NetEase, Inc.
Q2 2016 Earnings Call Transcript

Published: 18 Aug 2016

[Operator:]

Good day and welcome to the NetEase Second Quarter 2016 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over to Brandi Piacente. Please go ahead, ma'am.

[Brandi Piacente:]

Good day everyone, and thank you, operator. 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. 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 this forward-looking information except as required by law. During today's call, management will also 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 second quarter 2016 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 the NetEase corporate website at ir.netease.com. I will now turn the call over to Mr. Onward Choi, Acting Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

[Onward Choi:]

Thank you, Brandi. Before I begin, please note that, for the purposes of these discussions, all percentages are based on renminbi. Our outstanding second quarter results reflect our leadership in China's dynamic online games industry where we continue to introduce premium game content, innovative technology and effective marketing strategies. Each of our business segments delivered a strong financial performance and is positioned to sustain success in the second half of the year. Our total second quarter net revenues grew 96% compared with the second quarter of 2015. Online game services increased 76% year over year, highlighted by the strength of legacy IP titles and new mobile games. We grew advertising services revenue by 24.2%, driven by our proven ability to provide a more effective return on advertisers' budgets. Our e-mail, e-commerce and others business is leveraging new opportunities to accelerate growth and increase the revenue by 310.6% year over year. As we have noted [ph] previously, the dominant trend in our business and for the entire online game industry is the popularity and demand for mobile games. We are very well-positioned to exploit this trend with a mobile game portfolio that now includes more than 100 titles. We are very pleased with the market's response to our new and classic mobile games, and there are several highlights we would like to report on today. In the second quarter, we launched the mobile versions of New Ghost, which ranked as a top 10 grossing title on China's iOS app store. We also launched Fantasy Westward Journey

[Operator:]

[Operator Instructions] At this time we'll take a question from Eddie Leung with Merrill Lynch. Please go ahead.

[Eddie Leung:]

Good morning. Thank you for taking my question. Could you talk a bit [ph] about the potential virtual reality and augmented reality to NetEase? And do you think it's more an upgrade to existing games or is it going to be a new market which could attract incremental users? And then just a housekeeping question, could you also update us the percentage of mobile games as total game revenues. Thanks.

[William Ding:]

[Interpreted] So, basically with regard to your first question, Eddie, I believe that for NetEase, we are very focused on the recent development regarding the AR and VR. In fact recently, the Company has also been investing on other company in the U.S. called NextVR, which is focusing on doing some streaming broadcasting services. And we believe that this would also be another very good initiative that will be rolled out to gear up our service offerings. And with regard to another trend that we observed lately about the Pokemon Go in the overseas market, we do see that this actually is a new trend. But instead of just seeing that this will be an emerging trend, we would still need to critically evaluate and assess whether this would be sustainable in a much longer term. And we believe ta all times that NetEase would not be fall behind of this trend, and in fact we would upkeep our leading position in the overall market development. And in fact we have also been paying quite a lot of efforts in the past couple of years to get ourselves prepare to explore and innovate on some new areas that we believe would also bring us to the forefront of the market.

[William Ding:]

[Chinese language spoken]

[Onward Choi:]

Another point that William would also like to make a supplement is about that we have also another business partner with Google on the AR platform called the Daydream, and another thing is that we would also be partnering with other VR content providers, in order to make sure that we would upkeep a leading position in that sense. And I believe this will be more or less the feedback on your first question. With regard to your second question about our mobile games revenue percentages, for the second quarter 2016, this has been standing at 60.9% out of our total game revenues.

[Eddie Leung:]

Thank you.

[Operator:]

At this time we'll take a question from Jialong Shi with Nomura.

[Jialong Shi:]

Hi, good morning. Hi, good morning, William, Onward, thanks for taking my call. First, congratulations on a strong quarter. I have a few questions. My first question is a quick follow-on the previous question. So I just want, as a game player, when can we expect to play NetEase's first AR or VR game? [Chinese language spoken]

[William Ding:]

[Chinese language spoken]

[Jialong Shi:]

[Chinese language spoken]

[William Ding:]

[Chinese language spoken]

[Jialong Shi:]

Xie-xie.

[William Ding:]

Xie-xie.

[Onward Choi:]

So, basically, to recap on William's feedback about Jialong's questions about NetEase VR and AR game progress, basically for both the AR and VR games, we both have some products currently still in the internal testing phase. In terms of timeframe, we believe that we are maybe a bit later because currently the availability of the hardware or equipment in the market is still not that many. And perhaps we do see that AR would come up a little bit later as we expected. And to supplement on what Jialong has been following up about the expected timeframe, we do believe that hopefully for the AR games be launched, hopefully, before the end of this year.

[Jialong Shi:]

Thanks, Onward and William. My second question is about the e-commerce service. And I just wonder if management can give us an update on the cross-border e-commerce and also your private-label service called Yangshan [ph]. And what was the current growth rate and GMV size for these two e-commerce services in 2Q? And particularly for the cross-border e-commerce we understand the authority has postponed the implementation of some of the new regulations for one year. So I just wonder what's your current strategy for these cross-border e-commerce now given the regulation uncertainty. Will you continue to invest as much as before or you are holding investments as many of your peers do and your policies are becoming more clear? And for the private label business, what the current gross margin, and what is the highest margin that may achieve in the future? [Chinese language spoken]

[Onward Choi:]

So maybe I will take these questions. So, Jialong, with regard to your questions about how our e-commerce business has been progressing in the past quarters, I believe that we are still quite happy with both its growth and both its trending in terms of its GMV. Both are quite aligned with our expectations. And insofar as you have mentioned about the [inaudible] policies that has previously been implemented and currently in its tentative suspension phase for another one year, we believe that, just as what we have highlighted before, we do not expect that the implementation of such new policies or rules would have any significant impact to our NetEase cross-border e-commerce business. But rather we do see that this would be another thing to making sure that this would be a good business to go on in the near future. And with regard to the private label business that you highlighted, especially on Yangshan [ph], so far because this would be another new initiative that we are currently implementing and we do see that from the gross profit margin perspective this is also a good business to move on, but so far we do not got any additional highlights to share at this point of time.

[Operator:]

We'll move along to Tian Hou with T.H. Capital.

[Tian Hou:]

Yeah, William, Onward and Brandi, good morning. Congratulations on a good quarter. It is not a surprise to me. I do have a question related to the new trend [ph] in China which is live broadcasting. It seems like it's certainly become very popular in all front, in commerce, in entertainment, in news, everywhere, and NetEase also has some kind of broadcasting activities in news, in your mobile news app, as well as game broadcasting. I wonder, do we have any plans to continue in this area to do something to accomplish something? [Chinese language spoken]

[William Ding:]

[Chinese language spoken]

[Onward Choi:]

So just to recap on William's comments about our thoughts and many efforts working on the new live broadcasting initiatives, I believe that we have been working on quite a lot of things so far, I won't go through one by one. In four and a half years we have already introduced our product called CC. This would basically be a game-related broadcasting services we are offering to our users, and this would be related to direct broadcasting of how to play the games or some content-related sharing. And we believe that for games like our War Rage and popular Fantasy Westward Journey, and also Hostiles [ph] have also been -- got quite a lot of stuff on this platform. And in two and a half years before we have introduced another platform called Bobo. Its official website is bobo.com. And basically this would be --

[William Ding:]

Bobo, bobo.com.

[Onward Choi:]

bobo.com, yes. So this would basically be a performance-based broadcasting where people would be doing some singing performance or doing some events and stuff like that. And thirdly, in the start of this year, on our own mobile news application, we have also introduced another live broadcasting initiative about the news-related content dissemination. And one of the most remarkable incidents would be the heavy rainings earlier in Beijing this year and another -- some broadcasting about the Hunan, the execution of the government officials, that we have also been doing a sharing and got a very positive feedback from the market as well. And we do see that, well, all those businesses are currently working in a profitable mode, but we haven't been separately disclosed all those information yet. And some other stuff that we would like to share with you would be our thoughts about the newer developments on the [inaudible] broadcasting, direct broadcasting stuff, where we would be upkeep not -- because we think that the broadcasting would not only be just a two-dimensional stuff but this would be a multidimensional stuff that we can share with our targeted users. And another interesting initiative that we are also thinking would be getting in the education area, just like our [inaudible] education course and our cloud class products. And we do see that in the near future, perhaps people can just wear up their glasses and then we can -- they can also share some of the educational stuff as such.

[Operator:]

At this time we'll take a question from Alicia Yap with Citigroup.

[Alicia Yap:]

Hi, thank you. Good morning, William, Onward, Brandi and Juliet. Thanks for taking my questions. Congrats on the good results. I have a question related to Overwatch. Can you share with us, given the latest user engagement level for the game and given Blizzard's comment that, recently, that there are new content and features that are being introduced that will encourage digital content purchase. So, have you seen that already happen for the China user base? And what would be the revenue upside for this game? And related to that, can you remind us, for the accounting treatment for booking the box sales for Overwatch, how long it will amortize? Thank you.

[William Ding:]

[Chinese language spoken]

[Onward Choi:]

So with regard to your questions about the user engagement and the features with regards to Overwatch. We believe that Overwatch has made a very good success since its first launch since May 24 to now. And first of all, we would like to extend our gratitude and the appreciation to our partners, Blizzard Entertainment, for having a full confidence on NetEase and at the same time they have also been very good at developing at rolling out some content stuff to the market, especially in China. And insofar as the sales performance of the Overwatch is concerned, just as what we have highlighted earlier, it has already surpassed the record established last year by Blizzard Entertainment's Diablo III in the category of buy-to-play PC games in China. And we do see that in terms of the user satisfaction. They are very pleased with these games and we believe that, with the innovative content that we have been offering so far, they are also very happy to play these new games by Blizzard. And another incident that we would like to share with you is that we have also, we launched that in Korea, in the internet cafes, the games which that is the Overwatch, has been ranked as the number one game which is popular amongst the players there. And we are also looking upon that, the same what happens in China sooner or later that the Overwatch would become another very highly-received popular game in the PC game category. And another thing that we are looking upon is that sooner, when there would be the next expansion pack to roll out for the Overwatch, we do see that there would also be more local content that we would be offering to our targeted gamers in the China market. And on a separate note, we would also like to highlight that on September 1 this year, the World of Warcraft would have another new expansion pack called Legends to roll out. And we do see that this would make some positive surprises to our existing gamers and the new gamers alike. So on other separate point about Alicia's question about the accounting treatment on the Overwatch, because just like all of our other games in the -- that we are currently operating, this will be amortized over a period of about six -- not more than six-month period, because we have different games, whether we are talking about item-based games and also the buy-to-play games that basically we will adopt these policies.

[Operator:]

We'll then move along to Hillman Chan with Macquarie.

[Hillman Chan:]

Hi. Good morning, William, Onward, Brandi and Juliet. Congratulations on a strong quarter and thanks for taking my question. My first question is about Minecraft. Could management talk about the current status for development, and also share more on the timeline and also the monetization model? I think we were talking about changing the one-off license to the in-game monetization model. Just wondering if you can share more color on that.

[William Ding:]

[Interpreted] So with regard to your question about the Minecraft, I believe that in this year, early this year, we have already entered into a strategic cooperation with Microsoft and Mojang AB that we would be responsible for launching the game in the China market. And we are also foreseeing that in the, currently, in the China market, this has been recorded as the number one PC and mobile games category. If we look at the business models that has been adopted in the overseas market, this basically will be the sales of clients to the game -- when we are soon to introduce this game in the China market, we are expecting that this would -- the client itself would be offering free of charge to our gamers. And we would also be introducing some innovative business models to make it another new experience to our gamers on a much recurrent basis. And very soon when we are launching this game to the market, we do expect that there will be some content that will be specially targeted to the local market, and also, we would also introduce some innovative content to attract our targeted gamers as well. And at all times we always believe that we would leverage the experiences that NetEase have made out so far over the years, especially in the gaming industry, and to make the introduction of this new version of the Minecraft to the China market a success.

[Operator:]

And we'll move along now to Kenneth Fong with Credit Suisse.

[Kenneth Fong:]

Hi, good morning management. Thanks for taking my question and congrats on the very strong results. My question is mainly on the margin front, with regards [ph] on the online games, I noticed that the margin have declined Q-on-Q slightly, despite lower-margin mobile game actually decreased in contribution. So, is there any reason behind it? And the second question is on the e-commerce, others, the gross margin is around like 38% -- 33.8% in the second quarter. So, how should we think about the sustainable gross profit margin for that segment? And that's it. Thank you.

[Onward Choi:]

Okay. So with regard to your first question about the gross margin on the online games, you are quite right in saying that, in terms of the mobile revenues percentages, that this has come down a bit. But still we do see that there has been a slight drop in terms of our gross margins on our overall gaming businesses, because of the fact that the major increase was contributed by games like Overwatch and also Hearthstone which is they like this game, and of which the gross margins were relatively lower as compared with our own self-developed PC games. And while at the same time of course there would also be some incremental contribution bring about by our FWJ as well. And with regard to your second question about the e-commerce gross margin percentages, we are quite happy to see that there has been another new growth in terms of our gross margins from 24% in the last quarter to 33.8% this quarter. And we do see that this is mainly brought about by a better product mix and economy of scales that are brought about by our cross-border e-commerce businesses, and also our other e-commerce products, because we have also been adopting a shift in terms of our strategy from the direct merchandise sales model to the platform service model, and so this would also help out to have an improvement enhancement on the overall gross margins in this business segment.

[Operator:]

We'll move now to Alex Yao with JPMorgan.

[Alex Yao:]

Hi, good morning everyone. Thank you for taking my question, and congrats on a solid quarter. So if my calculations are correct, your PC gaming revenue actually declined quarter over quarter and year over year despite very successful launch of Overwatch. Can you guys talk about the trends for the legacy PC game? How should we think about the lifecycle and the revenue outlook over the next few quarters? Thank you.

[William Ding:]

[Interpreted] So with regard to your questions, we believe that in the -- for three months we do see that Overwatch has actually made very good sales in terms of its performance. And so in this sense we do see that, with newer and innovative content that we are offering to the game market, we do actually get some good performances as such. And on the other hand, we do see that, for NetEase, we do have another new PC game soon to launch, that we have also highlighted in this quarter's earnings release, which is called War Rage. And we do believe that, while we do see that there has been a growing trend in terms of the mobile games, but it doesn't mean that there wouldn't be any growth potential for the PC games, but rather we do see that a better balance should need to strike between the PC and also the mobile in order to ensure a much -- a longer-term development of our gaming businesses. So, basically in fact, in terms of our PC game revenue, basically in the second quarter we do see that there has been a growth rather than a decline on an overall basis [inaudible].

[Operator:]

We'll now move along to Martin Bao with Bank of China.

[Martin Bao:]

Thank you for taking my question. I have a question regarding to the cloud music business. I wonder whether the management can share with us the strategic target for this business after the latest [inaudible]. [Chinese language spoken]

[William Ding:]

[Interpreted] So with regard to our own cloud music product, basically we start off with this product development three years before, by our own development teams located in Hangzhou. And since the launch of this product, we made a very good success with this product, because we do see that the -- with the introduction of this cloud music product to the market, this does not just facilitate the users just to listen to music but, more importantly, we do see that, with the introduction of a very good design product, this can help to solve some of the problems of the users when they are doing their music listening or experiencing sections [ph]. Say for example, we were able to make a more targeted recommendation on some music that users actually prefer and interested to listen to, and we do see that this would also make another good appeal to our users for using the music product. And insofar as the choosing the strategic partners, we believe that the cloud music by itself is not just simply plugging -- put on the earplugs and listen to the music and using the handset. That's simple and easy. But rather we do see that there is lots of potential especially in the offline interaction with other TV stations or other radio stations in order to further enhance and leverage the experiences of our music lovers. And we do see that with the introduction of this very good product in the marketplace, with some innovative features that we have already built on, we do see that -- and with the will [ph] that we would upkeep our mission on our ongoing pursuit of the excellence, we do believe that for the music lovers this would be a very good product that they will enjoy and love. [Chinese language spoken]

[Onward Choi:]

Another supplement that William would like to highlight is that one of the very unique features of our NetEase cloud music versus all the other products currently available in the market is that, rather than just facilitating the users just to listen to the music or the songs that they would like or love to listen, we would be able to recommend and push the songs that we believe that they will be interested and love to hear. And this is also prove to be very helpful, especially to the music lovers.

[Operator:]

That is all the time we have for questions. I'll turn it back over to management for any additional or closing remarks.

[Brandi Piacente:]

Thank you everyone once again for joining us today. If you have any further questions, please feel free to contact Juliet Yang, NetEase's IR Manager who's based in Hangzhou, TPG Investor Relations. Thanks and have a wonderful day.