Earnings Call Transcript - NTES Q3 2021

Operator, Operator

Good day and welcome to the NetEase 2021 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, and the announcements and findings on the website of the Hong Kong Stock Exchange. The Company does not undertake any obligation to update this forward-looking information except as required by law. During today's call, management will discuss certain non-GAAP financial measures for comparison purposes only. For definitions of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results, please see the 2021 third quarter earnings news release issued earlier today. As a reminder, this conference is being recorded. In addition, an investor presentation and a webcast replay of this conference call will be available on NetEase’s corporate website at ir.netease.com. Joining us today on the call from NetEase’s senior management is Mr. William Ding, Chief Executive Officer, and Mr. Charles Yang, Chief Financial Officer. I will now turn the call over to Charles, who will read the prepared remarks on behalf of William.

Charles Yang, CFO

Thank you, Margaret. And thank you everyone for participating in today's call. Before we begin, I would like to remind everyone that all percentages are based on RMB. The third quarter was an exciting one for NetEase. We launched a number of top-ranking games, bringing our game revenues to a new record of RMB 15.9 billion. Our other business segments also grew robustly, supporting our total net revenue growth of around 19% year-over-year, reaching RMB 22.2 billion. For online games, our flagship title continues to demonstrate strong growth up to nearly two decades of operation. Revenues from Fantasy Westward Journey Online and Westward Journey Online both grew at double-digit rates year-over-year in the third quarter. The mobile versions of these two legacy sagas show resilient year-over-year growth as well. Adding to our strong portfolio of PC games, our new hit games, NARAKA: BLADEPOINT and Nightmare Breaker contributed to PC games revenue reaching a new record high in the third quarter, growing by 30% year-over-year, far outpacing industry growth. Featuring Unchained Combat, NARAKA: BLADEPOINT has taken the PC games market by storm, reinvigorating the stable battle royale genre with exciting new ideas. Its global success showcases our ability to bring first-rate games to the world stage. By November 10th, we had already sold more than 6 million copies of NARAKA: BLADEPOINT worldwide in just four months, making it one of the top sellers ever on the Steam platform. Players in both China and global markets are hailing NARAKA: BLADEPOINT for its thrilling combat experience. So far, NARAKA: BLADEPOINT has retained an 80% positive review rate on Steam, which naturally leads to excellent user retention and continued user growth. We believe NARAKA: BLADEPOINT will experience the same level of longevity as many of our other NetEase flagship titles. We work hard to keep our games fresh and plan to continuously introduce more exciting new content including new modes, heroes, and maps. To add to the enthusiasm, we are also currently working around the clock to extend the game offering to console and mobile platforms. We expect to bring players these exciting versions in the next year. On the heels of NARAKA: BLADEPOINT, we launched another PC game, Nightmare Breaker, in September. It is an action-based competitive fighting game taking place in a fantasy setting. Players can choose from a variety of roles with unique abilities to battle against dark forces and save the world. As a game with unique gameplay, Nightmare Breaker further expands our base of PC players. Turning to the mobile side, our new hit game, Harry Potter: Magic Awakens, has gained millions of players going viral across China. It instantly dominated both top downloads charts and top growth charts in China, following its launch in September. Harry Potter: Magic Awakens comes through as a charming wizarding world, touching the hearts of millions. The game has attracted large crowds from the younger generation across the gaming community. Its leveraged design is gaining great acclaim, including iconic European retro picture books and an interesting card-based comeback infused with abundant competitive gameplay. We hope Harry Potter: Magic Awakens will continue to gain traction from players in China, maintaining its popularity over the longer term as many of our other titles do. We are equally excited for its global launch, tapping into the nostalgia of generations of Harry Potter fans. We believe this game has great potential for extensive popularity across the globe. Currently, we are working hard on its localization for other geographies, with plans to formally launch Harry Potter: Magic Awakens in some of the major overseas markets next year. As another title we launched in the domestic market, our space-themed SLG game, Infinite Lagrange, also had a strong start in China in the third quarter. Sci-fi fans were captivated by the game's intense and exciting travel through time and space. Over time, we believe Infinite Lagrange will continue to earn respect from even more players, extending our strength in the SLG market through its immersive space experience. On the international brand front, we introduced The Lord of the Rings: Rise to War to the US, Europe, and several other overseas markets, making a strong debut at the end of the third quarter. The Lord of the Rings: Rise to War has amassed a huge user base across the globe with engaging and thought-provoking gameplay, as well as the strong appeal of The Lord of the Rings IP. We see great potential for user growth. We expect The Lord of the Rings: Rise to War to be phased similarly to our other time-proven SLG title, Invincible, with revenue ramping up gradually and showing an upward trend over time with a long-lasting lifecycle. Complementary to our in-house R&D capabilities, we have also been deepening our footprint through strategic investments and partnerships. We are searching for talent and teams that complement our R&D skills on a global scale. Over the past few years, we've invested in top teams, including Bungie, Quantic Dream, Second Dinner, and Theorycraft, as well as the recently announced strategic funding in Kaola and the acquisition of Grasshopper in Japan. With these partnerships, we plan to share our know-how in R&D and operations while gaining new inspiration from the creative minds of these overseas studios, as well as a deeper understanding of overseas users and their preferences. Together, we share the same passion and vision to build the next sensational blockbuster for players worldwide. Additionally, we have launched a few game studios in places such as Montreal, Tokyo, and LA, with the aim to attract the best international talent to further broaden our R&D capabilities. Moving to our game pipeline, as I mentioned earlier, we plan to launch Harry Potter: Magic Awakens in more overseas regions next year, as well as bring players console and mobile versions of NARAKA: BLADEPOINT. Very soon, we will introduce another highly anticipated game, The Showbiz: Dream Chaser, our self-developed showbiz simulation game. Catering mainly to emerging female users, this game provides players with a new role-playing experience as actors or actresses in the world of showbiz. Here, players get to live their dreams of fame and explore the exciting life of performers in the entertainment industry. Highly acclaimed for its distinctive setting, immersive experience, and art design, we believe The Showbiz: Dream Chaser could open up a new genre with great market potential for NetEase. Our pipeline also includes Diablo Immortal and Ghost World Chronicle. Moving ahead, we will continue to bring players inspiring new games that stand the test of time in China and worldwide. Turning to Youdao, we have made solid progress with our transition to better align Youdao's business with the latest regulatory guidelines which aim to alleviate excessive academic pressure on Chinese youth. While we are in the process of disposing of our academic after-school tutoring business, we are making excellent progress with our other pillars of future growth, including STEM courses, adult learning, mass devices, and education digital optimization solutions. Total net revenues for Youdao in the third quarter were RMB 1.4 billion, representing 55% growth year-over-year. Revenues from the after-school academic tutoring classes in China's compulsory education system account for around 25% of Youdao's total net revenues. In the third quarter, we continued to grow our STEAM offerings for Youdao; its gross billings and user engagement have been growing rapidly since its launch last year. During the quarter, we upgraded its current AI system, giving our students a more efficient platform for practice. Youdao Xiaotuling, which prepares children for programming education, launched pricing classes in this quarter and became a member of the China Computer Federation Programming Trainer Accreditation. Our reach in the adult education space is also expanding as encouraged by authorities. For example, our Extraordinary Memory has retained its leading position with gross billings approaching RMB 100 million in a single quarter. We also recently announced a collaboration with Amazon Web Services to bring digital training courses to Chinese users on the NetEase platform. Our learning devices remain robust with record-high revenues of RMB 255 million, a 56% increase year-over-year. Youdao continuously upgrades and enriches its product offerings to facilitate efficient learning in different scenarios. In the third quarter, collaborating with the People's Education Electronic and Audiovisual Press, we launched a new version of our award-winning dictionary pen containing over 4,000 original sounds from textbooks published by the press. We also rolled out our Youdao Listening part in September, which helped improve students' English skills in listening, speaking, and reading through real-time intelligent scoring and pronunciation correction functions. In addition, we are working with local schools experimenting with different digitization solutions, which provide school teachers with more automated teaching and grading tools and facilities, enabling more efficient teaching. Now, looking at our Cloud Music business, we continue to improve our differentiated music community ecosystem through our product and content enhancements to keep us ahead of the curve. We are now better positioned amid healthier industry developments. Our top-line growth drives solid margins in the third quarter, representing our second consecutive quarter of positive growth margins. Some of our innovations include upgrading our main Cloud Music homepage in August, adding new community features. Users are also enjoying our newly launched music function, which opens video creation capacity to individual users, allowing them to distribute customized content. Additionally, we launched Village Citizenship Cloud, giving each of our users a personalized ID in Cloud Village, allowing them to feel a fresh sense of belonging. This created strong bonds on social media, further extending our brand influence. In combination with other industry players, we are actively working to secure more high-quality content with respect to ROI, especially following recent favorable industry changes. In the third quarter, we completed a direct agreement with Warner Music Group, which means we now have direct digital distribution contracts with all three of the world's largest recording label groups. We are pleased to see such favorable collaborations with big labels at more reasonable cost structures, providing us with the flexibility to optimize our content investments with a more disciplined and predictable approach. Meanwhile, we are also actively completing our major Chinese music library, recently adding several new copyrights, including Modern Sky, one of China's largest independent record labels, and Emperor Entertainment Group, one of the largest entertainment groups in Hong Kong. Our negotiations with some major music labels are close to being finalized, and we expect more to come, further complementing our song library offering. Turning to Yanxuan as NetEase's private-label consumer brand, Yanxuan continues to build its brand awareness by regularly launching highly popular products through diversified channels. Apart from solid sales growth from external e-commerce channels, we now have strong momentum from short video platforms such as Douyin and Kuaishou with popular products like bathroom fragrances and coffee brackets. Our advanced and differentiated original design products are being very well received by users and the market. In Q3, we successfully launched several original design series across categories, including clothing, dining and kitchen, home furnishing, and personal hygiene and maternity. We are gaining increasing recognition for excellent design and creative style. In August, we won two prestigious Red Dot Awards for our Dear John bedding design and Yanxuan Dunhuang Museum packaging design, competing against thousands of design submissions from more than 60 countries and regions. This adds to NetEase's increasing number of awards which includes the 2021 German iF Design Award along with many other international awards and recognitions from the design industry. During the Double 11 promotion, we recorded over RMB 100 million GMV through Taobao and Tmall channels, and on JD, we were also the number one brand for daily goods and products. Commensurate with our extensive growth across our businesses, our capacity to give back has grown as well, enabling us to amplify our ability to help our communities. Our commitment to social responsibility has also been heightened by the immediate needs of those who may have fallen victim to natural disasters and public health crises. Most recently, we were deeply saddened by the destruction and loss felt in Jiangxi and Henan provinces. To help these flood-ridden areas ravaged by natural disasters, NetEase has donated over $50 million to Henan and RMB 20 million to Jiangxi to support much-needed relief efforts and post-reconstruction. The mounting environmental disasters tell us that we all must become better custodians of the earth. As a corporate citizen, NetEase is committed to environmentally responsible action. In addition to our financial contributions towards natural disaster alleviation and restoration, we’re leveraging our strength and resources for environmental protection. We believe games have the power to raise awareness among billions of people across the globe about environmental conservation and restoration. In the third quarter, one of our flagship titles joined the second annual Green Game Jam, organized by the UN's Playing for the Planet Alliance. Players are encouraged to do forest maintenance in the game to put out fires during the activation. Our participation in this alliance represents NetEase's increased social responsibility, using games as a tool to create environmental awareness and help protect our planet. As we continue to advance our environmental and social pursuits, we are thankful for our growing business that allows us the financial capability and social influence to support these efforts. Moving ahead, we will continue to cultivate our business by exploring more creative practices to enrich our broad content, increase our product exposure, and bring even more diverse and engaging experiences to our users while leveraging our strengths to enact positive social and environmental change. This concludes William's comments. I will now provide a brief review of our third quarter 2021 financial results. Given the limited time on today's call, I will be presenting some abbreviated financial highlights. We encourage you to read through our press release issued earlier today for further details. Total net revenues for the third quarter were RMB 22.2 billion or $3.4 billion, representing a 19% increase year-over-year. Our net revenues from online game services were RMB 15.9 billion, up 15% year-over-year. The year-over-year increase was primarily due to our newly launched games, such as NARAKA: BLADEPOINT and Harry Potter: Magic Awakened, as well as from existing games such as Fantasy Westward Journey Online and Westward Journey Online 2. Net revenues from our mobile games accounted for approximately 69% of the total net revenues from online game services in the third quarter. Youdao's net revenues reached RMB 1.4 billion, up 55% year-over-year, driven by fast growth in Youdao's Q3 services, as well as increased sales of intelligence learning devices. Of the Q3 total revenues, about 25% relate to academic subject courses in China’s compulsory education system. Net revenues from innovative businesses and others were RMB 4.9 billion for the third quarter of 2021, up 26% year-over-year, mainly due to increased contributions from NetEase Cloud Music. For Cloud Music, both membership and live streaming revenues maintained solid growth momentum, driven by robust paying user expansion. Our total gross profit margin was 53.2% in this quarter, with the breakdown as follows: Gross profit margin for our online games services was 64.5%. As a reminder, this number is generally stable with some narrow fluctuation based on the revenue mix of mobile and PC-type hosts, as well as self-developed and licensed games. Gross profit margin for Youdao was 56.6%, compared with 45.9% in the same period of the last year. Significant growth was primarily attributable to the improved learning services gross margin due to improved economies of scale and continuous optimization of our faculty compensation structure. Substantial sales growth of the smart learning hardware, such as our Youdao Dictionary Pen 3.0, also contributed to these gains as this line carries a higher gross margin than other product lines. Gross profit margin for innovative businesses and others was 15.6%, compared with 16.8% last year. The decrease was mainly due to decreased gross profit margin from the game streaming business and CC live streaming. NetEase Cloud Music, however, enjoyed its second consecutive quarter of positive GP margin. For the third quarter, total operating expenses were RMB 8 billion, or 36% of our total net revenues. Our selling and marketing expenses as a percentage of net revenues were 14.1%, compared with 14.7% in the prior quarter. The quarter-over-quarter decrease was mainly due to decreased marketing spending related to Youdao. R&D expenses were RMB 3.8 billion. The third quarter is our seasonally high quarter for R&D as our new campus hires graduate and commence their career with us. We remain committed to investing in content creation and product development, which is core to our sustainable future growth. The effective tax rate was 19.6% for the third quarter. The effective tax rate is presented on an accrual basis and a tax credit differs from each of our entities at different time periods depending on applicable policies and our operations. Non-GAAP net income attributable to our shareholders for the third quarter totaled RMB 3.9 billion, or $599 million. Our non-GAAP basic earnings per ADS were $0.9 or $0.18 per share. Our cash position remains strong. As of September 30th, our total cash and cash equivalents, current and non-current time deposits, and short-term investment balance totalled RMB 98 billion compared with RMB 100 billion as of the end of last year. In accordance with our dividend policy, we are very pleased to report that our Board of Directors has approved a dividend of US$0.045 per share or US$0.225 per ADS. Lastly, under the current two-year share repurchase program, approximately 13.5 million ADS have been repurchased as of September 30, for a total cost of approximately US$1.3 billion. Meanwhile, under NetEase's Youdao share purchase program, approximately 0.1 million ADS have been purchased for a total cost of $1.8 million as of September 10th. Thank you for your attention. We would like to open the call to your questions. Operator, please go to Q&A.

Operator, Operator

Thank you. We will now take our question from Alex Poon from Morgan Stanley. Please go ahead.

Alex Poon, Analyst

My question is first of all, congratulations on very strong results and game pipeline. My question is regarding the Harry Potter overseas release schedule. Do we have a more specific timeline for different regions for release next year? How's the progress of content localization and community localization, etc.? Do we have a revenue expectation for overseas? How does it compare with China revenue? Thank you very much.

Charles Yang, CFO

Thank you, Alex. Let me answer your question directly in English. We have a strong pipeline and Harry Potter is one of them. Right now, we're subject to obviously the progress of localization. We intend to launch Harry Potter in some overseas markets as early as the first half of next year. Given the huge fan base of the Harry Potter IP worldwide and particularly encouraged by the very strong performance of Harry Potter in China, we are hopeful that this game would become a worldwide sensation. The publishing right is a commercial arrangement between NetEase and the original IP holder for some markets; NetEase will be in charge of publishing, while the majority of the overseas market publishing will belong to others.

Operator, Operator

Thank you. I will take our next question from Alicia Yap from Citi. Please, go ahead.

Alicia Yap, Analyst

Thank you. Thank you, Management. My question is related to NetEase Cloud Music. How do you see the overall competitive landscape and also the time spent dilution from the short video platform? Do you worry that leading short video platforms like Douyin could enter more aggressively in the online music content that could actually pose a threat to Cloud Music over time and also affect the user time spend on Cloud Music? Thank you.

William Ding, CEO

We have noticed that, at least in the short term, short-format video has captured some user attention, which affects not just us but also games and other entertainment forms. However, a key difference between music and video is that music resonates with users and creates an immersive experience. After watching a video, people often don’t feel inclined to rewatch it, whereas with music, listeners often want to replay their favorite tracks. Regarding potential new competitors in the market, we see it as very open and we welcome others to join in supporting independent musicians in China to fulfill their aspirations. Thank you.

Operator, Operator

We will now take our next question from Natalie Wu from Haitong International. Please go ahead.

Natalie Wu, Analyst

Thank you. Thank you for taking my question and congratulations on a better short quarter. So my question is regarding NARAKA: BLADEPOINT. Just want to get an update on the copy sales versus in-game purchase revenue contribution at the point of 6 million copies worldwide. Also for each part, how should we understand the deferral treatment in terms of revenue recognition? If management can share thoughts on the longevity of these games, that would be great. Thank you.

Charles Yang, CFO

Natalie, in the interest of time, I'll answer that question directly in English. Firstly, on your question on revenue recognition: both for the copy sales as well as the in-app purchases, we adopt the revenue deferral treatment over an expected lifespan. This is consistent with our revenue recognition treatment of other PC and mobile games. As the games have been launched for a few months, we expect the gross billings will increasingly come from in-app purchases. We are very confident that NARAKA: BLADEPOINT, just like many of our other NetEase flagship titles, will have a long-lasting lifespan. We believe the combination of stellar global sales records and our longevity through operation and content updates will create a unique model for global PC games in terms of proving longevity and sustainability of the gross billings over the longer term. Hopefully that answers your question.

Natalie Wu, Analyst

Yes, very clear. Thank you, Charles.

Operator, Operator

We can now take our next question from Kenneth Fong from Credit Suisse. Please go ahead.

Kenneth Fong, Analyst

Thank you management for taking my question. I have a question on the NetEase Cloud Music. Note that we have obtained full corporate rights authorization from Emperor Entertainment recently, and also the big three. How should we think about the pace of signing up new copyrights and the impact on our content costs and margins going forward? Thank you.

William Ding, CEO

Over the last few years, the landscape in China has not been perfect, which is why industry players have been paying a much higher price to label companies than anywhere else in the world. As everyone has seen, on July 24th, authorities issued guidelines to certain companies and asked them to give up exclusive rights. What we would like to see is the ability to pay fair prices to label companies across the world. Now, we are confident that under the proper direction from our authorities, the Chinese music industry will continue to take the right direction. Secondly, we see that every music company in China should focus on helping independent musicians create good music and positive messages. As a socially responsible company, NetEase Cloud Music has been making those preparations, and that is our agenda and goal. Thank you.

Kenneth Fong, Analyst

Thank you.

Operator, Operator

We will now take our next question from Thomas Chong from Jefferies. Please go ahead.

Thomas Chong, Analyst

Thanks, management, for taking my questions, and congratulations on a very strong set of results. My question is about our M&A strategies as well as the use of cash. Additionally, can management share insights regarding the trend in operating expenses? Thank you.

Charles Yang, CFO

Thank you, Thomas. I will answer your question directly in English. Firstly, regarding our M&A strategy, NetEase has always been focused on our core business pillars: games, online music, online education, and our private label brand, Yanxuan. Our business development will concentrate on these major verticals. We have grown organically for the past two decades but also remain highly active in exploring opportunistic opportunities to deploy M&A to supplement our growth. This has always been our consistent approach towards M&A. Regarding cash usage, we primarily invest in ourselves, focusing on talent acquisition and retention and content creation, which requires patience and commitment. For instance, a major title can take several years to develop. This is one of our competitive edges as we can afford to focus on what we do best and want to create. As for OpEx trends, NetEase has been listed for over 21 years, and we have always had a consistent approach to expense management. We focus greatly on our returns. Given our strong cash position, we are not shy in spending but will not spend for spending's sake. Whenever we invest in marketing or R&D, it is ultimately ROI-driven. We expect to maintain a prudent yet healthy level of spending on selling, marketing, and R&D, as we need to sustain the long-term technology company’s growth.

Thomas Chong, Analyst

Thank you, and congratulations on a strong quarter again.

Charles Yang, CFO

Thank you, Thomas.

Operator, Operator

We'll now take our next question from Eddie Leung from Bank of America. Please go ahead.

Eddie Leung, Analyst

I will do the translation myself. I have a follow-up question on your pipeline for the overseas game market. We understand that a good game should be suitable across our different regions. However, there are also cultural differences. So I just wonder about the size of studios involved in overseas developments. Will smaller studios also be involved in our game projects specifically for overseas markets? Thank you.

William Ding, CEO

Our China-based team primarily focuses on Chinese-themed games that they know well, specifically in Chinese-speaking countries. Secondly, we have been dedicating a lot of energy and resources to games designed for global launch. For those games, the gameplay, the world view, and all other details are considered on a global scale. All these types of games are typically joint-developed by our China-based teams and some of our overseas teams in places like Montreal. We also have games that are being developed solely by overseas teams who target markets they are intimately familiar with. Together, we hope to introduce more and more exciting games to the global audience. Thank you.

Eddie Leung, Analyst

Thank you.

Operator, Operator

We will now take our next question from Jialong Shi from Nomura Securities. Please go ahead.

Jialong Shi, Analyst

William, Charles, Margaret, and I will translate myself. My question is about the metaverse, which is a very hot new area these days, and lots of companies are planning to invest heavily in this field. Can management share your vision on the metaverse and what potential growth opportunities it may bring to the online gaming industry? What strategies do you plan to tap into this opportunity? Thank you.

William Ding, CEO

The metaverse is indeed the new buzzword today. However, I think nobody has had a tangible experience of what it actually is. We are totally ready from a technological standpoint. We know how to accumulate the relevant know-how and skill sets for when that day comes. When that day eventually arrives, we will probably be one of the fastest adopters of the metaverse.

Operator, Operator

At this time, I would like to 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 on TPG Investor Relations. Have a great day. Thank you.