NetEase Inc

NASDAQ:NTES

Earnings Call Transcript 2017-Q4

[Operator]

Good day, everyone and welcome to the NetEase Fourth Quarter and Fiscal Year 2017 Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Brandi Piacente. Please go ahead, Ma'am.

[Brandi Piacente, IR]

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. 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 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 2017 fourth quarter and full year fiscal year 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.

Joining us today on the call from NetEase Senior Management is William Ding, Chief Executive Officer; Mr. Charles Yang, Chief Financial Officer; and Mr. Hilton Huang, Co-President of NetEase Game.

I'll now turn the call over to Mr. Yang, who will read the prepared remarks on behalf of Mr. Ding.

[Charles Yang, CFO]

Thank you Brandi, and thank you everyone for participating in today's call. Before we begin, I'd like to remind everyone again that all percentages are based on Renminbi. With that said, I'm pleased to deliver opening remarks on William's behalf.

We are pleased with another year of strong performance with the 42% increase in total net revenues. During the year, we launched the number of popular new titles including two global hit Knives Out and Terminator 2: Judgment Day. These games quickly became the fast performers in their genre. This further strengthens and diversify our high quality game portfolio. And also makes us a meaningful player in the international online game space. As we continue to advance our international expansion strategy, many of our games have proven to have large, universal appeal. With over 200 million players globally, our Onmyoji is now available in 69 countries. Knives Out was also particularly well received internationally with Google Play Store recommending in over 10 countries. Similarly, Terminator 2 has been ranked as one of the most popular games on iOS and Google Play platform across multiple countries including the US market.

Also during the year, our e-commerce business more than doubled achieving net revenues of RMB11.7 billion. e-commerce is now our second largest business segment, accounting for approximately 22% of our total net revenues in 2017. For the fourth quarter, our total revenues came in at RMB14.6 billion representing an increase of approximately 21% year-over-year. Non-GAAP net income was RMB1.9 billion compared to RMB4 billion in the previous year. The year-over-year decrease to our bottom line reflects the strategic investment we made this year, particularly in mobile games and e-commerce. These investments offer us expanded reach and momentum. They also support our diversification strategy as we build a solid foundation to our long-term growth.

Online game services continue to lead our business. On the PC side, we propound the success of our flagship PC clients' titles. During the fourth quarter, we introduced new expansion packs for longtime fan favorite including Fantasy Westward Journey Online, Westward Journey Online 2, and Tianxia III. These compelling new expansion packs invigorate existing players, as well as attract new players. Mojang's Minecraft is now available across all platforms in China since October. We are currently on track to commence small scale monetization for the mobile version of Minecraft in the first half of this year.

Total revenues from mobile games accounted for approximately 68% of our online games revenues in the fourth quarter. Our flagship mobile games such as Fantasy Westward Journey Mobile and Westward Journey Online 2 Mobile continue to impress the market with their strong and sustainable performance. For other popular titles such Onmyoji and New Ghost mobile game, we release new content in the fourth quarter, which revised our user interest. Onmyoji's number release in Thailand and December expansion pack brought back earlier players and brought in brand new players. For New Ghost, players are also delighted by the new content, including new characters and promotion with other traditional Chinese animation IP.

In terms of new mobile games, Knives Out and Terminator 2 along with its global version Rules of Survival were launched in early November. Both games became immediate blockbusters. To date, Knives Out boost over 100 million registered users and Terminator 2 has accumulated 80 million registered users. We also started early monetization efforts for these titles in December.

Moving on to e-commerce. This business segment has grown substantially with revenues in the fourth quarter increasing nearly 175% year-over-year to RMB4.7 billion, by partnering with leading providers, Kaola.com and Yanxuan, focus on providing customers with highest quality product and services. Our primary objective in this market is to create an elevated user experience that sets the standard for what online e-commerce should be. Our goal is to provide our growing users community with the best in class interface, as well as broad purchase options. We plan to continue adding new products and premier services to further enhance our customer experience.

For advertising services, revenues in the fourth quarter increased by approximately 11% year-over-year to RMB736.6 million with automobile, internet services and real estate as the top performing verticals. The mobile advertising market in particular continues to expand. We hold considerable advantage in the mobile arena proving to be a reliable partner to current and new client. Email and others net revenues were RMB1.2 billion or US $186.4 million in the fourth quarter with year-over-year increase of 55%.

2018 is off to a strong start. Our online games pipeline will focus on expanding and diversifying our portfolio, as well as increasing our global footprint. January has been a busy month as we've already begun executing on this strategy with the handful of thrilling new releases. We've introduced the English language version of Onmyoji to Canada, Australia, New Zealand and Scandinavia. Additionally, players greeted the highly anticipated mobile version of Onmyoji with great enthusiasm. And the game's early performance has exceeded our expectations. We also launched MMORPG Chu Liuxiang, and the game is currently available for play on all major platforms. With an extremely receptive fan base and its innovative game play, Chu Liuxiang has been recognized as one of the top grossing games from iOS since its launch. We plan to launch new mobile games across a variety of genre, strengthening our position by appealing to a broad range of players and user preferences. Our release schedule presently cost full and array of new genres including the asymmetrical battle arena game Identity V, RPG Sky and 2.5D casual battle arena game Alive.

To further strengthen and diversify our product offerings, we will continue to invest in self-developed games. We also plan to broaden our reach through partnerships with other industry leaders that help us bring games to users worldwide. Under our recently announced joint venture with Mattel and the formation of Mattel 163, we are delighted to extend Mattel's popular IP such Uno, [Avi], Hot Wheels, Fisher Price and Thomas & Friends to create mobile games and education apps that uses everywhere, can enjoy on an exciting, new digital level.

As we move through the year, we will continue to make effort towards our long-term growth objectives. Our strategy calls for diversification across our business lines. Our games pipeline is strong. Our e-commerce business is developing rapidly. And our advertising services and email and other businesses are also growing. Each of this offers growth opportunities where we can generate value for our partners, shareholders and community.

This concludes William's comments.

I'll now provide a brief review of our fourth quarter 2017 financial results. Given the limited time on today's call, I'll be presenting some abbreviated financial highlight. We encourage you to read through our press release issued earlier today for further details. I would also like to remind our audience that effective beginning the fourth quarter of 2017, we move from three to four reporting segments. We are now reporting financial results for our e-commerce business, which primarily includes Kaola.com and Yanxuan. All historical quarterly and year end amounts for 2016 and 2017 that we will be discussing today, reflects this change.

Net revenues for the fourth quarter of 2017 were RMB14.6 billion, or US $2.2 billion. This represents an increase of 17.1% and 20.7% compared with the preceding quarter and fourth quarter of 2016, respectively. The increase was mainly led by our e-commerce business and partially offset by a decline in revenue contribution from our online game services.

Our gross profit for the fourth quarter of 2017 was RMB5.7 billion, or US $882.9 million compared to RMB5.9 billion and RMB6.5 billion for the preceding quarter and the fourth quarter of 2016, respectively. Our gross profit for our online game segment declined year-over-year and quarter-over-quarter in the fourth quarter as a result of decreased revenue contribution from some of our self-developed mobile games. Margins for our online game segment were relatively stable at 61.4% in the fourth quarter compares to 60.7% a year ago and 62.5% in the preceding quarter. With the record development and expansion of Kaola.com and Yanxuan, gross profit for our e-commerce business increased. Gross margin decreased to 7.4% which was primarily impacted by larger scale promotion and certain sales discount in the fourth quarter of 2017 such as Single's Day on November 11, 2017. This compares with gross margin of 11.5% and 12.5% for the preceding quarter and the fourth quarter of 2016 respectively.

Gross profit and margin for advertising services business increased year-over-year and quarter-over-quarter in the fourth quarter of 2017. Gross margins were 71.2% compared to 68.0% and 66.5% for the preceding quarter and the fourth quarter of 2016 respectively. Gross loss margin for our email and others business was 3.3% compares to gross profit margin of 13.1% and 46.9% for the preceding quarter and the fourth quarter of 2016, respectively.

Total operating expenses for the fourth quarter of 2017 were RMB4.3 billion or US$663.6 million, this compared to RMB3.4 billion and RMB2.6 billion for the preceding quarter and the fourth quarter of 2016, respectively. The increase in operating expenses was mainly due to increased selling and marketing expenses, research and development investments, staff-related costs, and increased operating expenses due to our e-commerce businesses. E-commerce related Shipping and handling costs included in selling and marketing expenses for the fourth quarter of 2017 were RMB393.3 million or US$60.4 million, this compared to RMB294.8 million and RMB177.2 million for the preceding quarter and the fourth quarter of 2016, respectively.

The effective tax rate for the fourth quarter of 2017 was 18.2%, compared to 8.1% and 19.2% for the preceding quarter and the fourth quarter of 2016, respectively. The changes in the effective tax rate were mainly due certain of our subsidiaries being recognized as Key Software Enterprises in the third quarter and fourth quarter of 2017, and subject to a preferential tax rate of 10% for 2016. We recognized related tax credits in the third quarter and fourth quarter of 2017 accordingly.

Our net income attributable to shareholders for the fourth quarter of 2017 was RMB1.3 billion or US$197.6 million, this compared to RMB2.5 billion and RMB3.7 billion for the preceding quarter and the fourth quarter of 2016, respectively. Non-GAAP net income attributable to our shareholders for the fourth quarter of 2017 totaled RMB1.9 billion or US$288.8 million, this compared to RMB3.0 billion and RMB4.0 billion for the preceding quarter and the fourth quarter of 2016, respectively.

For the fourth quarter of 2017, our basic and diluted earnings per ADS were US$1.50 and US$1.49, respectively. Our Non-GAAP basic and diluted earnings per ADS were US$2.20 and US$2.18, respectively, for the fourth quarter of 2017.

Turning to some highlights from the full year 2017 financials. Total net revenues for fiscal year 2017 were RMB54.1 billion or US$8.3 billion, compared to RMB38.2 billion for the preceding fiscal year. Gross profit for fiscal year 2017 was RMB25.9 billion or US$4.0 billion, compared to RMB21.7 billion for the preceding fiscal year. The increase was mainly due to: one, increased revenue contribution from our self-developed mobile games such as Onmyoji and the mobile version of New Ghost. Two, the increased monetization effort for mobile applications primarily our mobile news app and three, the expansion of our e-commerce business.

Total operating expenses for fiscal year 2017 were RMB13.8 billion or US$2.1 billion, compared to RMB9.0 billion for the preceding fiscal year. The increase in operating expenses in 2017 was primarily due to increased selling and marketing expenses, research and development investments, and higher staff-related costs, as well as increased operating expenses related to our e-commerce businesses. E-commerce related Shipping and handling costs included in selling and marketing expenses for fiscal year 2017 were RMB1.2 billion or US$181.8 million, compared to RMB503 million for the preceding fiscal year. The effective tax rate was 16.6% for fiscal year 2017, compared to 15.1% for fiscal year 2016. The changes in the effective tax rate were mainly due to the higher withholding tax recorded for fiscal year 2017.

Net income attributable to our shareholders for fiscal year 2017 totaled RMB10.7 billion or US$1.6 billion, compared to RMB11.6 billion for the preceding fiscal year. Non-GAAP net income attributable to our shareholders for fiscal year 2017 totaled RMB12.7 billion or US$2.0 billion, compared to RMB12.9 billion for fiscal year 2016. Our basic and diluted earnings per ADS were US$12.50 and US$12.41, respectively, for fiscal year 2017. Non-GAAP basic and diluted earnings per ADS were US$14.85 and US$14.73, respectively, for fiscal year 2017.

Our cash position remains strong. As of December 31, 2017, our total cash and cash equivalents, current and non-current time deposits and short-term investments balance totaled RMB43.2 billion or US$6.6 billion, this compared with RMB36.9 billion as of December 31, 2016. Our cash flow generated from operating activities was RMB11.9 billion or US$1.8 billion for fiscal year 2017, compared with RMB15.5 billion for the preceding fiscal year.

Returning value to our shareholders remains the top priority. For the fourth quarter of2017, we plan to pay a dividend of US$0.38 per ADS in accordance with our 25% dividend distribution policy. Under our current share repurchase program, which began November 16, 2017, we had not yet purchased any ADSs as of December 31, 2017.

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

[Operator]

[Operator Instructions]

We will take our first question from Alicia Yap with Citi.

[Alicia Yap, Citi]

Hi, good morning, William and Charles. Thanks for taking my questions. I actually have couple of questions if I may. Number one is related to the sales and marketing spend and overall margin. So can management share with us the step up spending in the more aggressive to promote your e-commerce and your gaming business? What is the rationale behind the strategic decisions? And how should we be thinking and modeling in the upcoming spend for 2018? Should fourth quarter level be the similar level that we should be thinking for 2018? Thank you.

[William Ding, CEO & Director]

[Foreign Language]

[Charles Yang, CFO]

Thank you, Alicia. This is Charles. So, first of all, sales and marketing expense is a format of our strategic investment to build a very solid foundation for NetEase's long-term growth objectives. And specific to Q4, there are certain seasonality impacts, for instance, in Q4 sales and marketing expenses e-commerce is relatively higher due to the promotional season, Double 11, Double 12, Black Friday. For games in Q4, as you all know, we have very successfully launched a couple of very promising titles. And related sales and marketing expenses on those titles are relatively higher comparing to the preceding quarters. Overall, I'd say we remain very, very confident about the return of our investment in the format of sales and marketing. And also as I noted in the transcript just now, embedded in the sales and marketing are also the e-commerce related shipping and handling cost which you can get the numbers from our earnings release.

[Operator]

Next we move to Eddie Leung with Merrill Lynch.

[Eddie Leung, Bank of America Merrill Lynch.]

Hey, good morning. Thanks for taking my questions. I have questions on the cross border Kaola piece, so when we look at the very fast growth of your e-commerce revenues. I am just curious, how much think that's driven by industry growth and how much that's driven by successful market share gain over some of over competitors. And then along the line, I am just curious on your thought in terms of your longer term strategy. How you can differentiate from a couple of the more general e-commerce platforms which potentially have better economic scale in terms of the infrastructure? Thank you.

[Charles Yang, CFO]

So Eddie to answer your question let me do a quick summary and translation. For Kaola, since the inception of Kaola business, we have focused on the cross border e-commerce segment, which over the past years we've already build a leadership in terms of market share. And we are the fastest growing player in this cross border segment. Talking about competition, we do not think is hats to hats competition with the major players for this cross border segment because there is huge Chinese consumption demand when you see Chinese tourist spending overseas when they do a physical travel. So that we are talking about trillions of spending. And that's obviously a very, very potential market, addressable market for our cross border e-commerce Kaola business. With respect to Yanxuan, again our strategic position and rationale is that China is now already the largest manufacturing base for the world. A lot of made in China products represent very high quality. So we have close partnerships with the select manufacturers in terms of designing and manufacturing product specific tailoring to the Chinese consumer user demand and this consumption upgrade trends. So a longer term, we are very confident that we are going to sustain a very fast growth of our both Kaola.com and Yanxuan e-commerce business.

[Operator]

Next we will move to Thomas Chong with Credit Suisse.

[Thomas Chong, Credit Suisse.]

Hi. Good morning, William, Charles and Huang. And thanks for taking my questions. I have a couple of questions. The first question is about survival bookings. Can management provides us some color about our expectations in terms of user and monetization by year end in China and overseas market? And follow up on that, how should we think about the competition of the survival games in China and overseas? And my second question is about the e-commerce business. Can management provide us some additional color because we have the shipping expenses but how should we think about operating profit level in terms of the operating profit and the timing of profitability? And my third question is about the trend in terms of the operating expenses in 2018. And my final one is about the online game broadcasting business that we recently see that NetEase want to invest around RMB1 billion in this area. Thank you.

[Charles Yang, CFO]

Okay. Thomas its text full of questions in total. Let me translate for William. [Foreign Language] Okay. So for your first question we have already established an early mover advantage in the survival genre both domestically and globally. And we also very glad to see that the games that we have launched has achieved its success in both domestic and overseas market. The way we think about this genre is this is a very, very exciting genre with very promising long-term sustainability by combining the survival battle arena stand box element into the new and innovative game play. So we are very confident that this genre will be a very long lasting genre that can create different innovative game play and apply that into different genres. And accordingly we have also deployed our strategic resources in new games pipeline in this broader survival battle arena and sent box genre. For our e-commerce in terms of the trend for operating margins, given we are - comparatively speaking we are relatively new entrant into e-commerce, so in the near term our primary focus will be gaining broader user recognition and providing an elevated experience to the users. So margin profitability is not an eminent near focus. However, given our continued growth and skill up effect, margins will continue to improve and we are very, very confident about the future profitability of our e-commerce business. Thomas for your question on the trend, overall trend for the operating expense and margins. So, as I explained earlier question, Q4 was a little bit unique with a couple of one off impact e-commerce seasonality, as well as the promotion of newly launched games in Q4. For those strategic investments we made in Q4 based on the results now we continue to receive were very satisfactory with respect to the returns on those investments. And for R&D throughout the year and going forward, we will continue to focus and invest because that is building our core confidence. And so overall we think margin trend we are confident and William also commented that in Q4 there were certain copyright related one-off expenses in relation to our online music business that is also one -off. So online broadcasting and esports have becoming increasingly more important elements of the overall game industry ecosystem. We observe that from the newest trend that players they do not only play and experience the game, but they also enjoy watching and participating in the games from another format. So with that trend and also given that nowadays we have very suitable and relevant IPs both self-developed as well as licenses that we are making very prudent and strategic deployment of our capital and resources in terms of online game broadcasting esports which we think will also bring positive value to our games ecosystem overall.

[Operator]

We will move next to Natalie Wu, CICC.

[Unidentified Analyst]

Hi, good morning, management. Thank you for taking my question. This is [Chow] speaking on behalf of Natalie. Actually I have a follow up question regarding our survival game. We noticed Knives have launched a couple of new survival games recently. Could management share your thoughts on the positioning of these new games and how they differentiate it from previous ones and how they differentiate from the Knives Out and Terminator 2? And how they differentiate from each other in terms of the positioning? And also could management give us some color on your promotion plans for the survival games going forward especially during Chinese New Year? Thank you.

[Charles Yang, CFO]

Okay. So in terms of the survival battle arena sent box genre, we do have very strong pipeline with differentiated games, with differentiated from multiple aspects. Some differentiate from the view angle; some differentiated from 2.5D, 3D, different highest qualities in their respective category. Some are differentiated in terms of play mode with some new and innovative concept embedded into these games. We think those will be very strong supplements to our existing games. With respect to the upcoming Chinese New Year, for our exiting games Knives Out and Terminator 2, we will have a series of interesting new contents and new game play being introduced. At the end of January, Terminator 2 has introduced eight times eight biggest map with that kind of accommodate 300 concurrent players which again set a record for game this in genre. Knives Out very recently have introduced a 50v50 a new concept of game play. Again these are just some specific examples of a series of innovative action we plan to bring exciting and creative concepts to the players.

[Operator]

We will move next to Marcus Young with Macquarie Research.

[Marcus Young, Macquarie Research]

Hi. William and Charles. [Foreign Language] So I got three questions. So first one regarding to Chu Liuxiang, always has been performing pretty well since launch last month. So can you share some like data like your ARPU at the moment and if it is, is this kind of mix genre and send box MMORPG in this case, its high freedom become a key direction for NetEase to work on? And how does that compare to typical MMORPG or same box game in terms of our pool of user base? And my second question is about the survival genre. Can you share the customer acquisition calls for Knives Out and Terminator 2? And my third question is regarding the overseas retention there? Can you share some monetization strategy comparison between the overseas market and domestic market especially for Knives Out and Terminator 2? Thank you.

[Charles Yang, CFO]

Okay. So I'd a very quick translation of the answers. First question regarding Chu Liuxiang, this is highly anticipated game we recently launched. We call this is MMO2.0, it represents a highest quality. As you all know, MMORPG games is the most complicated genre with the highest entry barrier. And that it has a core competence in this genre. We think in terms of ARPU and overall performance of Chu Liuxiang, this will be in line with our other previous legacy games that have a very sustainable long-term growth. For the second question, for the user acquisition cost for Knives Out and Terminator 2, as William earlier commented, we incurred relatively higher selling and marketing expenses in Q4 when the games were initially launched. But longer term we think the trend on the user acquisition these survival battle arena game should be comfortable ending line without our other games. And with respect to overseas monetization, currently the monetization assets are more or less consistent with the monetization attempts we launched in domestic market. Going forward, we'll also gradually introduce more tailor made monetization offerings dedicated to differentiate overseas market for the global audience.

[Operator]

Next we will move to Jialong Shi with Nomura Securities International.

[Jialong Shi, Nomura Securities International]

Hi. Good morning, William and Charles and Margaret. Thanks for taking my questions. I have two follow up questions. I think management mentioned in previous question, in Q4 there were some expenses related to the royalty fees for your online music service. So I just want to know how big that expense was in Q4. And second question regarding Chu Liuxiang. Just wondered if management can share some colors on the popularity expand of this game? I will do the translation myself.

[Charles Yang, CFO]

Jialong let me answer your first question in English directly. With respect to our copyright expenses for online music, there are two components. One is the natural ongoing accrual basis of the copyright. The one-off copyrights we talked about are with respect to certain additional copyright that expects to incur. So from accounting perspective we will need to do expense provision. And the magnitude is - we don't disclose the specifics but it's in line with the copyright expense increased as the general market trend. Your second question I would refer to the rest of the management. As you all know, nowadays we hold our core competence and track record in operating some of the most successful MMORPG games in the industry. So equally we are highly confident about the ongoing sustainable performance of Chu Liuxiang. And this represents like previously mentioned elevated experience in the MMO, recall is the MMORPG 2.0 new generation.

[Operator]

And due to time constraints, we are not taking any more questions at this time. I'd like to turn the conference back over to management for any closing or additional remarks.

[Brandi Piacente, IR]

Thank you once again for joining us today. If you have further questions, please contact NetEase's IR Director, Margaret Shi based in Hangzhou or GBJ Investor Relations. Have a great day.

[Operator]

Everyone, now this concludes our conference call. We do thank you all for your participation. You may now disconnect.