NetEase Inc

NASDAQ:NTES

Earnings Call Transcript 2019-Q4

[Operator]

Good day, and welcome to the NetEase 2019 Fourth Quarter and Fiscal Year 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.

[Margaret Shi, IR Director]

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 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 in this discussion.

A general discussion of the risk factors that could affect NetEase's business and the 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 fourth quarter and fiscal year financial statements news release issued earlier today. And with respect to non-GAAP financial measures related to the results of our consolidated subsidiary, Youdao, please visit the Investor Relations website of NetEase at ir.netease.com. As a reminder, this conference is being recorded. In addition, an Investor Presentation and a webcast replay of this conference call will also be available on NetEase IR website.

Joining us today on the call from NetEase senior management is Mr. William Ding, our CEO; 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.

[Zhaoxuan 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 now based on renminbi. 2019 was an eventful year for NetEase. We expanded the reach of our online games, grew our international presence, IPO-ed our online learning, Youdao, advanced our music platform and refined our operations in e-commerce.

For the full year, we grew our total net revenues by 16% to CNY59.2 billion and increased our GAAP net income from continuing operations attributable to our shareholders by 60% to CNY13.3 billion. Online games segment is the cornerstone of our business. Despite having launched fewer games throughout the year, we continued to grow our online games business at a healthy rate in 2019 with 16% year-over-year increase in net revenues. Driven by the steady performance of our long-standing titles, we once again exceeded CNY10 billion this quarter for the past 7 consecutive quarters.

Our flagship titles continue to provide solid support for our online games business with increasing longevity and user loyalty. In 2019, revenues from Fantasy Westward Journey Online and Fantasy Westward Journey Mobile both grew at double-digit rate, remaining prevalent after years of operations. Westward Journey Online and its mobile version also grew steadily in 2019. After over 15 years of operation, our FWJ and WWJ franchises have been instilled in the collective memory of a generation of Chinese players. We further expanded the reach of these IPs through the introduction of FWJ 3D in mid-December last year, captivating both returning fans as well as new audience.

As another iteration of the FWJ franchise in mobile, this 3D version game reserves the classic gameplay and social system while bringing brand-new experiences to mobile users in a real-time 3D world. We are still working on new updates and expansion packs to further optimize the experience for FWJ 3D. And we are confident that over the long term, the 3D version will show similar longevity and popularity as our other titles in this franchise. In addition to growing and strengthening our existing franchise, we are also good at incubating new ones. Our corporate DNA in content innovation, marketing expertise and long-term operations have allowed us to consistently deliver new and long-lasting game titles to our users. Onmyoji is the first of these relatively younger franchises that we have built in-house. We are pleased to see that as we introduce more innovative new storylines, new characters and other new content, the influence of Onmyoji's IT is growing and resonating well with game players.

In 2019, Onmyoji passed the iOS grossing chart 4 times, stabilizing at a new run rate after more than 3 years of operation. In December, we launched Onmyoji: The Card Game, its second spin-off game. Living up to expectations, the new Onmyoji card game carried on the tradition of impressing the market with its exquisite artwork. With this iteration, we also introduced more competitive and strategic gameplay, winning over a large group of hardcore, collectible card players. We are now also currently working on several new Onmyoji games, including Onmyoji: Yokai Koya, a simulation game, which we plan to launch in the first half of this year.

Identity V is another young IP, where we see the potential to be building to a successful NetEase franchise. With this goal in mind, we are continually enriching this IP through a variety of initiatives, including eSports, IP collaborations and off-line activities. We have hosted a number of high-profile events featuring Identity V, including both international and regional series tournaments, most notably our global championship, Call of the Abyss, has attracted over 800,000 players from around the world since December. We also collaborated with Happy Valley, a popular national theme park brand in China bringing some of the in-game characters to life. We are pleased to see the early success of Identity V as it becomes another powerful IP franchise, establishing a broad and vibrant community of young players in China and abroad.

Invincible, our 2015 launch that has been growing steadily year-over-year in terms of the revenue and active users, is now one of China's biggest SLG titles. Like with many of our games, we invented a brand-new in-game mechanism that resets gamers' scores every season, creating a much more balanced game experience and setting a new standard for the genre.

Given the recently increasing popularity of SLGs in China, we are optimistic about our prospects and are working to bring more exciting content to the promising SLG category. The prerequisite to build a successful franchise is the ability to create popular game IPs in-house which is propelled by our world-class R&D infrastructure. Over the past 2 decades, we have built one of the largest in-house R&D teams with China's most talented and passionate game creators, supported by one of the most unique and comprehensive R&D infrastructures in the world. We empower each of our talent with our game-enthusiastic corporate culture and second to none training mechanism in the industry. Our training program at NetEase Games Academy are widely recognized in China as a premier online games training institution for the creative minds.

Most recently, two of our training programs were awarded the 2019 ATD Excellence in Practice awards by the Association for Talent Development, one of the most authoritative international awards in the global talent development industry. As we move ahead, we will continue to foster talent and stimulate new ideas that propel the development of our games. 2019 is also a fruitful year for our licensed games, especially for our joint venture with Blizzard Entertainment. World of Warcraft Classic was launched in August as an inventive recreation of WoW 6, and it was very well received by a generation of returning players and newcomers alike. We are very pleased to see the continued popularity of WoW in China, achieving a record number of total monthly subscribers in the fourth quarter with increased revenue quarter-over-quarter.

In 2019, we continued to advance our games and make inroads that expand our reach in overseas market. Knives Out remained a household name in Japan, topping the iOS grossing chart multiple times during the year. Leveraging our knowledge of building game brands, we further strengthened Knives Out's brand presence by engaging in a series of successful collaborations and our first ever eSports championship tournament in Japan.

Identity V also exemplifies our ability to operate games in the overseas market over the long term, leading Japan's iOS topping chart for the first time in September. With the success of these titles, we have accumulated a better and deeper understanding of our users in terms of their interest, social behaviors and preferences in style, aesthetics and gameplay. We have integrated this successful experience and know-how into the design of our other games, enhancing our ability to deliver popular titles to Japanese users. In addition to our success in Japan, we've also expanded our footprint across more regions. In December, we launched Marvel Super War in several Southeast Asian markets where it topped many of the iOS download charts.

Building on our existing success at home and abroad, we have many exciting games in our pipeline, including Harry Potter: Magic Awakened, EVE Echoes, Onmyoji: Yokai Koya, Ghost World Chronicle, Revelation mobile game, Diablo Immortal and Pokémon Quest.

Turning to our online learning business, Youdao made solid progress in 2019, significantly growing its online course businesses. Youdao enhanced several course products including high school Chinese and Physics, practical English for adult and coding courses for kids. We are also seeing excellent adoption and a rapid increase in sales of Youdao's intelligent learning devices, driven by the successful launch of our second-generation dictionary pack. We also expanded our tutoring and sales team and substantially improved our tutoring and operating systems to support them. These efforts have been rewarded by robust growth in gross billings of Youdao's online courses by 125% in 2019 and over 200% in the fourth quarter. More importantly, we have accumulated experience that we can replicate across our highly scalable online course model and are beginning to benefit from economies of scale. In 2020, NetEase will continue to support Youdao's mission to bring users more effective and technology-driven education experiences.

Our Cloud Music revenue hit a record high in the fourth quarter, with membership revenue more than doubled year-over-year. Revenues from digital albums and live streaming also grew rapidly. Sales of digital albums have proven to be particularly effective on our platform. For example, sales from a 22-year-old Chinese popstar, Wang Yibo, digital, single, No Sense, exceeded CNY10 million within just 11 hours. Similarly, sales of Chinese singer-song writer [indiscernible] exceeded CNY50 million after 45 days online, marking the highest digital single sales record online in China according to a third-party data source.

NetEase Cloud Music is home to a large number of independent musicians. More than 100,000 independent artists feature their music on our platform and their songs were played back more than 270 billion times in the year. This makes NetEase Cloud Music the most recognized platform for original music by Chinese artists. In 2019, we plan to use the platform's distribution capability and its broad influence to create more viral content across the Chinese music industry.

And finally, our focus with Yanxuan in 2019 remained on improving supply chain management and operating efficiency. We effectively reduced our inventory compared to a year ago and consistently improved our positive feedback rate from users in the quarter. We made adjustments to our pricing management, which resulted in increased revenue and better gross margins from the business. Our participation in product design has resulted in the creation of many hit products by providing valuable research and market analysis gained from the customer end to our manufacturers. At the same time, we have significantly improved our membership system and are seeing the benefits of increased member repurchase rate.

As for our manufacturer and factory initiatives, we have helped to build tailored online data systems that have further improved their manufacturing process and quality. In 2020, we will continue to enhance our brand influence and reaching China by bringing even more high-quality and personalized products to a growing number of consumers. We are excited for the new year. As our existing game titles continue to impress the market with their phenomenal longevity, 2020 will also see more game launches in China and globally from NetEase. 2020 also marks the 20th anniversary of NetEase being a publicly-traded company. As an internet battery in China, NetEase has remained relevant and continues to be a forerunner in the evolving market. With our long track record of success, our goal is to inspire our ever-growing community while bringing increasing value to each of our stakeholders.

Before I pass the call over to Charles, I would like to share some updates on the evolving situation with the coronavirus outbreak in China. Right after the Corona outbreak, we reacted instantly and rolled out a series of initiatives to support the affected regions. We set up a special fund of CNY100 million. The fund will be used to purchase medical equipment and medicine from home and abroad and deliver to places where the outbreak is the most severe and help is most needed. At the same time, Yanxuan immediately delivered over 200,000 free masks and other protective supplies to our customers and set up special funds for the supply apartments.

For Youdao, we were among the first ones in the industry to offer free courses to K-12 students in affected areas, which was later expanded to other regions of China. For the college students, Chinese University MOOC connected with 800 universities covering 4,000 professors' lectures. We also provide our technology support to help other off-line educational institutions to move courses to online through Youdao Intelligent Cloud.

Our company took every effort to protect the health and safety of our employees and adopted multiple measures to maintain our operational efficiency, such as flexible work policy and remote office collaboration using our proprietary technology. Overall, with respect to the outbreak, we currently expect to see some impact to our business lines in the near term. However, the situation is evolving. NetEase is committed to providing support to our employees, users and communities and working together as we together move through this challenging time. This now concludes William's comments.

I will provide a brief overview and review of our fourth quarter and full year 2019 financial results. Given the limited time on the call, I will be only presenting some abbreviated financial highlights. We encourage you to read through our press release issued earlier today for further details.

Total net revenue for 2019 were CNY59.2 billion or $8.5 billion representing a 16% increase year-over-year. Net revenue for the fourth quarter came in at CNY15.7 billion or $2.3 billion, representing a 9% increase year-over-year. For 2019, our net revenues from online games services grew 16% year-over-year to CNY46.4 billion. And in the fourth quarter, it was also up 5% year-over-year to CNY11.6 billion. Mobile games accounted for approximately 70% of net revenues from our online games services in the fourth quarter. For 2019, net revenues from Youdao were up 78% to CNY1.3 billion. And in the fourth quarter, net revenue from Youdao was up 78% to CNY410 million primarily due to increased net revenues from its online courses and sales of the intelligent learning devices.

For 2019, net revenues from innovative businesses and others were up 12% to reach CNY11.5 billion. In the fourth quarter, it was up 18% year-over-year to reach CNY3.7 billion, mainly due to the increased revenue contribution from Cloud Music and CC live streaming. Our gross margin was 52.2% in the fourth quarter. Gross margin for our online games remained relatively stable. It fluctuates quarter-to-quarter within a narrow bandwidth based on the revenue mix of mobile and PC as well as self-developed and licensed games. Youdao's gross margin improved to 29.8% in the fourth quarter. This was primarily driven by the improvement of the sales and better economies of scales.

Gross margin for innovative businesses and others was 20.6% in this quarter. Margin improvement, both year-over-year and quarter-over-quarter, was primarily due to the increased revenue from Cloud Music. For the fourth quarter, total operating expenses were CNY5.2 billion. Our selling and marketing expenses as a percentage of total revenue was 13.7% in this quarter. On a full year basis, selling and marketing expense as a percentage of full year net revenue was at 10.5% compared with 13.5% in 2018.

R&D expenses were CNY2.3 billion, up 5% from the previous quarter. We remain committed to investing in content creation and product development, which is what defines us as a technology company. On a full year basis, R&D expenses represent 14.2% of full year's net revenue comparing to 14.4% in 2018. The effective tax rate was 22% for Q4 and 18% for the full year 2019. The lower effective tax rate for the fourth quarter and for the full year compared to the 2018 period were mainly due to reduced losses from certain loss-making subsidiaries of the company.

Non-GAAP net income from continuing operations attributable to our shareholders for the fourth quarter totaled CNY3.7 billion or $526.1 million representing a decrease of 23% quarter-over-quarter and an increase of 15% year-over-year. Our non-GAAP diluted earnings per ADS from continuing operations were CNY28.03 or $4.03 for the fourth quarter of 2019.

Our cash position remains strong. As of December 31, 2019, our total cash and cash equivalents, current and noncurrent time deposits and short-term investment balance totaled CNY74.4 billion compared with CNY49.7 billion as of the year-end of 2018. In accordance with our dividend policy, we are pleased to report that our Board of Directors have approved a dividend of $1.02 per ADS.

On February 26, our Board also announced and approved a new share repurchase program for up to $1 billion of our outstanding ADS for the next 12 months beginning on March 2.

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

[Operator]

[Operator Instructions] We will take our first question from the line of Alex Poon from Morgan Stanley.

[Chun Man Poon, Morgan Stanley]

[Foreign Language]

I'll translate my questions. First is regarding music. So we are hearing the master agreements between Tencent Music and the top 3 labels are ending this year and next year? And how will this change the competition landscape, revenue growth and cost structure of NetEase Cloud Music in the next two years? And my second question is regarding the overall company, [indiscernible] has been loss-making, but it has been sold and Music already raised enough funds and the overall company margin is improving. So what's the thoughts on balance sheet, cash flow in the next two, three years?

[Zhaoxuan Yang, CFO]

[Foreign Language]

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

Thank you, Alex. For your first question, let me provide a brief translation of William's response. So firstly, label companies exclusivity arrangement in the past years has served China's overall online music industry and affects all sorts of players along the value chain, not only just the platform like us, but also app stores and hardware manufacturers, upstream and downstream players along the chain. We hope that all label companies, not just the big 3, going forward, can all comply with the regulatory frameworks serving China with aim to provide a healthy environment to the overall industry as a whole. Financially, it's definitely going to make the cost structure of the Cloud Music -- of the whole industry to return to a more healthy and normalized level because in the past, we -- the whole industry has been overpaying the content cost twice, 3x or even more to the label companies in this unfair setup. Once the cost structure can normalize, then players like NetEase Cloud Music can focus more resources in promoting innovative music content and encourage native Chinese musicians with our mission to create a vibrant, healthy and successful music culture and community in China. So that's the response to your first question.

On your second question, on the cash. So first of all, let me make a comment that with a conscious effort of being more focused on our core businesses, starting from the end of 2018, and you see a series of fruitful actions throughout 2019, we are benefiting from the economies of scale. As a result, our balance sheet has been growing strong. Our cash position has been very, very strong. Along the way, we've been also very disciplined, retained dividend, increase the dividend payout ratio and have a regular stock buyback programs. All in all, we've acted in a responsible way to our shareholders. And especially in a relatively more volatile market, we think by having a strong cash flow position together with a disciplined and responsible treasury policy to our shareholders, that will make NetEase an even stronger and more defensive company throughout this macro turmoil.

[Operator]

Our next take our next question from Hillman Chan from Citigroup.

[Hillman Chan, Citigroup Inc.]

[Foreign Language]

So my first question is on the coronavirus impact on our various business lines, positive and negative and how long the impact would last in your point of view? And my second question is on the overseas game expansion. Can management update on the time line with the major IPs like the Apple, Marvel and Harry Potter?

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

Okay. Thank you, Hillman. Let me provide a brief translation for two questions. First question on the coronavirus impacts to our different business lines. Firstly, William commented that the situation definitely affects the economy as a whole. It also affects us different BUs to a different extent. But in particular, advertising segment will be more affected by the situation, whereas our online games and online education businesses are relatively less impacted by the situation for now, especially for online education given the physical restrictions of people going out and moving around. It helps to raise the awareness and the adoption rate of online education, which propels the trend of the growth of this new format of learning.

For your second question on our general strategy and pipeline about overseas games. Firstly, William commented that we are very serious and very focused on overseas expansion as a major business strategy of our games BU. We've achieved first step achievements in Japan with a couple of games that's been well established, and we are hoping to further leverage this experience and expanding to mainstream Western market by offering -- by bringing more high-quality products to the users in those geographies. In the past couple of years, we've been consciously moving up the learning curves, and we think we are more prepared, more ready to reap some fruits in this year and in the coming 2, 3 years.

[Operator]

[Operator Instructions] We will take our next question from the line of Alex Yao from JPMorgan.

[Alex Yao, JP Morgan Chase & Co.]

[Foreign Language]

So, I would like to follow up with a question regarding the impact of coronavirus breakout on the gaming side of the business. So from a consumers' perspective, are you guys seeing increasing usage and a better monetization during the coronavirus breakouts? And then secondly, from content development perspective, is the current situation making internal content development more difficult? Would that potentially affect the new game launch in China this year?

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

Thank you, Alex. I'll provide a brief translation for everyone's benefit on the call. So in terms of the user metrics, William commented that Chinese New Year period is always a high season for online entertainment as a whole for our games. This New Year period is obviously being affected by the coronavirus situation, so it is a longer Chinese New Year period. User metrics has been stronger than the previous similar quarters in Chinese New Year. And for your question on the R&D impact. So now we do not see any significant delays or impacts to our R&D development progress as well as the planned pipeline launch schedule. Obviously, the virus situation is evolving, and we will continually to assess the impact on the game development, if any.

And William also further supplemented the virus impact on the online learnings in particular, we are a firm believer that online learning actually offers a better user experience overall vis-à-vis the traditional off-line learning. I think with the virus situation, more and more people are now more receptive and adaptive to the online lending model. And for a lot of learners, it is also an opportunity for them to be more outreaching to a more variety of knowledge that is only available and offered in a convenient way online. So all in all, we think this virus situation is probably a catalyst to propel the overall online learning industry as a whole.

[Operator]

We will take our next question from the line of Natalie Wu from CICC.

[Yue Wu, China International Capital Corporation Limited]

[Foreign Language]

I would translate myself quite quickly. My question is regarding the Cloud Music. Just wondering, despite that you launched several features last year including the Cloud Village, so you emphasized on the highlights broadcasting features on the Cloud Music app. But according to the Quest model, the daily time spent per user dropped by around 20% in the second half of last year. Just wondering what's the reason it's high. Or it's just simply because the Quest model data is not acting right. Can you give us some color on the Cloud Village business contribution for the Cloud Music? And also what kind of the new features that we should be anticipating this year?

[Zhaoxuan Yang, CFO]

[Foreign Language]

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Yue Wu, China International Capital Corporation Limited]

[Foreign Language]

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Yue Wu, China International Capital Corporation Limited]

[Foreign Language]

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

[Foreign Language]

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

Thank you, Natalie, for your question. Let me briefly translate William's comment. So Cloud Village as well as the other features such as live streaming, et cetera, this is overall -- this is our way of thinking how, as a music platform, we can enhance value-add to our users. Most of them are very vibrant music enthusiasts. We want to provide an integrated experience, not only just listening, but from listening to also spending more time watching the streams as well as interactions. So many of the initiatives and the strategies are around us building a more vibrant community on our NetEase Cloud Music platform, but the mission of us tapping into the online music segment is really to provide the most conducive channel of promoting native songs, native IPs for the Chinese independent musician artist.

With regard to your second part of the question, on the Quest mobile data. Again, I think you are referring to the average daily user time spent on the app. Again, we do not know how external third-party data channels track this number. But based on what we are seeing in the second half, there's no decline in the user activity and the user time spent on our platform as a whole. So that's probably something you can further verify and double check with the external channel.

[Operator]

We will take our next question from the line of Shi Jialong from Nomura.

[Jialong Shi, Nomura Securities Co. Ltd.]

[Foreign Language]

I have two questions. My first question is a follow-up on the overseas expansion. Just wondering how much of NetEase mobile gaming revenue is currently generated of our overseas market? And the management mentioned earlier on the call, this year will be a harvest year for NetEase online gaming business in the overseas market. So I just wonder what is the growth potential for the revenue contribution from the overseas game market going forward. My second question is about regulation. I just wonder how management think of the regulatory environment this year for China's online gaming industry. Last year, the authorities suspended new game approvals for certain number of miles. So I just wonder what management think of the regulatory trend this year for China's game market.

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

[Foreign Language]

[William Ding, Founder, CEO & Director]

[Foreign Language]

[Zhaoxuan Yang, CFO]

Okay. Thank you, Jialong, for your questions. Let me provide a brief translation and further supplement to some of the number related answers. Firstly, William commented that I think as all of us have noticed that over the Chinese New Year period, Apple iOS App store has also implemented more stringent requirements, requiring developers who upload their content onto Apple iOS would -- needs to provide evidence of approvals, which is in line with the regulator's more emphasis in regulation or IP protection. In a way, we think that this is going to be more beneficial to first tier players, big players like NetEase. We have over 50 game studios, over 10,000 in-house developers working in a very compliant way of creating premium content. So when the whole environment, whether it's the iOS App Store, whether it's the regulators that's putting more emphasis in protecting IP and also encouraging regulated content to only regulate content to be uploaded and also having more punishment on the IP violations, that is longer-term beneficial for the whole industry, in particular, towards upstream content providers.

On the top of our emphasis on in-house development, we are also putting more focused on collaborating with global developers. Joining hands strong hands together hopefully in making a joint effort to provide some exciting content to the global audience that naturally brings to your first part of the question. For 2019, on a full year basis, this is the very first time that NetEase overseas game revenue has accounted for more than 10% of the overall game revenue. First time in NetEase's history as bringing us closer to a global premium game operator. Like William commented earlier on, I think this year and the next couple of years, we are going to see more fruit. We are going to bear more fruit in our international expansion.

[Operator]

Due to the time limit, that concludes today's question-and-answer session. At this time, I will turn the conference back to Margaret Shi 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 regulations. Have a great day.

[Zhaoxuan Yang, CFO]

Thank you, everyone.

[Operator]

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