learning space because we, again, like I commented earlier, we have over a decade of experience and a period cultivating our Youdao brand in multiple products. Natalie, to your second question, overseas gained in revenue this quarter. It's still approximately 10%.
Just a very quick follow-up. Does that mean the focus of traffic acquisition or user acquisition for Youdao online K12 would be app traffic redirection rather than the traffic purchase to external channel?
[Foreign Language] Yes. So it's a mixture of both. I think we have a unique advantage of traffic. At the same time, we will also be acquiring users from external traffic channels. But ultimately, that is driven by the efficiency, whether or not the acquisition cost makes sense vis-à-vis, for instance, the lifetime value of that particular user that can contribute to our Youdao online courses.
[Operator Instructions] We will take our next question from Hillman Chan from Citibank.
I've got two questions. First one is on the overseas expansion strategy for our games in Japan and international markets. Could you share more on our strategy on that regarding the game development and publishing capability? In addition, can management highlight a major update on our partnership and synergy with the game studios that we previously invested globally? And my second question is more a housekeeping one. We see some decrease in the marketing expenses for this quarter, which should be related to the e-commerce seasonality of game launches. Could you share more color behind that? And how should we think about the trend going forward, please, as a percentage of revenue relative to the revenue growth of respective business lines?
[Foreign Language] So for the overseas game expansion strategy, I think that is also a common question that we've been asked quarter-over-quarter. So as of today, we have achieved some small achievement in Japan, in particular with Knives Out. To continue on that momentum, we've introduced Night Falls: Survival, Cyber Hunter, et cetera, and we will continue to bring more and more games into major markets like Japan, like U.S. and, ultimately, into the mainstream western market. But we also recognize the fact that in many of these mature western mainstream game markets, mobile game is not yet the -- unlike in China, it's not yet the number primary conduit.
For the western markets, it's probably still PC and console, but we do believe that the mobile game market has the most potential in terms of upcoming growth. So as a result, NetEase is going to continue to explore to try different ways of trying to benefit from that upside potential of the international market turning more and more mobile-focused. Our investment strategy is also in line with that. And Hillman, to your second question -- asking for the general trend in our selling and marketing, let me broadly answer. For the overall operating expenses, as we mentioned in prior quarters, NetEase is a very prudent and return-focused company. For us, we continue to invest in areas that we think that can ultimately strengthen our competitive advantage such as R&D.
In terms of selling and marketing, for the first quarter, the cost is very well controlled, largely because, number one, Q1 is generally a seasonality low season for our e-commerce business. So we have been very, very cautious and prudent in spending on e-commerce. Secondly, as you all know, because of the overall regulatory control on the new registration license, there's no new game that is being launched in the first quarter. As a result of combined relatively lower spending in e-commerce, as well as games that result in our selling and marketing spending in the first quarter, very, very disciplined.
Now looking beyond the first quarter, as we continue to receive more and more approvals on our new games, when the new games are getting ready to be launched and then, for sure, for NetEase, we will be continuing to invest in selling and marketing into promoting our newer titles, which we fundamentally believe we have a track record of generating very, very high return on the level of investment. Also, for the second quarter, for instance, there will be more promotional events for e-commerce as a general industry trend for 618. Also, for Yanxuan in April, we just celebrated our third year anniversary, et cetera.
But all in all, I think the way we look at selling and marketing is not a very rigid budgetary percentage application, but rather it is internal ROI return-driven. For whatever marketing dollars that we spend on the different business verticals, what we are ultimately hoping for is a satisfactory return that's going to be reflected on the top line. That may not necessarily happen in the same quarter depending on the business nature, but hopefully now with longer and longer track record of NetEase operating in the nongame business verticals, we have a pretty good track record of keeping on a satisfactory return on our general OpEx spending.
We'll take our next question from Alex Poon from Morgan Stanley.
I'll translate myself. My first question is related to Fantasy Westward Journey 3D version. No doubt this will be a blockbuster title. How should we think about the user base and revenue potential cannibalization? And also, actually the synergy, some users may play 3D and go back to play the 2D version as well. And second is regarding the Diablo mobile development and licensing progress.
And third is regarding music business. Selectively renewing some of the music label may be good for margin, but would that affect user experience? How should we balance between these two? And regarding your competitor, Tencent Music, they have been doing a lot of live streaming and karaoke to monetize. How do you position in this segment?
[Foreign Language] Let me translate the answer to the first question on FWJ 3D first. So in March, we just completed another testing run. Result is pretty satisfactory. In terms of the addressable user market, we do not have much concern about a potential internal cannibalization with existing FWJ titles because FWJ 3D is more missioned towards broadening a potential user outreach to both PC and mobile and hardcore users as well as users who play real time MMO. So when the FWJ 3D eventually launched we think that's going to bring incremental net gains to our overall user metrics.
For Diablo Immortal, the mobile version, it's on track. We will be applying for the regulatory approval in accordance with overall, the latest guidance from the ministry. And I guess people do not need to worry too much about it. It's on track because Diablo, the PC version, was approved. It's long been launched and released in China. So for now, we think the approval process is well on track, but again, at this moment, we do not have a specific timetable for the launch of Diablo Immortal as yet.
Alex, for your last question on music, William's answer is twofold. First of all, the current status of very high cost in renewing -- essentially, a renewing business is a rental business, right? We pay the price to rent the music content for a period of time. A very high cost of that is not healthy to the overall industry. And we fundamentally believe that the cost will come down and be more rationalized in the longer run, which then will be a more conducive environment for the overall healthy and sustainable growth of China's online music streaming industry.
Secondly, from NetEase's perspective, we are also applying a lot of thought and innovation in thinking of how we can potentially change our NetEase Cloud Music from merely just listening to music into a very active forum for music enthusiasts together to facilitate their communication sharing. And if we achieve that, I think the potential for imagination of what NetEase Cloud Music can enable is more than just playing songs, a content IP-driven business.
Next up, we have Alex Yao from JPMorgan.
My question is about the overall capital allocation strategy for 2019. You guys have touch based on some of the key strategies that you're going to implement this year, including a pretty sensitive focus on core business from gaming, to music, to e-commerce, et cetera, and also cost reduction in the noncore business, even within these core business we noticed from the media reports that there seem to be a pretty systematic cost reduction initiative across different business units. My question is about what is the trigger for such a philosophical change in capital deployments or allocation? And how long would this operational strategy last?
Alex, I'll briefly translate William's answer. So the guiding principle is really that we've been more selective in terms of what we are good at. For instance, for education, that is a broad sector that many players come and go. For us, we've been here for over a decade. We know what we are good at. We know how we are going to be differentiated and we continue to invest into our competitive edge. The same applies to e-commerce, whereby this is a relatively crowded vertical, but there are areas we think that we have a better understanding and it's probably more suitable for NetEase, whether it's from a user appeal or from a brand image perspective, that we can continue to cultivate that, creating something of a differentiation and with uniqueness.
Businesses that we are relatively less familiar with -- or good at, for instance, comics business that we've divested that business to other players who are probably better positioned to operate. So that is really the guiding principle. From a financial perspective, NetEase, being listed for 19 years, we've always been financially very disciplined. When we think about investment, again, it is return-driven. We are not shy of making big investment into areas that's being highly selective in our focused areas but whatever investment amount that we make, or the scale, or magnitude that we make, ultimately, the purpose is to drive our unique and competitive positioning.
Thank you, everyone, for participating in the Q&A session. Now, I would like to turn the conference back to Ms. Margaret Shi for any additional or closing remarks.
Thank you once again for joining us today. If you have any further questions, please feel free to contact us or TPG Investor Relations. Have a great day.
Thank you, everyone.
That concludes today's conference. Thank you, everyone, for your participation.