NetEase Inc

NASDAQ:NTES

Earnings Call Transcript 2019-Q3

[Operator]

Good day and welcome to the NetEase 2019 Third 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.

[Margaret Shi, IR Director]

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 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 2019 third 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 corporate Web site at ir.netease.com.

Joining us today on the call from NetEase senior management is Mr. William Ding, Chief Executive Officer; and Mr. Charles Yang, Chief Financial Officer.

I will now turn the call over to Charles who will read the prepared remarks on behalf of William.

[Charles Yang, CFO]

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.

Firstly, to assist better understanding and analysis of our quarterly results, I would like to remind everyone that based on the changes in this quarter, including the sale of Kaola and the NYSE listing of Youdao, we will now be reporting segment reports as online games, Youdao, and interactive businesses and others which include now Yanxuan, NetEase Cloud Music, Internet media, CC live streaming, and others.

Kaola’s financial results has been deconsolidated and listed as discontinued operations. This applies to the current quarter as well as the historical comparative period. This quarter, our total net revenue represents both year-over-year and quarter-over-quarter growth. You can also refer to Youdao’s earning release for more details about its quarterly results.

I will now read the prepared remarks on behalf of William. We have had quite an eventful third quarter with a number of strategic moves made across our business lines. Those moves allow us to realign our resources and sharpen our strength in areas where we see the most potential for our sustainable long-term growth.

During this quarter, we continued to grow our online games business with steady performances from existing titles and further expanded our overseas presence. We are pleased to have achieved another quarter of strong financial performance with total net revenues increasing by 11% and non-GAAP net income from continuing operations increased by 74% year-over-year.

For games, our online games revenue continues to exceed RMB10 billion for the sixth consecutive quarter, driven primarily by the steady performance of the long running titles in our game portfolio. Our flagship, Fantasy Westward Journey series and Westward Journey series continued to perform strongly as two of the longest and largest running game IPs in China, both games continued to attract a loyal crowd.

Fantasy Westward Journey online achieved another record high quarter of gross billings since its debut in 2003, 16 years ago, while the mobile version also reached its highest quarter of gross billings in the last two years. For the Westward Journey series, we introduced a brand new dragon character in conjunction with an expansion pack in August for both the PC and mobile games, which quickly gained popularity within fans. Westward Journey Online also peaked in gross billings this quarter, reaching the highest level we’ve seen since 2015.

Other games launched in more recent years are also enjoying an impressive popularity with highly active core user bases. Invincible had another quarter of record revenue with continued growth in active users. In October, with its fourth year anniversary, Invincible reached number two on China’s iOS grossing chart. Onmyoji also celebrated its third anniversary this quarter and topped China’s iOS grossing chart for the third time this year since September.

In addition, other games in our portfolio, including our new ghost series, Identity V, All About Jianghu which previously known as CLX and Life-After are also enjoying a sizable and steady run rate with their respective large bases of loyal fans. Two weeks ago, we launched an updated version of Life-After. The update came with an overhaul of the game introducing a series of new themes and innovative gameplay leading to a strong growth in the number of active users and gross billings. These games span different genres, target different user profiles, and lasts a long time horizon. This is how we achieve sustainable revenue base for our existing portfolio of games and continuously add more and more game titles to this expanding game portfolio.

The fans that these games have accumulated over the years and the reach of their influence have turned each of them into valuable IP giving rise to the possibility of more renditions of these popular characters and story lines. Most recently in October, we launched Xuan Yuan Sword: Dragon Upon the Cloud, a Chinese style turn-based MMORPG which topped the iOS downloads chart soon after its launch. And for Bloom & Blade, a new MMORPG we just launched last Friday is also trending well. This game is designed to target female game players and was featured by the iOS App Store.

Our joint venture with Blizzard Entertainment has also had a good quarter. In line with our successful 10-year partnership operating Blizzard’s World of Warcraft in mainland China, the popular franchise continues to provide new thrilling game experiences to players across the world. August 27 marks the official launch in China of Blizzard’s World of Warcraft Classic, an inventive revitalization of WoW as the world’s renowned MMORPG calling on the nostalgia of a generation of old players and intriguing new players alike. This latest release increased both revenue contribution and total number of subscribers for the game.

In terms of overseas revenues, we delivered a record quarter. We now have two blockbuster games in Japan; Knives Out and Identity V, both of which gained top position on Japan’s iOS grossing chart. Life-After, our newer release is also ramping up well in Japan. With the success of Knives Out, we gained a better and deeper understanding of users in Japan in terms of their interest, social behavior, and preferences in style, esthetics, and game play. We passed the successfully experienced knowledge on to the design of other NetEase games, enhancing our ability to deliver popular titles to Japanese users. Identity V topped Japan’s iOS top grossing chart for the first time in September while Knives Out remains a household name in Japan amongst the gamers.

To further support our games growth in Japan and stimulate player enthusiasm, we hosted Knives Out Championship, our first ever e-sport championship tournament in Japan from May to August with more than 500,000 players participating. In terms of our pipeline of games, we are pleased to have received license for FWJ 3D, which is currently undergoing the final round of beta testing and is scheduled for launch in December. In addition, we are excited to announce plans to release Harry Potter: Magic Awakened, a card game featuring a blend of strategic role play elements that invites players to experience the magical wizarding world.

Other games included in our lineup include Onmyoji: The Card Game, Marvel Super War, Onmyoji: Yokai Koya, EVE Echoes, Ghost World Chronicle, Diablo Immortal and Pokémon Quest. While our existing games are expected to sustain our online games revenue at a high level, the abundant pipeline titles represent opportunities to further fuel the revenue growth for our online games.

Now turning to our education business, we have completed Youdao public listing on the New York Stock Exchange in October. This marks our first-ever carve-out IPO under the NetEase umbrella and the beginning of a new journey for Youdao to lead our efforts in revolutionizing the ways that people learn and receive education. Following the IPO, NetEase remains Youdao’s majority shareholder and will continue to support Youdao’s future growth that propels their mission to empower the people of China on their lifelong learning journey.

Over the past 30 years, Youdao has become a strong contender in the online education space with clear advantages in Internet native pack-driven content offerings. The Internet has disrupted many industries in the world, but so far it has had a minimum impact on the education space in China. This offers tremendous opportunity for Youdao. Led by Dr. Zhou, Youdao’s senior management team is comprised mostly of computer science graduates and doctorates from top universities who are best suited to lead the transformation in the online learning space enabled by the application of technologies. Both Youdao and NetEase are fully committed to investing in technology and content creation in order to bring to our users more effective and technology-driven education experience.

Moving on to innovative businesses and others. For NetEase Cloud Music, we continue to deliver a highly differentiated music product with the mission to have tens of thousands of talented Chinese independent musicians create indigenous content that resonates with Chinese listeners. We strive to provide our users with the most intimate, interactive and high quality music experience as we continue to amass more and more of what we call Cloud Villages, we know we are on track.

NetEase Cloud Music continues to ramp up its monetization efforts reaching new record high revenues in the third quarter. Revenue growth has been strong across the board in subscriptions, advertising and live streaming leading to continued improvement in our financials. We entered into a definitive agreement with Alibaba and Yunfeng for approximately US$700 million in September. With our new strategic partners we are able to explore more innovative forms of monetization for this highly engaging music platform.

For Yanxuan, the focus continues to be about operating efficiency. During the third quarter, we continued to optimize our supply chain management to reduce our inventory and to deepen our relationships with choice manufacturing partners. We help our manufacturing partners better understand the consumer metrics and provide them with better visibility and ultimately better sales figures. Looking ahead, Yanxuan will continue to focus more on quality control and bring high-quality products to our consumers.

In September, we completed the sale of our cross-border e-commerce business Kaola and we are pleased to have found a strategic fit for Kaola within Alibaba’s extensive ecosystem. In summary, we had a busy quarter being more focused and realizing value for each of our core business areas. We are very confident in the future prospects of the sectors we chose to be in, and we have developed and will continue to strengthen our distinct product offerings in each of these markets.

We will persist in our pursuit of excellence across all of our business lines and the needs of our users always remain at the heart of our business strategy. As we advance each of our businesses and create value, we are always looking for ways to increase returns to our shareholders. This quarter, in addition to our regular dividend representing a 30% payout ratio, we were also distributing a special dividend of US$3.45 per ADS this quarter in consideration of the sale of Kaola business. As always, we appreciate and value the long-term support from our shareholders and we are always devoted to maximizing the interest of our shareholders.

This concludes William’s comments.

I will now provide a very brief review of our third quarter 2019 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.

Our total net revenues for the third quarter were RMB14.6 billion or US$2 billion, representing a year-over-year increase of approximately 11%. And again, let me remind everyone that the revenue has taken into the consideration that we have deconsolidated Kaola results in the current quarter as well as the historical comparative period.

Net revenues from online game services were RMB11.5 billion, up 11% year-over-year. The year-over-year increase was primarily driven by Life-After, which was launched at the end of last year as well as continued strong performances from Invincible and Identity V.

Mobile games accounted for approximately 71% of net revenues from our online games in the third quarter. Net revenues from Youdao nearly doubled year-over-year to RMB346 million primarily due to increased net revenues from Youdao Premium Courses driven by higher paid student enrollment and average selling price.

Net revenues from innovative businesses and others were RMB2.8 billion, up 4% year-over-year due to mainly the increased monetization from Cloud Music, partially offset by decreased revenues from online advertising businesses due to macro environment.

Overall, gross margin was 53.8% in the third quarter. Gross margin for our online game services for this quarter were 63.8%. Our gross margin for online games is generally stable fluctuating quarter-to-quarter within the narrow band based on the revenue mix of mobile, PC, as well as self developed and licensed games.

Youdao’s gross margin 25.8%, an improvement from 23.3% in the prior year period due to increased net revenues from Youdao Premium Courses and down from 32.9% in the previous quarter.

Gross margin for innovative businesses and others for the quarter was 15.2% compared to 15.5% and 17% for the previous quarter and prior year period, respectively. The year-over-year decrease was primarily due to decreased net revenues from advertising services.

For the third quarter, total operating expenses were RMB4.5 billion. Our selling and marketing expenses as a percentage of our net revenue were 11.1% compared with 8.9% in the second quarter. The quarter-over-quarter increase was mainly due to increased marketing expenditures related to online game services as well as a summer promotion of Youdao which is typical in the online education space.

R&D expenses remains steady at around RMB2.2 billion. We remain committed to invest in content creation and product development which is what defines us as a technology company.

Non-GAAP net income from continuing operations attributable to our shareholders for the third quarter of 2019 totaled RMB4.7 billion or US$661 million, representing an increase of 21% quarter-over-quarter and 74% year-over-year. Our non-GAAP diluted earnings per ADS from continuing operations were RMB36.31 or US$5.08 for the third quarter.

Our cash position remains strong. As of September 30, our total cash and cash equivalents, current and non-current time deposits and short-term investments balance totaled RMB61.4 billion compared with RMB49.7 billion as of year-end last year.

As William mentioned in his remarks, we are pleased to report that our Board of Directors has approved a dividend of US$7.59 per ADS. This includes a regular quarterly dividend of US$4.14 per ADS equivalent to approximately 30% of our net income attributable to the shareholders, plus a special dividend of US$3.45 per ADS.

Thank you for your attention. We would like now to open the call to your questions. Operator, please go ahead to the Q&A.

[Operator]

Thank you. [Operator Instructions]. We will take our first question from Natalie Wu from CICC. Your line is open. Please go ahead.

[Natalie Wu, CICC]

Hi. Good morning. Thanks for taking my question. I have a question on the upcoming FWJ 3D. Just wondering if management can give us some color on your expectations for that game? And do we need to worry if that game could have the possibility of cannibalizing your current FWJ mobile grossing, if that FWJ 3D could be the next hit game? Thank you.

[Charles Yang, CFO]

Okay. Thank you, Natalie. I’ll translate that question for William.

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

I’ll provide a brief translation of William’s response. FWJ 3D is currently scheduled to launch in the first half of December and we are quite excited about this game because this game represents accumulation of over a decade long of R&D experience both from the PC version as well as the mobile version of FWJ, and we can adhere to the users and the investor community that we’re going to see a lot of innovation in this game. So, this game is – we are hoping that this game can attract many enthusiastic fans about the Westward Journey franchise, and given all these games are in-house developed by NetEase, we are not overly concerned about any cannibalization to our existing FWJ PC and FWJ mobile.

[Operator]

Next up, we have Alex Poon from Morgan Stanley. Your line is open. Please go ahead.

[Alex Poon, Morgan Stanley]

[Foreign Language]

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

Thank you, Alex. I’ll provide a brief translation of William’s comments for the audience. Firstly, on music. So in short, yes, we are very actively exploring different opportunities in terms of monetization that will be reflected in the upcoming quarters as we continue to explore, strengthening existing monetization channels, as well as to apply some innovative brainstorming new features, for instance social aspect, et cetera, that we mentioned previously. In terms of cost control, NetEase as a whole not only as NetEase Music, we are very prudent and practical in terms of cost control.

We think that in order to differentiate our music business from the competition, we are going to further strengthen sales production UGC independent musicians as a differentiated content. As a result, we do not see any material increase in terms of music content acquisition cost. Overall, we are very confident about the prospect of monetization which will lead the path to profitability. We do not have any definitive timetable for breaking even or IPO, but I think as long as we progress on track towards the mission, and those will come just naturally.

To your second question on the overseas games strategy, so as you have mentioned, we’ve been also quite active in exploring overseas opportunities. The various overseas investments that we made in those studios are mostly valuing their R&D expertise, which we think can supplement to our in-house R&D capability. Equally, our NetEase R&D expertise is something that attracts those business partners to collaborate with us. Today, we have achieved a small milestone in Japanese market, and we are hopeful that with more new game launches on the global stage, step by step we are also going to have a more promising future in terms of the U.S. and European Western market.

[Operator]

Next up, we have Hillman Chan from Citi. Your line is open. Please go ahead.

[Hillman Chan, Citi]

Hello, William, Charles, and Margaret. [Foreign Language] Thank you very much for taking my question. My first question is to follow up on the FWJ 3D mobile. During the final beta testing for Android, do we have a sense of the percentage of participants coming from those currently playing mobile FWJ? And also could you share more observation from the beta testing as well? And then another question is on the Marvel Super War. Could you share more on the development status and launch timetable? And what other game genres for the Marvel IP under development and the status please? Thank you very much.

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

Okay. Thank you, Hillman. For your first question on FWJ 3D, as you know we’ve started beta testing as early as in the summer. So far, the testing results has been very promising which leads to our confidence in launching this game in the first half of next month. For your second question on Marvel IP, as we have reviewed the overall partnership with Marvel on our May 20th Game Day, there will be multiple games that’s going to developed by NetEase for Marvel IP, and Marvel Super War is one of them. I think Marvel Super War is well on track from a development perspective. So, this game could be expected in the near term. Obviously, for Chinese market, this is also subject to the license approval, but several of these Marvel games are targeting both the Chinese market as well as international markets.

[Operator]

Next up, we have Kenneth Fong from Credit Suisse. Your line is open. Please go ahead.

[Kenneth Fong, Credit Suisse]

[Foreign Language] I have a couple of questions related to the overseas business. First, what is the overseas game revenue as a percentage of our total game revenue? Second, among our game pipeline, which one of you, you see great potential for the overseas market next year? Third is how do you see the competitive landscapes for the overseas game development? Especially I noticed that there’s a lot of Chinese game developers also very active in publishing overseas. Thank you.

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

Kenneth, to translate William’s response and also to add a few more color, in terms of the overseas game revenue [indiscernible] above 10% of our overall game revenues. We see great potential in terms of further enhancing both the absolute dollar by overseas game revenue as well as this percentage ratio.

To your second question in terms of game-specific product lineups for the various international markets, apologies for your understanding that we would not be able to elaborate the details here, but there is a solid plan where we say that we are confident to increase the overseas game revenue as well as the percentage. It is actually bottom up. It is supported by a very extensive study of the overseas market as well as our product lineups.

For your third part of the question in terms of the competitive landscapes of the overseas market, I think that’s a good question because when we are launching our products to the overseas market, we realize that in more developed markets like Japan and U.S., users are actually a lot more sophisticated. The only way to impress, to retain, to attract these users is through product innovation and game quality. That is something that NetEase is proud of our competitiveness. And with that confidence, I think it represents actually a very, very optimistic upside of the overall NetEase games in the markets beyond China.

[Kenneth Fong, Credit Suisse]

Thank you.

[Operator]

Up next, we have Jialong Shi from Nomura. Your line is open. Please go ahead.

[Jialong Shi, Nomura]

Good morning, management. Thanks for taking my call and congratulations on a solid quarter. Let me first ask my questions in Chinese. [Foreign Language] I have two questions. The first question is about the online gaming business. So I was just wondering when company will officially launch the upcoming new mobile game, Harry Potter. And also I was wondering what company did in Q3 to have helped the two legacy titles, FWJ and WWJ2 to achieve record high growth in Q3, respectively.

My second question is about the online music business. We heard from some media that China’s regulator is likely launching investigation into the license and practice between record labels and the music streaming companies. So I was wondering if management can provide some colors on this ongoing investigation and – or specifically what potential changes this investigation may bring to the music streaming industry? And related to that, what potential impacts these changes may have on NetEase Cloud Music business? Thank you.

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

Thank you, Jialong. I’ll translate William’s response for the audience. Firstly, given that we have abundant lineups for the game pipeline, William is actually encouraging people to try not to focus too much on individual titles, whether it is existing FWJ, WWJ or the upcoming FWJ 3D or Harry Potter. All of these are high-quality games that we self-develop and we are very confident about their performance, longevity and we have a lot more than just those couple of names that we quoted. For the past summer, yes, FWJ and WWJ both have delivered a record quarter stimulated mostly by expansion packs in the summer. Harry Potter is also scheduled for launch. We don’t have a concrete timetable yet, but it should be planned for next year.

On your second question, Jialong, on the music, we’ve also learned from the media about potential regulatory investigations and queries into that. Our general attitude is that for any sort of industry growth, a conducive environment from the players and from the regulators are ultimately longer-term beneficial to serious and long-term players. Our mission ultimately is to ensure that the industry as well as the passionate Chinese online music users benefit from a healthy and diversified growth of the industry. Overall, we think an appropriate and conducive environment is going to be long-term beneficial to all the players in this sector.

[Operator]

Next up, we have Daniel Chen from JPMorgan. Your line is open. Please go ahead.

[Daniel Chen, JPMorgan]

[Foreign Language] I will translate myself. I’m asking on behalf of Alex Yao. So my question is, first one is related to PC games. We noticed some of our top PC games such as World of Warcraft Classic and Fantasy Westward Journey actually performance is very resilient. So could management talk about the PC game market outlook in next few years? And what are the key growth areas? Second question is related to some of the new innovative trends. Could management talk about NetEase strategy in these new innovative trends, such as 5G and cloud gaming? Thank you.

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

Okay. Thank you, Daniel. I will translate William’s response and also add on to your first question. Your second question, William commented that’s a great question, that the industry has been noticing these new features. First of all, William thinks that the user recognition of game titles, so any sort of content is ultimately attracted to the content, less so on the different screens or media. So ultimately, it is the best quality content for the different sector of users that dictates who is the winner.

Cloud gaming as well as 5G, all these are great features to supplement to this content creation industry, whether they are going to be a mainstream feature or whether that’s going to be disruptive to the overall user experiences, those are all good questions to ponder and to be further observed. Overall, we think as long as it’s content industry, whether it’s education, whether it’s music, whether it’s games, ultimately content is the king. The one who has the capability of developing the highest quality content would always be the ultimate winner.

For your first question on the PC games, we have recorded a great quarter in terms of PC games of our portfolio. We’ve seen both FWJ, WWJPC as well as WoW Classic delivering quite strong quarterly results. Overall, we think – obviously we can’t speak for the entire industry but as for us, we are fairly confident about the steady performance of our PC games into 2020.

[Daniel Chen, JPMorgan]

Thank you.

[Operator]

Next up, we have Thomas Chong from Jefferies. Your line is open. Please go ahead.

[Thomas Chong, Jefferies]

Thanks management for taking my questions. I have two questions. The first question is about our Cloud Music business. Given that we are going to include more features such as live streaming to the music side, how should we think about the impact of our short-format video to live streaming?

And my second question is about the OpEx trend. Given the fact that we are innovating a lot of new business as well as we are also expanding to overseas, how should we think about our R&D headcount going forward? Are we going to expand our headcount in overseas? Thank you. [Foreign Language]

[William Ding, CEO]

[Foreign Language]

[Charles Yang, CFO]

Okay. Thank you, Thomas. I’ll translate William’s remarks. Firstly, he thinks that the short video industry in general is actually a positive catalyst to China’s online music industry because as you can see, all the presentation of short format video as well as live streaming requires some sort of a music element, which actually helps to promote music popularity.

For NetEase Cloud Music specifically, we now have over 80,000 Chinese independent musicians that’s been nurturing on our platform and this figure is growing. We think short-format video is a very conducive way to promote good music. Based on our data and user statistics, we are not seeing short-format video as a distraction or a competition for users screen time and others. We think ultimately user traffic is attracted by good music, Chinese and global alike. Currently, on Cloud Music we now have almost all the good music of the last couple of decades, those are the core assets that attracts users.

And quickly before we wrap up this call, for your second question on the OpEx trend, our R&D headcount is steadily increasing. In fact, overall by the end of the third quarter, especially after the summer recruiting season, our headcount has represented a slight increase comparing to last quarter as well as to the last year-end. I think this is a strong factual evidence dismiss many ungrounded market rumors of so-called massive layoffs about NetEase.

[Thomas Chong, Jefferies]

Thank you.

[Operator]

Thank you. I would now like to turn the conference to our management for any additional or closing remarks.

[Margaret Shi, IR Director]

Thank you once again 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]

That concludes today conference. Thank you everyone for your participation.