NetEase, Inc.
Q3 2020 Earnings Call Transcript

Published: 19 Nov 2020

[Operator:]

Good day and welcome to the NetEase Third Quarter 2020 Earnings Conference Call. Today’s conference is being recorded. And I would now like to turn the conference over to Margaret Shi. Please go ahead, ma’am.

[Margaret Shi:]

Thank you, operator. Please note 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.

[William 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. We are pleased to report another strong quarter with financial and operational growth across all of our primary lines of businesses. Our total net revenue increased by around 27% year-over-year reaching RMB 18.7 billion for the third quarter. Our net income from continuing operations was RMB 3 billion, which includes a net foreign exchange loss of RMB 1.6 billion compared with RMB 4.1 billion one year ago, which included a net gain on foreign exchange rates. Net revenues from online game services grew by 20% year-over-year reaching RMB 13.9 billion in the third quarter, driven primarily by the resilience of our existing titles, a best illustration of our operational efficiency in addition to our R&D expertise. For our PC games net revenues, we delivered 13% growth year-over-year, well above the general industry trend with new expansion packs lunched for the summer holidays, our legacy PC titles including Fantasy Westward Journey Online, and new Westward Journey Online II continued their strength into the third quarter. As two of the largest and longest running game IPs in China, both games continue to attract a loyal crowd after nearly two decades of operation, and we continue to build on that.

[Charles Yang:]

I will now provide a very brief overview of our 2020, third quarter financial results. Given the limited time on today's call, I will be presenting some abbreviated financial highlights. We encourage you to read through our press release issued earlier today for further details. Total net revenues for the third quarter were RMB 18.7 billion or US$ 2.7 billion, representing 27% increase year-over-year. Net revenues from online games were RMB 13.9 billion up 20% year-over-year, primarily driven by the increased net revenues of from FWJ H5, Life-After, Knives Out and Sky.

[Operator:]

We will now take our first question from Alex Poon, Morgan Stanley. Please go ahead. The line is open.

[Alex Poon:]

Translating my question, my question is regarding overseas game strategy. In the last eight, nine to 10 months during COVID, we have seen very successful expansion, overseas expansion of Chinese mobile games in overseas market even for Chinese RPG games. So NetEase has a lot of strong and top legacy RPG IPs. Can you share with us what's your strategy in terms of geographical focus, genre, and your product investment and lastly, about the competition landscape? Thank you very much.

[William Ding:]

[Charles Yang:]

I will provide a brief translation of William's remarks. So Alex, first of all, we are very dedicated in focusing on the overseas strategy for NetEase. Right now, in Japan, we have achieved a small step. Beyond Japan, we think major markets what NetEase is eyeing for in terms of game lineups, there will be games that are being developed specifically for global launch, games such as Harry Potter as well as certain games in the SLG genre. There's also another more casual game, UNO, which has been also performing quite well in the overseas market. Going forward, we are very confident about our NetEase developed games competitiveness when Chinese games are going overseas because quality and the sophistication of these games are what we think we have a competitive edge vis-à-vis the peers. Thanks. Operator next question please?

[Operator:]

Thank you. We will now take our next question from Elsie Cheng from GS. Please go ahead. The line is open.

[Elsie Cheng:]

[William Ding:]

[Charles Yang:]

Okay. I will briefly translate the question and then also the translation of William's remarks. So, the question is asking what is in the next three to five years, what is the NetEase’s game development strategy? How -- what is our view of this industry, both in China and globally? William's response is that, first of all, we think this is a very good sector. Game entertainment is a very good sector. If you read the recent news of how well received that PS5 and Xbox were by the global consumers, as well as for instance, throughout the COVID-19 situation entertainment, new format of game interactions are all being encouraged. It's been, it's a demand, a strong demand from the consumer side. So, we think this is really a good sector with a very promising future upside. Now focusing back to NetEase, we have a track record of almost two decades, dedicating ourselves in game development and game operations. We are willing to invest more and more into the future, into R&D, into marketing. And we are not only complacent about Japan, but we are also eyeing for mainstream Western market, Western market, European market. So all-in-all, we are very confident that by combining our experience, track record, willingness to invest and also our suaveness into directing the genres of future game development. We're very confident that our high-quality game product can be well received by both the domestic China market as well as more geographies in the international market.

[Elsie Cheng:]

Thanks.

[Charles Yang:]

Operator, let's go to the next question please?

[Operator:]

Thank you. We will now take our next question from Alicia Yap from Citi Group. Please go ahead. The line is open.

[Alicia Yap:]

Hi, thank you. So, my question is related to the online music. So how does management envision the future landscape of online music industry in China? Will there be just two major players or do you foresee more players will come into the market, and is there a market share target that NetEase Cloud Music hopes to achieve in the future? Thank you.

[William Ding:]

[Charles Yang:]

Okay, I will provide a brief translation of William's remarks. So first of all, we have launched NetEase Cloud Music since more than seven years ago and over the last seven years, as we all can see, the consumer habit has dramatically changed to streaming music, streaming consumption rather than buying a CD or downloading mp3. We, right now, there are two players. Obviously, we are very confident and ambitious that into the future, we will have a leading market share. The way for us to position ourselves as on one side, we do want to emphasize on original and organic music, and bring them to the end users to be better appreciated and accessed by the music listeners and at the very same time, provide resources to support and nurture China's independent musicians in supplying more and more high quality music content building a healthy cycle organically. Obviously, there might be more challenges coming into this sector, but we are confident that as long as we commit to the purpose and mission, we should be able to achieve a leading market share in this very promising online music sector in China.

[Alicia Yap:]

Thank you, Charles. Thank you, William.

[Charles Yang:]

Operator, next question please? Thank you, Alicia.

[Operator:]

We will now take our next question from Kenneth Fong from Credit Suisse. Please go ahead. Your line is open.

[Kenneth Fong:]

We noticed that some recent game launch like Genshin Impact have been launching through like BiliBili and TapTap have been to avoid the high revenue sharing of Android channel. With the success of this launch as well as the Cloud gaming platforms, does it means that the power of negotiation power is gradually shifting towards us as a major game developer? How should we think about the margin upside over the medium term and also any room for this channel fee to gradually decline over time? Thank you.

[William Ding:]

[Charles Yang:]

I will provide a brief translation of William's remarks. So Kenneth, so first of all, we remain very optimistic on how the future trend is shifting. Right now, as we all know, China is arguably the most expensive channel fee country in the world, especially for Android channel fee, whereby the global standard is the same as Apple iOS app Store 30%. In China, the norm is 50% Android channel fee. So we also encourage players such as Yanxuan and others, including ourselves to try to explore other non-conventional ways of distributing high quality content to the end users. Last night, I think we all saw the news that Apple has announced that they are going to reduce the channel fee to 10% for small developers, in an effort to encourage the better upside and economics for the developers. We do think, probably Google Play and others will also follows suit. Let's wait and see, but broadly speaking, as a trending wise, a shift towards content providers is probably a more and more clear and visible trend that we can all observe globally and that should also come to China.

[Kenneth Fong:]

[Operator:]

Thank you. We will now take our next question from Binnie Wong, HSBC. Please go ahead.

[Binnie Wong:]

My question is mainly on the sales and marketing expense. We actually see that even excluding Youdao, NetEase itself also increased in terms of the sales and marketing as a percentage of revenue. Is it because of some of the overseas launches? And then into -- going forward into the future quarters, as we are launching some of the bigger things we had in the pipeline, shall we expect that other further changes or any structural changes in our marketing strategies that we should be aware of too? Thank you so much and congrats on a very strong quarter again.

[Charles Yang:]

Thank you, Binnie. I will answer this selling and marketing expense question directly from my end. Well, I think for Youdao, they posted the earnings call just now ahead of this call. The explanation was fairly sufficient that we are very, very confident that this is the right time and we are in a ready state to continue to invest more aggressively in acquiring users. We will be rewarded by the ROI given how prudent we are, although we are investing more into selling and marketing in Youdao, but the unit economics works. So this, we are not shy of investing more into expanding our market share, and the user scale as robust as possible. Excluding Youdao for this quarter, our selling and marketing as a percentage of net revenues again, excluding Youdao, stays at around 12.9% slightly below 30%. This is still a very healthy level comparing to many of the industry peers. Our NetEase approach towards selling and marketing is always very straightforward. It is always ROI driven. We have a very, very high standard of the required rate of return internally. So when we invest, by the way, the excluding Youdao, the substantially, substantial amounts of the selling and marketing are game related, now game related either for the existing titles for the maintenance, old tax that we spend to maintain the longevity and the efficiency of the gross billing, as well as new games such as the FWJ H5 and new genres of the games that we are going to launch down the road. So all-in-all, I do not think when we tap into international market, when we go into a new genre, that's a determining factor for us to spend irrationally. Regardless of which market, which genre or which specific new game that we are going to launch, I think we always do a very prudent math behind it before we deploy the selling and marketing resources. So it's just a matter of timing gaps. Sometimes we will be launching, we will be spending up front in the same quarter, but the gross billion of these sales and marketing expenses will be reflected into the gross billions, which might be only recognized in the subsequent quarters into recognized revenue.

[Binnie Wong:]

Thank you, Charles, very clear. Thank you.

[Charles Yang:]

Thank you, Binnie.

[Operator:]

Thank you. We will now take our next question from Natalie Wu, Haitong International. Please go ahead. Your line is open.

[Natalie Wu:]

Okay, I will translate myself. So thanks for taking my question and congratulations for a very solid quarter. So my question is regarding the increased sales and marketing, just wondering how much of that is related to Cloud Music. And regarding a margin if we exclude the impact of deal last year, and also Youdao expanded loss, actually the margin jumped 4% year-over-year. So just wondering how much of that is related to expanding scale of low margin music business or if you have some investments on the other business units? And also speaking of Cloud Music, how should we think of the revenue model compensation of music business as well as the margin profile going forward? Thank you.

[Charles Yang:]

Okay, thank you, Natalie. It's a finance related question, so I'll answer directly from my end. For this quarter, total selling and marketing expenses was RMB 3.4 billion. Roughly speaking, RMB 1.15 billion is Youdao, the remaining about RMB 2.3 billion are selling and marketing excluding Youdao. Out of that RMB 2.3 billion super majority of that is game related. So music Yanxuan media and others comparing to games that's just represents a small fraction. So it is not really about us investing irrationally into some lower return segments in a big amount. You've also pointed out the declining trend of the operating margin overall. I think obviously, mathematically, a big reason of that is what I just explained to Binnie’s question. There's a timing gap right, for instance, for both Youdao and games, in particular. The expenses are recognized in this quarter. However, gross billions are not entirely recognized into revenue into the same quarter. Beyond that, there's also another factor is in the game revenue mix. For instance, the PC and mobile game ratio stays relatively stable. However, within the mobile games, we are also pioneering with some different genres of the games, for instance FWJ H5, which is a more casual mobile game, so even though it is the same broad category of a mobile game, but if you were to look at a more casual game, vis-à-vis a hardcore MMORPG, mobile game, they would demonstrate different margin profiles. I think that's another small factor explaining why you are observing a downward trend of the operating margin. That in fact reminds us of many years ago, when we decided to transition from the PC game into mobile games, a revenue mix change, resulting in certain margin profile changes. I do think that's, again, it's the mathematics right, whether you want a bigger pie, whether NetEase is bold enough and confident enough to tap into more genres of the games, they might be demonstrating some different margin profiles, versus our most familiar MMORPGs, but we do think it is the right move for us to be more diversified in terms of genre offering. So Natalie, hopefully it answers your question.

[Natalie Wu:]

Yes, very clear, but what about the longer term margins of your music business?

[Charles Yang:]

For music, so you hide your second question into your first question. For music, yes so I have to admit that it is still a loss making business for now, even at the GP margin level, because we all know that the music content licensing fee, it is still at a irrationally high level. Because our music monetization is growing very well, the economies of scale is helping us to improve the margins. So in a sense, it is still negative GP margin, negative operating margin, but the negative margin is being narrowing down. Going into the future, we do think the macro trend is in favor of us. On one side the music, record labels, music licensing fees are more rationalized, especially following the non-exclusive licensing arrangement into the medium to longer run. At the same time, we are also emphasizing a lot more on organic and original music from independent musicians. With all that, I think it is something to expect that very soon, in two to three years time, the overall China's online music segments should be a very profitable segment.

[Natalie Wu:]

Got it very clear. Thank you, Charles.

[Charles Yang:]

Thank you.

[Operator:]

Thank you. We will now take our next question from Thomas Chong from Jefferies. Please go ahead. Your line is open.

[Thomas Chong:]

Thanks management for taking my questions, and congratulations on a strong set of results. My question is about the NetEase Cloud Music. Just now we just touched upon the strong revenue growth momentum. But if we go into the revenue mix, can you talk about the growth momentum in terms of the paying subscribers, as well as the live streaming revenue, and how we should think about the revenue mix over time as well as the opportunities on new business models? Thank you.

[Charles Yang:]

Okay, thank you Thomas. I'll answer your question directly in the interest of time. I think this probably would be the last question on this earnings call. So first of all, subscription revenue has been trending up very well. We have seen a notable increase this quarter, both in terms of the paying user base, as well as the paying ratio, as mentioned in the scripts earlier on. In fact, when we compare that to our peers who have publicly disclosed their paying ratios, I think our paying ratio is slightly better. But for the entire industry, this is still a single digit. It’s a very low paying ratio. There's plenty of upside room for China's online music industry to improve, substantially improve the paying ratio, that the first comment. Live streaming is a very fast growing, monetization vertical format is Cloud Music, well partly also because we also grow from a relatively much smaller base. So right now live streaming is already becoming a very sizable and significant major revenue contributor of my overall NetEase Cloud Music revenue. At the same time, we are also very, very actively ramping up other formats of monetization such as advertising for instance. New business model it is always a time . I think that, I've been saying this for multiple quarters already, that's the exciting part of China's online music industry. Because try not to fix your imagination by what Apple Music or Spotify has been doing in a different geography. I think for China's online music industry as a whole, we will be, together with the other players in the sector, we will be experimenting and pioneering some interesting and new format event monetization that is probably not yet available in the Western world. And on that, we can give one thing on the direction, we do think that music is not, at least NetEase Cloud Music is not just a platform to play songs. It is an avenue for social interaction. So social interaction, social media, this is a direction that we are focusing a lot on exploring potentially new business models and potentially new monetization models.

[Thomas Chong:]

Thank you, Charles. Congratulations on a strong set of results.

[Charles Yang:]

Thank you, Thomas.

[Operator:]

Thank you. Ladies and gentlemen, that will conclude today's Q&A session. I will now turn the call back to your host.

[Margaret Shi:]

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

[Operator:]

Thank you. Ladies and gentlemen, that will conclude today's call and you may now all disconnect.