Earnings Call Transcript - NTES Q3 2022

Operator, Operator

Good day and welcome to the NetEase 2022 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 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 and the announcement of the filings on the website of the Hong Kong Stock Exchange. 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 2022 third quarter earnings news release issued earlier today. As a reminder, the conference is being recorded. In addition, on the 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's senior management team 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 RMB. We saw healthy growth across our businesses in the third quarter with solid gains in each of our core business segments. Our total net revenues for the period were RMB24.4 billion, an increase of over 10% year-over-year despite a high base effect in the third quarter of last year. This demonstrates the resilience and improving operational efficiency of NetEase through different macro cycles. Our online games continue to be our primary growth driver with net revenues from our games and related value-added services coming in at RMB18.7 billion for the third quarter, up 9% year-over-year. Our flagship titles delivered another quarter of solid growth. In the third quarter, with new expansion packs launched for the summer holidays, our legacy PC games, including Fantasy Westward Journey Online and New Westward Journey Online 2, continue to attract players. Even with 2 decades of operations, we are constantly exploring, creating, and introducing innovative new elements to our games, keeping our content fresh, boosting engagement levels, and fostering players' continuous willingness to spend. This further proves our long-term operational know-how on franchise titles, a unique strength of NetEase games that we are hoping to replicate in our other self-developed proprietary titles. For our new titles, Diablo Immortal was launched in China in July, topping China's iOS download chart shortly after its release. Following its launch, Diablo Immortal has enjoyed similar popularity in Western markets. Players are enjoying the exciting adventure in the authentic Diablo world and the thrilling MMO RPG social experience. Diablo Immortal is of great strategic importance to us. It showcases our game development expertise on the international stage and further demonstrates that NetEase has the right capabilities to produce AAA games for worldwide audiences. As with all of our other games, our team works very hard to regularly and rapidly introduce exciting new game content to invigorate our players and ensure the longevity of our games. In September, we issued our first major update, Forgotten Nightmares, after Diablo Immortal's official launch, introducing a new dungeon, an exploration system, and a battle pass, and players love it. Naraka: Bladepoint maintained strong popularity in the third quarter, amassing a passionate community of fans that are extremely engaged with this title. With the game's 1-year anniversary in August, we released our major new map, Holo Rock, which includes a wealth of new features such as weather systems, interactive objects, and new areas to explore, bringing in both new and returning players on a large scale. As a result, the number of active users for Naraka: Bladepoint hit a record high in August. To keep this game fresh and engaging, we will follow a continuous rollout schedule, adding new content updates such as more heroes, weapons, and new gameplay to this exciting game. Naraka: Bladepoint introduces a unique combat-style gameplay that is easy to learn but hard to master. To bring more players into the mix, we have been introducing more beginner-friendly mechanisms such as a new beginner's guide and shortcut keys for combat to help new players quickly learn the skills to fully enjoy the fun of combat. We have made the game more accessible to a wider range of players around the world. Simultaneously, we are actively developing Naraka: Bladepoint for mobile and are making very solid progress. We are going through rigorous testing rounds to ensure we can replicate the combat gameplay experience on mobile screens. On the console side, we released Naraka: Bladepoint on Xbox Series X|S and joined Xbox Game Pass in June. Transitioning from PC to console is not an easy process, involving a highly different user interface and controls. We are very pleased to have smoothly transitioned Naraka: Bladepoint into the console arena, bringing our users a satisfying gaming experience. Our next move will be to make the new game available on Xbox One, which will expand the fan base for this IP even further. In addition to the Naraka: Bladepoint mobile game, we have a number of other exciting upcoming games in our pipeline. We conducted the first round of testing in October for the Justice mobile game and saw very encouraging results with over 10 million players pre-registered, with lots of exciting new technological innovations and state-of-the-art game design. We hope the Justice mobile game can represent what the next generation of games looks like and further boost the user base of the Justice franchise as a whole. Equally exciting is our planned global market launch of Harry Potter: Magic Awakened, which has already launched in the Chinese market. Since its launch last September, we are putting great efforts into the global version, leveraging all the lessons we have learned along the way from game development to year-long operations. We are working intensely to optimize the game's mechanics. Simultaneously, we are preparing expansion packs ahead of the launch to enable timely, frequent new content updates after the game launches. With great effort and dedication to its development, we hope to do justice to this great IP and impress fans on a global scale. Harry Potter: Magic Awakened is now expected to be launched globally in 2023. We are confident that this highly anticipated game will withstand the test of time, ensuring great longevity and stability. Turning to our licensed games, as previously disclosed, we have entered into certain licensing agreements covering the publication of several Blizzard titles in the Chinese Mainland. These licenses will expire in January of next year and will not be renewed. Net revenues and net income contributions from these licensed Blizzard games represented low single digits of our total net revenue and net income in 2021 and during the first 9 months of 2022. The expiration of such licenses will have no material impact on our financial results. The co-development and publishing of the Diablo Immortal mobile game is covered by a separate long-term agreement. In the third quarter, we continued to make great progress with our global operations. At the end of August, we announced our acquisition of Quantic Dream, which is now officially our first fully owned studio in Europe, based in Paris. Since our initial investment in the studio 3 years ago, we have been working very closely together and we have realized how like-minded and complementary we are to each other. Having Quantic Dream as a studio of our own exemplifies our vision of supporting innovation and game development around the globe. We will continue to fulfill our promise to support Quantic Dream to realize its full potential. Also during the quarter, we were very pleased to announce that Jonathan Morin came on board as a new Creative Director in Montreal. Here, he will work together with the team to build up the next exciting game. With more than 24 years of experience making AAA games, Jonathan played a key role in shaping the critically acclaimed Watch Dogs franchise at Ubisoft and was one of the main contributors to the Far Cry series and many other blockbuster brands. In Japan, earlier this month, we announced GPTrack50, a new first-party studio in Japan, led by a seasoned industry veteran. The studio will primarily focus on producing high-quality console and PC games with the goal of delivering original entertainment content from Japan to users worldwide. We've also announced our investment into startup studios such as Liquid Salt in Sweden and Something Wicked Games in the U.S. Both are being led by top industry veterans who are using their creativity to forge their best titles yet. After years of strategic planning, our self-owned overseas studios now stand in multiple regions: Japan, North America, Europe, and more to come. Through investments and partnerships, we've welcomed many best-in-class game developers worldwide who will be pivotal in attracting more talent within their local developers and gamers' community. Our investment philosophy attaches a high value to top talent and their passion for games. We will continue to attract, invest in, and support these creative minds, combining talent with our powerful resources and execution capabilities. Turning to our education business, total net revenues of Youdao continued to improve in the third quarter and reached a record high of RMB1.4 billion, led by increased sales of new services and smart devices. Net revenues of Youdao's smart devices reached RMB356 million in the third quarter, up 40% year-over-year, with robust contributions from its flagship products, the Youdao Dictionary Pen and Youdao Listening Pod. Meanwhile, we continue to expand Youdao's portfolio with more AI-empowered educational tools. In August, we launched the Youdao Dictionary Pen X5, featuring a self-developed operating system that accommodates a variety of external applications such as NetEase Cloud Music and Ximalaya FM to further enhance our user experience on these products. This new version has been very popular among users as the initial batch of products quickly sold out. In addition, the Youdao Smart Learning Pad X10, which was released in October, also showcases several user-oriented and customized AI functions to better serve the learning needs of different age groups, and we expect more growth opportunities for this product. We made additional headway with our learning services as well, maintaining a healthy trajectory with net revenues reaching RMB888 million. Net revenues for our STEAM courses more than doubled in the third quarter compared to the same period last year and now account for over one-fourth of the segment's total revenue. In addition to further content upgrades to Youdao gold courses, we have also coordinated with local board game associations to hold open tournaments for students, which have been advocated by the General Administration of Sport of China for their positive contribution to expanding the popularity of board games among students. We are very proud of what Youdao has achieved in the last 12 months, which confirms that we are swift in transitioning and we are on the right track for future sustainable growth. Looking ahead, we will continue to serve more learning needs of our users by leveraging our leading technological capabilities while diversifying our content and product offerings. On to Cloud Music, we completed the third quarter on a positive trajectory with our key operational trends and financial performance. During the quarter, we further improved our music-oriented community and content ecosystem as well as continued to advance our monetization efforts and gain meaningful operating leverage. Our total Monthly Active Users (MAU) remained steady, while the Daily Active User (DAU) over MAU ratio stayed well above 30%. Our paying user ratio was also stable quarter-over-quarter. Amid a challenging macro environment, total revenues of Cloud Music grew by 22% year-over-year as we continued to expand our paying user base and optimize our pricing strategy. We also witnessed the gradual recovery of our advertising business, aided by rapid performance-based ad growth, along with solid momentum in social entertainment services. Our strong top line growth and better operational efficiency drove solid margin gains, with gross margin expanding for the fourth consecutive quarter, reaching 14.2% in the third quarter. Additionally, Cloud Music's net loss further narrowed in the third quarter, both year-over-year and quarter-over-quarter. Adding to our robust music content, we continue to augment and diversify our copyright library. Since the regulator's antitrust ruling last July, NetEase Cloud Music has been actively in discussion with label companies to secure the best content for our music lovers. By now, we have managed to bring back most of the major label content, including content from a variety of entertainment groups. We are still working very hard to secure more titles at reasonable costs. Additionally, we continue to nurture aspiring musicians, serving more than 570,000 independent artists as of today. Our in-house music production capabilities are showcased by another hit song, which recorded over 200 million streams within a week and topped multiple music charts, enhancing our music-inspired ecosystem and user connections. In the third quarter, we further boosted our community atmosphere through innovative offerings, including a star-rated comment section to display high-quality user comments and fan spaces to strengthen bonding between artists and their fans while encouraging user interaction. We also added new offerings such as style recommendations that bring users more personalized options in the daily recommendation function to better reflect their taste, as well as a Dolby Atmos feature, allowing users more authentic and immersive ways to listen to music. Turning to our private-label consumer brand, Yanxuan, it continues to build its brand awareness by constantly creating highly popular products. For example, some of the new top-selling products this quarter were particularly well-received. In Q3, we saw solid growth in sales from external e-commerce channels, particularly with short-form video platforms. Over the years, Yanxuan has gained increasing recognition for its excellent design and creative style. Most recently, some of our products won prestigious awards for their uniquely and elegantly presented Chinese-style packaging. In summary, we are confident in our ability to realize strategic growth across our business lines. The portfolio we have curated of diverse and long-lasting games in China provides a steady base for us to build further upon. Coupled with our globalization strategy, our prospects are exciting, and we believe we are well positioned for continued growth. As we advance each of our businesses with innovative products and services, we will continue to use our strong cash position to buy back shares and pay dividends that directly reward our shareholders. This concludes William's comments. I will now provide a brief review of our 2022 third quarter financials. 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. Net revenue totaled RMB24.4 billion in the third quarter or US$3.4 billion, representing a 10% increase year-over-year. Total net revenues from our games and related value-added services were RMB18.7 billion, up 9% year-over-year. The growth was primarily due to increased revenue contributions from both mobile and PC games, including our existing games and newly launched titles. Net revenues from our mobile games accounted for approximately 69% of our total net revenues from online game operations. Youdao's net revenues were RMB1.4 billion, a moderate increase from last year. Last year's revenue contained a significant portion generated from K9 after-school tutoring services, which was later terminated. The decreased revenue related to K9 termination is now offset by the increased revenue from Youdao's new services and smart devices as a result of a successful transition. Net revenues of Cloud Music were RMB2.4 billion, up nearly 22% year-over-year. The increase was mainly due to increased revenues from social entertainment services and membership subscriptions. Net revenues for innovative businesses and others were nearly RMB2 billion, up 14% year-over-year, mainly due to increased contributions from Yanxuan in the third quarter. Our total gross profit margin rose to 56.3% in the third quarter compared with 53.2% in the third quarter of last year. Looking at the composition, GP margin was 65% for our games and related value-added services compared with 61.3% in the same period of last year. The year-over-year increase in gross profit margin was mainly due to more revenue contribution from our organic channels. Our gross profit margin for Youdao was 54.2% compared with 56.6% in the same period of last year. The year-over-year decrease was mainly a result of the decline in net revenues from its learning services due to the termination of K9 offerings. GP margin for Cloud Music continues to improve in the third quarter, climbing to 14.2% versus 2.2% a year ago. The significant margin improvement was primarily a result of strong top-line growth as well as improved efficiency in content management. For our innovative businesses and others, GP margin was 25.5% compared with 27.2% last year. The year-over-year fluctuations were mainly due to changes in GP margin from advertising services. Total operating expenses for the third quarter were RMB9 billion or 37% of our total net revenues. If we look at our cost composition, our selling and marketing expenses as a percentage of total net revenues was 15.4% compared with 14.1% for the same period last year. The increase was mainly due to increased spending on certain new games promotions during the quarter. Our R&D expenses as a percentage of total net revenue remained relatively stable year-over-year at 16.2%. We remain committed to investing in content creation and product development. We are also seeing leverage in our R&D investment. Our other income was RMB3.5 billion for the quarter compared with RMB785 million last year. The quarter-over-quarter increase was mainly due to investment income arising from the disposal of certain equity investments. Additionally, the exchange rate fluctuations of the U.S. dollar against RMB over the last couple of periods also contributed to the accounting gain. Our effective tax rate for this quarter was 19.3%. As a general reminder, the effective tax rate is presented on an accrual basis and the tax credit deferred from each of our legal entities at different time periods depending on applicable policies and our operational results. Our non-GAAP net income from continuing operations attributable to shareholders for the third quarter totaled RMB7.5 billion, or US$1.1 billion. Non-GAAP basic earnings per ADS from continuing operations for the quarter was US$1.61 or US$0.32 per share. Additionally, our cash position remains strong. As of the quarter end, our net cash position was about RMB95 billion compared with RMB86 billion at the year-end of last year. In accordance with our dividend policy, we are pleased to report that our Board of Directors has approved a dividend of US$0.08 per share or US$0.435 per ADS. Lastly, we continued to buy back shares during the volatile period under our current share repurchase program for up to US$3 billion, which expires in March of next year. Approximately 27 million ADS have been repurchased as of September 30 for a total cost of approximately US$2.5 billion. And today, our Board announced the approval of a new share repurchase program of an additional up to US$5.0 billion of the company's ADS and ordinary shares in open market transactions for a period not to exceed 36 months. Meanwhile, under our repurchase program for up to US$50 million, approximately 2.3 million ADS has been purchased for a total cost of about US$20.7 million as of September 30. In addition, NetEase purchased 0.7 million ordinary shares of NetEase Cloud Music for a total cost of about US$6.9 million during the third quarter. Thank you for your attention. We would like now to open the call to your questions.

Operator, Operator

Our first question today will come from Kenneth Fong of Credit Suisse.

Kenneth Fong, Analyst

On today's announcement about not renewing certain licenses related in China that are still set to expire next year. Can you please share with us the rationale behind and the subsequent arrangements that we should expect?

William Ding, CEO

Thank you. We had hoped to continue operating Activision Blizzard games in the Chinese Mainland and put in significant effort to make that happen. However, negotiations turned out to be more difficult than we anticipated, and we could not agree to certain key terms that Activision Blizzard requested. We regret the early announcement from Activision Blizzard. Despite our efforts to keep the deal from falling apart, we accept the division. In the meantime, we will do our utmost to fulfill our responsibility to serve our players until the end, ensuring the safety of their data and other assets.

Operator, Operator

Our next question today will come from an unidentified analyst from CICC.

Unidentified Analyst, Analyst

And congrats. In the third quarter, Infinity received approval for a multi-device version. We also understand that a car also features multi-terminal capabilities. Can management provide more details about the upcoming games? Additionally, my second question pertains to the game IP franchise. NetEase has developed several overseas IP games such as Harry Potter and Lord of the Rings. What is the status of the approval for the domestic version beyond Harry Potter? How can these efforts support the company's long-term business?

William Ding, CEO

Let me translate the answer to this question. Over the years, we have found that many of our mobile game players want to play our games on other platforms, especially PC. They desire a more immersive gaming experience on a larger screen. This is why we provide PC simulators for many of our mobile games or create standalone PC versions to enhance the gaming experience. Additionally, we have noticed that in certain regions, many users own PCs, mobile devices, and consoles, and they play games across all three platforms. These players want to switch seamlessly between platforms, which is why we are exploring cross-platform game development. There are no significant technical challenges in creating and operating cross-platform games, so we consider user needs, product features, market feedback, and other factors when deciding whether to develop multi-platform versions of our games. We do not receive many foreign IP comments, but we are currently processing those that have been submitted. Our self-developed IPs are unique because of the virtual worlds we create for gamers. Previously, we have released many games influenced by our rental culture, including titles like FWJ, WJ, Justice, and Naraka. However, by introducing IPs like Harry Potter and Lord of the Rings, we can diversify and enhance the worlds available to our users, allowing them to have varied experiences. Since these IPs differ, the worlds they create are distinct, which influences the types of games we can develop. For instance, in the Eastern world, we see more cold weapons like swords, while in the Western world, firearms dominate. This results in varying gaming experiences, such as an MMO for our rental base versus an FPS game in a Western context. Therefore, having a variety of IPs enriches our game pipeline and offers unique gaming experiences for our players. Thank you.

Operator, Operator

Our next question today will come from Lincoln Kong of Goldman Sachs.

Lincoln Kong, Analyst

The question is about overseas expansion. NetEase has been investing in international markets since the start of the year, particularly by investing in or acquiring studios. Looking ahead to 2023, how should we anticipate our growth strategy and the growth drivers, especially in the PC and mobile game markets?

William Ding, CEO

In summary, there are essentially two main strategies for the international market. One is focused on sales development and the other on investment. Over the past few years, we've successfully launched several self-developed titles in innovative regions, including Identity V and Knives Out in Japan. We've also seen significant success with PC titles in the global market, such as Naraka: Bladepoint, which we released last year. Overall, in the international market, PC and console are expected to remain the primary formats. Additionally, we have made investments in various overseas studios. In the long run, we aim to collaborate closely with these global studios to produce major hits for gamers worldwide.

Operator, Operator

Our next question today will come from Charlene Liu of HSBC.

Charlene Liu, Analyst

I would like to ask about the gaming market outlook. We observed that both the domestic and overseas mobile game market revenues further declined year-on-year in the third quarter. There are some short-term challenges due to weaker consumption, but we also noted the latest industry developments. Given this positive trend, how should we view the timing and extent of the market recovery, as well as the long-term outlook for the domestic market?

William Ding, CEO

Our understanding is that the gaming market relies on content. The market's vitality at any given time is influenced by the availability of compelling games. We will consistently offer a range of high-quality games for players, which will stimulate market growth. Conversely, if the gaming content is uninspiring, average, or repetitive, the market will experience a slowdown. Therefore, we perceive the current situation not just as a temporary decline but as a clear indication of the need for more high-quality games.

Operator, Operator

Our next question today will come from Alex Poon of Morgan Stanley.

Alex Poon, Analyst

My first question is about overseas games. Over the past one to two years, we have launched many new games internationally. Can management provide insights into the feedback from players and the longevity of these new games? Additionally, are we working on developing more genres that align with the demand for overseas games in relation to our cost structure? Let's also discuss our trends in headcount and other operational expenses moving forward.

William Ding, CEO

Since we launched Naraka last year and transitioned it to Xbox in June this year, we have been closely monitoring the reactions and feedback from the gaming community. From what we've seen, players are overall very satisfied with this unique combat experience. Some gamers engage hundreds of hours a day and still feel positive about it. One of the things we noted is that there are many statements from gamers on lower spec platforms, such as the Xbox One, who are also craving this game. We are now working on adapting this game to different levels of devices and platforms. At the same time, we are optimizing the beginners' guide. So, if the game is harder to get into, we are looking for ways to assist new players in learning more quickly. This is a task that we are addressing with our Montreal office. So every day, we are having discussions on how to make our users happier within the game. Hopefully, we'll be able to deliver the game to more players on more platforms.

Charles Yang, CFO

And Alex, for your second question about the overall trend of headcount and operating expenses, over the last 5, 6 quarters, our overall total headcount stays relatively steady at above 30,000. More specifically in the last quarter, by the quarter end, we had over 31,000 overall headcount, representing a quarter-over-quarter increase of about 1,000. This is consistent with our recruitment during the summer season on campuses. In terms of overall operating expenses, for many of you who have been tracking NetEase for long enough, we are very cost-conscious and effective in expanding our investment organically into ourselves in a very strategic manner. Oftentimes, when you see an increase in R&D or in selling and marketing, it is actually an indication that we are developing a strong pipeline or are about to launch an exciting new game. If we are patient enough, you will see the huge reward for the seeds we are planting today. For the future outlook, I think we will continue to grow. We will continue to invest. The absolute dollars of operating expenses will continue to increase but we will be hugely rewarded by operating leverage when we see the next cycle of product launches in both domestic and international markets.

Operator, Operator

Our next question today will come from Felix Liu of UBS.

Felix Liu, Analyst

My question is about the overseas market. We noticed that the publishing time for Harry Potter has been updated. Can you provide more details on the focus for Harry Potter in the overseas market and any projects planned after its launch? Additionally, I’d like to know about the overseas position regarding genre and market strategy. What genres and markets are you concentrating on with your significant investments at this time?

William Ding, CEO

Firstly, Harry Potter will hopefully be launched very soon. As we mentioned earlier in the call, we're scheduled for launch in 2023. Currently, we have a considerable number of games set to launch in this market. We have three games in the Japanese market, including diverse genres such as PCG, racing, and others. We also have competitive games in the European and North American markets, including various genres like PCG and combat. So our focus is primarily on the Asia Pacific region and the European and North American markets.

Operator, Operator

Our next question today will come from Natalie Wu of Haitong International.

Natalie Wu, Analyst

Let me calculate myself. So my question is regarding Diablo Immortal. Can you provide the latest figures on cash revenue and user engagement for Diablo Immortal so that we can better understand the game's longevity and contribution? Also, you mentioned before that Diablo Immortal is covered by a separate long-term agreement with Blizzard. It would be great to know exactly how many years the long-term arrangement entails. Will there be uncertainties regarding the future collaboration, especially in the overseas market for that title under the backdrop of the latest changes?

William Ding, CEO

Diablo Immortal has performed exceptionally well globally since its launch and has been online for nearly six months in international markets. The version for China was released about a month later. Currently, the revenue contributions from both the China and international markets are largely equivalent. Looking ahead, we plan to launch more expansion packs and additional content to keep users engaged while continuing to meet the needs of both Chinese and overseas players. I've observed that many of our Chinese users are in their 30s or 40s, mostly from tier 1 and tier 2 cities. In contrast, North American users tend to come from the original PC game background. In the future, we aim to discover more gamers and broaden our promotional efforts to reach a wider audience.

Charles Yang, CFO

And Natalie, for your second question, we can follow up offline.

Operator, Operator

This concludes the question-and-answer session. At this time, I would like to turn the conference back over to management for any 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. Thank you.

Charles Yang, CFO

Thank you, everyone.

William Ding, CEO

Thank you.

Operator, Operator

The conference has now concluded. We thank you for attending today's presentation. You may now disconnect your lines.