NetEase, Inc.
Q2 2020 Earnings Call Transcript

Published: 13 Aug 2020

[Operator:]

Good day and welcome to the NetEase 2020 Second Quarter Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Margaret Shi, IR Director of NetEase. Please go ahead, ma’am.

[Margaret Shi:]

Thank you, operator. Please note the discussion today contain forward-looking statements relating to 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 its 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 form on Form 20-F and with the Hong Kong Stock Exchange. The company does not undertake any obligation to update these forward-looking information except as required by law.

[Charles Yang:]

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. This is our very first earnings call as a public company on both NASDAQ and the Hong Kong Stock Exchange. With the support of our shareholders, this past June, we celebrated our 20th anniversary on NASDAQ and completed our listing on the Hong Kong Stock Exchange. This dual listing reminds us of our commitment to shareholders, both domestically and overseas, of our deep responsibility to continue creating value for our growing base of global stakeholders. I am pleased to report a solid second quarter amongst challenging macro backdrop with healthy gains across each of our primary business lines. Once again, we saw steady performances from our flagship titles and franchises and rapid growth from Youdao and NetEase Cloud Music. In total, we grew our net revenues year-over-year by nearly 26% to RMB18.2 billion for this quarter, and our net income from continuing operations attributable to our shareholders grew year-over-year by 35% to RMB4.5 billion. Our online games was up 21% in the second quarter year-over-year, reaching net revenue of RMB13.8 billion, driven by the impressive strength of our existing titles. Our flagship, Fantasy Westward Journey series and Westward Journey series, continued their strong performance in the second quarter. As two of the largest and longest-running game IPs in China, both games consistently attract a loyal crowd. Adding to the success of our Fantasy Westward Journey franchise, we introduced Fantasy Westward Journey H5 in June, a more casual and light version of the legacy IP. This new addition has captivated an untapped audience, enlarging the user base of our Fantasy Westward Journey franchise even further.

[Operator:]

We will take our first questions from the line of Alex Poon from Morgan Stanley.

[Alex Poon:]

I’ll translate my question. My first question is related to your progress in Japan. In the last couple of years, the progress has been very great. The grossing ranking has done very well. Can you share with us what’s your next milestone? What’s your next goal in Japan mobile game market? And my second question is related to Harry Porter launch. What’s the launch strategy for the game? Is it a global launch together with China and overseas? And if we have to think about the potential of the grossing of overseas versus China, which side would be stronger?

[William Ding:]

[Charles Yang:]

Okay. Alex and for the audience, for everyone’s convenience, I’ll quickly translate William’s remarks and apologies for the technical glitch just now. Firstly, regarding our objective for the Japanese market, it’s a very important market for our global initiatives, and we’ve achieved a small milestone there over the last couple of years. But we still think there’s huge upside potential for us to further cultivate into the Japanese market. For instance, we are committed to even diversifying more offerings, more genres of games into that important market. With regards to Harry Potter, this is a highly anticipated game. We focus a lot more on the product itself, on the possible user reactions and feedbacks and the likeness of this product. Whether it’s a simultaneous launch for China plus global market or at a different pace, we don’t think that’s the top priority for us. The good thing is that we’ve got approval already. So, we have the flexibility. But for us, the focus is really on the product and making sure users are happy with the product when we are fully prepared. So far, the progress has been very well on track. Operator, next question please.

[Operator:]

Okay. We will take our next question. Alicia Yap. Your line is open. Please go ahead.

[Alicia Yap:]

Hello, thank you. . So my first question is actually regarding the margins. So with the newly signed contract with UMG how will that change the gross margin and cost profile for the new, innovative business and assuming you may have to pay an upfront fee on that? So – and also, with more contracts and all that, how should that change in terms of the potential monetization? Second question quickly is on the sales and marketing. So it seems like this quarter, the spend is a bit higher than previous quarter. So wonder if this is one-off or it will be a new norm for the rest of the second half.

[Charles Yang:]

Alicia, and for quick translation of William’s remarks, we’ve added comments from my side. So first of all, William commented that the multiple year contracts, in In nature, this changes the sublicensing formatting for direct partnership. So in essence, it’s not really changing the margin trend or on the business side. The big, positive impact from direct partnership is that beyond music content subscription revenues, that we are now in a direct partnership to possibly explore other formats of monetization with a record label provider, and that gives us more confidence that NetEase Cloud Music would explore and try out more interesting and innovative ways of monetization potential, which, in the longer term, will lead to a much more healthy user experience on the platform, which then naturally would result in a much more healthy financial profile of NetEase Cloud Music. For your second question, specifically on selling and marketing expenses, yes, like in my earlier comment, this represents the increased absolute dollars primarily for two reasons. One is the selling and marketing effort for new game launches, in particular the Fantasy Westward Journey H5 game, and also partly due to the summer promotion initiative of Youdao spending, which is, again, kind of a seasonality for the overall online education industry. However, if you look from different aspects, this quarter, selling and marketing represented about 12.8% of my overall top line revenue. Of course, there are some gaps of spending first and repeated, sustainable revenue growth into the coming quarters. All-in-all, this percentage level represents a very prudent and disciplined level comparing to our historical level on an annualized basis in the last 3 years. Hopefully, that answers your question, Alicia.

[Alicia Yap:]

Okay. Yes, thank you.

[Operator:]

We will take our next questions from the line of Alex Yao from JPMorgan. Your line is open. Please go ahead.

[Alex Yao:]

I have two questions. The first one is to follow up Alicia’s question on music monetization. William, you mentioned that you guys are considering to diversify the music monetization. So in addition to the current subscription-based monetization model, what are the monetization models that you guys are trying or contemplating? So that’s the first question. The second question is regarding the international gaming expansion strategy. You guys have quite a number of gaming titles with a very famous of Western IP. Those games are very suitable for global, including both domestic and international, publishing. So given the current geopolitical tension between China and the U.S., especially what’s going on between U.S. government and some of the China Internet companies, would you reconsider your international gaming strategy? Let me stop here.

[Charles Yang:]

So Alex, I will provide a brief translation of William’s remarks. For the first question on the possible monetization format around NetEase Cloud Music, obviously that would require some innovation. There are certain monetization formats, that’s been proven, but what’s more interesting is what are the other more innovative ways that the online music streaming industry can further explore. We are very confident on that front because that’s our DNA, content development innovation. And the one commitment that’s unchanged is that we are dedicated to invest more resources and capability into native content, into supporting independent musicians to create a more healthy and sustainable industry trend for China’s music industry by and large. Second question, we recognize the complexity around the current background of geopolitical uncertainty. But what we believe as a content developer is that high-quality content, great game content is universally appealing. This is universal. And we are committed to remaining highly selective and serious in developing good game content not only for Chinese users but for the global audience. We think as long as we are committed and focused on content development and universally appealing content goes beyond geopolitical complexity. Operator, next question please.

[Operator:]

Okay. We will take our next question from the line of Eddie Leung from Merrill Lynch. Your line is open. Please go ahead.

[Eddie Leung:]

So I have two questions. The first one is about the cloud music pieces. How do you think about the positioning of the soc media companies in the online music market in the long-term? It seems like some of these soc media companies have been adding musical-related video contents to their platforms. So just I wonder whether they might become competitors in the long-term. And then secondly is about the performance of your legacy HIT gains, some of them still generating pretty good revenue and even seeing some growth. So in general, I would like to know whether it’s more driven by paying user growth or ARPU growth. Thank you.

[William Ding:]

[Charles Yang:]

Eddie, I will provide a brief translation of William’s remarks. Firstly, on your question, we believe short-format video and music actually are very synergistic verticals. However, they are fundamentally different because usually, for short-format video, firstly it is chopped. It’s usually less than a minute, whereby a full complete song typically require 3, 4 minutes of listening. So – and also, short-format video usually takes a highlight part where that’s particularly strong. And as a predominantly UGC content platform, it’s highly dependent on the music or the background music, whereas the product itself doesn’t require so much of a professional touch. On the other hand, on the music platform, it’s mostly PGC or professional content creation, and it’s a much longer format. So short-format video is a very, very conducive channel to promote a high-quality music content. However, if you are a user and a true music enthusiast who wants to enjoy the full length of the song or the kind of a music-oriented touch, then a short-format video cannot replace the importance and relevance of the music platform. That’s how we look at the relationship of the two. We do not think it is a replacement per se. Secondly, on the game growth, William’s remark is that if it does seem that the spending habits or the structural changes is that more users are willing to pay now, pay for high-quality content, pay for a better experience in the game, that would mean as a whole the number of overall paying users is on the increasing trend. At the same time, for games, at least for certain genres of the games, you would also note a very distinct polarization of the spending pattern. Some people are more like a kind of a subscriber, right? They spend not so much, but they spend consistently whereby some users spend a lot more on certain games. And typically, for these types of games, they are more picky, they are more selective on the highest quality of the games, the best in-game experience. So by and large, we think our number of users are going to grow. ARPU may not necessarily grow at the same noticeable trend. However, if our content is relevant and represents the highest quality of the respective genre, we have the potential to grow both the ARPU as well as the number of users on our products. Operator next questions please.

[Operator:]

Okay. We will take our next questions from the line of Thomas Chong from Jefferies. The line is open. Please go ahead.

[Thomas Chong:]

Thanks management for taking my questions and congratulations on a very strong set of results. I have a question about our overseas game strategies. Given that we have IP licensing, we have our strong in-house development as well as we get the cash proceeds coming from our Hong Kong listing, so how would we think about our overseas strategies in terms of M&A, IP licensing as well as in-house development? Thank you.

[Charles Yang:]

Thomas, I will provide a brief translation. So actually, with the Hong Kong IPO, it doesn’t really change our mentality or approach towards a content-focused global initiative. We are always very active and open minded on all the strategies you mentioned. Actually, there’s no forced ranking in terms of priorities. IT licensing represents a very, very critical element of our global initiative because that showcase is the involvement of our content creation capability, operation, publishing capability. At the same time, self-development remains the core of our competence. M&A, we are very optimistic, but we are also highly open minded and active particularly in genres that’s supplementary to our core in-house R&D capability.

[Thomas Chong:]

Thanks, William and Charles, I have a follow-up question. It’s about the paying ratio and ARPU. If we try to compare Japan versus China, should we expect China is heading towards the Japan level in the long run? Thank you.

[Charles Yang:]

Okay. Thomas, I will provide again a translation of William’s remarks. So first of all, it is very common that different geographies, different economies demonstrate different kind of consumer behavior. But on the longer-term trend, we do think that the Chinese consumers’ willingness to spend and the ability to spend is on the rising trend. For instance, one small example, if you look at today, the cost of a movie ticket in China is already comparable to a cinema movie ticket spending in the States. Just a decade ago, there is a huge gap, right. For some of us who can recall, there’s a huge gap, which means Chinese consumers are more willing to pay on entertainment. As Chinese economy further advances, people are more willing to pay a broad format of entertainment to enrich their lifestyle. We think that trend is on the rise. Operator, I think, in short of time, let us cut this call.

[Operator:]

Okay. Due to time limit, that concludes today’s questions-and-answer session. At this time, I will turn the conference back to Margaret Shi for any additional closing remarks.

[Margaret Shi:]

Thank you once again for joining us today. If you have any further sessions, please feel free to contact directly our TPG Investor Relations. Have a great day.

[Charles Yang:]

Thank you everyone.

[Operator:]

That concludes today’s conference. Thank you everyone for your participation. You may now disconnect.