Earnings Call Transcript - NTES Q3 2023

Operator, Conference Operator

Good day, and welcome to the NetEase 2023 Third Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Margaret Shi, Senior IR Director of NetEase. Please go ahead, ma'am.

Margaret Shi, Senior 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 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 announcements and 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 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 2023 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 the NetEase corporate website at ir.netease.com. Joining us today on a call from NetEase Senior Management is Mr. William Ding, Chief Executive Officer; and Mr. Charles Yang, Chief Financial Officer. I will now turn the call over to Charles, who will read the prepared remark 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 another period marked by outstanding results. Our beloved legacy titles and new hit games are strengthening our reach throughout the gaming world. Our total net revenues were RMB27.3 billion for the third quarter, up nearly 12% year-over-year, and our net income attributable to shareholders rose to RMB7.8 billion, increasing by 17% year-over-year. Our time-honored flagship franchises have maintained robust popularity. Notably, we brought players updates for the Fantasy Westward Journey Saga in the third quarter with a brand-new storyline and captivating activities, which once again breathed new life into the saga and drove year-over-year revenue growth for our more than 20-year-old epic title. In addition to our well-established games, we are actively expanding our portfolio by consistently launching and cultivating long-lasting franchises across more genres. We have strengthened our leadership in MMOs by pushing the boundaries of industry standards. We have also expanded our presence in broader game categories and demographics with innovative content, gameplay, and monetization models. We can see this in the growing popularity of the games that we have introduced in recent years, such as Eggy Party and Naraka: Bladepoint. Furthermore, our recently launched titles including Justice Mobile Game, Racing Master, and Dunk City Dynasty have quickly climbed to the top of the iOS growth charts after their release. Looking at our newest hit title, Justice Mobile Game, launched just in June, it impressively surpassed 50 million registered users in October, establishing itself as one of the largest MMOs in NetEase company history in terms of user base size. Notably, a significant portion of its player community comprises Generation Z players who were previously unfamiliar with the MMO genre, becoming a gateway for MMO games for the younger generation in China as a trendsetter in the MMO industry. NetEase has once again brought key innovations to the genre with the launch of Justice Mobile Game and reshaped the MMO landscape. It offers players a vast array of high-quality content for free, revamping the conventional paying model for MMOs. The shift to a more balanced spending approach gives players more freedom to enjoy the game's rich features and gameplay, with optional purchases focused on avatars, cosmetics, and accessories. This model was very well received by the game's player base solidifying its stability. In late October, we introduced Justice Mobile Games' first seasonal update, which significantly enhanced player engagement with captivating storylines, new gameplay, and additional professional role options. It swiftly propelled Justice Mobile Game to the number two position on China's iOS growth chart shortly after its release. The innovative seasonal mechanism we've introduced to the MMO genre gives all players a fresh start with a focus on fair and balanced gameplay. It also reduces the gap between experienced and new players, ensuring that everyone can enjoy and engage in this game. In addition to the success of this new blockbuster MMO title, we also achieved success across other game genres in the third quarter. Our new racing simulation game Racing Master consistently ranked among the top three most downloaded and highest grossing games on the iOS chart in China following each new game update, proving its broad appeal to racing enthusiasts. Notably, as China's very first AAA standard racing simulated mobile game, Racing Master has introduced an authentic racing experience into China's mainstream gaming sphere, and with the plan for Racing Master’s global market expansion, we will soon commence overseas testing to bring this exciting racing simulation experience to players worldwide. We also achieved a significant milestone with our foray into sports games, a historically less popular category in China. We've broken new ground with Dunk City Dynasty, a street basketball game that provides various modes to deliver a casual basketball gameplay experience. Dunk City Dynasty quickly rose to the number two position on the iOS growth chart in China just a few weeks after its release. Following our latest seasonal updates with the introduction of new basketball superstars to the team roster like James Harden, the game rose to the number one position on the iOS grossing chart in China. The innovative gameplay and balanced gaming experience we've infused in Dunk City Dynasty are important differentiators for our game. By integrating players authorized by the MBPA with street basketball, we provide players with higher gameplay freedom along with expanded cosmetic options. The game also includes a fair card for fair play, meaning increased player spending doesn't dictate who wins. This facilitates more inclusive gameplay and even more potential for the game's long-term success. Player enthusiasm for Racing Master and Dunk City Dynasty underscores the significant demand in China for top-tier games in the casual game genre. Along with our rich R&D capabilities, we are leveraging the inroads we've already made across a broad spectrum of genre verticals to fill these gaps in a market with new hit games that players love. Games we've introduced in recent years continue to resonate with players, demonstrating enduring popularity and long-term operating potential. Eggy Party, for example, continues to achieve remarkable milestones. In August, Eggy Party set new records by mapping over 100 million UGC maps and attracting 100 million MAUs. We are committed to fostering and nurturing our UGC ecosystem, which is a cornerstone of Eggy Party's success. We enhanced our self-developed editor in the third quarter by introducing more advanced and interactive functions. We also added collaborative map crafting functionality that lets users create with friends online on a shared canvas. To help foster even more creativity, we have introduced tutoring systems and a range of incentives to reward and motivate creators through various activities. Building on the game's notoriety in domestic markets, we are actively pursuing a global expansion plan for Eggy Party. In the third quarter, we launched Eggy Party in Southeast Asia, where it consistently secured dominating positions on the Google Play download chart for multiple weeks, particularly in Indonesia and Thailand. These early overseas releases also gave us valuable feedback and insights that guide our assets as we optimize the game for a global audience. We are also proud to announce that Naraka: Bladepoint recently reached a remarkable milestone of 40 million users. Following the transition to a free-to-play mode in July, we also introduced new heroes to the game in the third quarter, igniting greater player enthusiasm and attracting a massive influx of additional users to the game. To bolster our robust portfolio of games, we have a number of new games under development. As we get closer to some of these introductions, we are particularly excited about Where Winds Meet, our new AAA martial arts-themed action-adventure game. Where Winds Meet infuses an immersive open-world experience with an exciting historical backdrop that's relatively untouched in Chinese gaming. This interactive sandbox-style adventure features an extensive map, a diverse array of weaponry, and captivating martial arts techniques; players have the flexibility to explore this interactive world both individually and in groups. With two gameplay options, players can freely roam in the Asian-Chinese landscape in single-player mode, enjoying a highly personalized combat experience. In multi-player mode, players can work closely with friends to complete tasks, engaging in exciting and heartwarming social interactions. We will soon launch the second round of testing, where players will be able to see more of the game with a longer playtime. Early feedback fuels our excitement as we get closer to officially launching this brand-new open-world experience to our players in 2024. As a developer of China's first ACG hit title, we have made ongoing investments in the animation genre accumulating valuable industry expertise, and we hope to impress the ACG community once again. The promotional video release of our upcoming ACG title under development, set in the metropolitan-themed open world genre, has garnered significant attention from players both domestically and internationally. We are committed to infusing new vitality into the ACG arena by joining forces with our renowned innovation capabilities and experience in the realms of animated games. Beyond these titles, we also have a number of other games in the making, including Mission Zero, Once Human, and Naraka: Bladepoint mobile game. On the global stage, our game development is progressing smoothly in Japan, North America, and Europe. This month, we are excited to welcome Fantastic Pixel Castle as our newest addition to the NetEase family. Fantastic Pixel Castle is led by Greg Street, who is well-known for his contribution to massively successful games around the world including World of Warcraft and League of Legends. Greg and his experienced founding team are currently developing a top-tier MMO game code-named Ghost to provide players with a fresh and immersive fantasy MMO experience. We are thrilled to collaborate with so many talented industry producers, leveraging their creativity in synergy with our deep research and operational capabilities. Together, we aim to deliver even more captivating games to players worldwide.

William Ding, CEO

Now let's move on to Youdao. In the third quarter, Youdao achieved record-high revenue of RMB1.5 billion, growing 10% year-over-year, driven by the growth in learning services and online marketing. Additionally, as part of our continued efforts to improve profitability, our operating loss for Youdao narrowed by a significant 74% year-over-year to RMB58 million. A solid growth in our learning services was due to our consistent ability to launch unique and high-quality courses. Notably in the third quarter, our coding courses introduced a specialized program aimed at preparing students for the CSP Informatics competition, one of the most popular competitive programming events in China. Our program features all-encompassing services that include learning, context practice, and an evaluation system. The evaluation system is supported by our in-house developed scoring model allowing students to estimate their scores and assess their probability of progressing into the next round of the contest. Youdao's online marketing services have consistently grown at an impressive rate of approximately 100% for the second consecutive quarter. This underscores our expertise in proprietary algorithms and the effectiveness of our customized solutions, which are precisely crafted for diverse industry sectors. Revenues from our smart devices declined in the third quarter as we strategically optimized our channel mix by reducing sales through less cost-effective channels. Although this may have a temporary impact on Youdao's revenue, we believe it will lay a solid foundation for sustained long-term growth and enhance Youdao's profitability potential over the long run. Our focus on technological innovation remains our driving force. In addition to Youdao's tech-boosted performance, we upgraded AI Box on Youdao's translation product in the third quarter, which enables more accurate and natural translation across various types of documents. With the support of our machine-generated functions, third quarter revenue from subscription fees for translation increased by over 160% year-over-year. Furthermore, following the August introduction of our digital human language coach Hi Echo through Youdao Dictionary Pen X6 Pro, we expanded our reach to a broader user base through an independent app in October attracting over 100,000 user registrations within just a month. We will continue to iterate Hi Echo with a new update coming soon. Looking forward, we will look to drive more technological innovation and introduce more products that genuinely meet our users' needs by harnessing our expertise in machine learning technology. Next, turning to NetEase Cloud Music. In the third quarter of 2023, Cloud Music continues to navigate quality development across our core music-centric ecosystem while further extending the robust monetization momentum in the core online music sphere and improving overall profitability. Total online music MAUs remained largely steady, staying above RMB200 million in Q3, total revenues for the quarter were RMB2 billion, on par with late last quarter. Growth in our music-centric memberships accelerated, demonstrating our ability to introduce premium offerings including exclusive content and innovative features. Additionally, our social entertainment services started to stabilize on a monthly basis during the latter part of the third quarter, following our strategic positioning refinements in live streaming, which resulted in short-term setbacks with solid monetization momentum in the core online music businesses and continued cost structure optimization. Cloud Music maintained steady margin improvement for the period. We are constantly expanding our music library to provide a comprehensive selection of music for our diverse audience base. During the third quarter, we broadened our extensive music collection by adding songs from popular Chinese pop artists like Karen Mok, Zheng Jun, and Zhang Jie. In addition, we were delighted to release albums by pop stars including JAM, KeyNG, and Shen Yichen. As part of our ongoing commitment to enriching our music-centered ecosystem, we remain dedicated to empowering and assisting independent artists. As of the end of September, we proudly serve a thriving community of over 660,000 registered independent artists showing strong growth of 16% compared with the same period last year. We have also broadened our support for emerging music talent. Our new programs are tailored to regional routes and distinctive styles in different areas, including programs like Localized Sound and Project Sound Season Five to honor and promote more diverse artists. At the same time, we hosted offline music festivals such as the 65PARK Camp Music Festival, providing more exposure for our independent musicians. In addition to broadening our content selections, we continued our product innovation initiatives, aiming to elevate users' music listening experience and foster our music-centric community. We have recently officially launched the Private DJ feature, incorporating music recommendations with an intelligent and personalized music introduction and explanatory experience. This feature allows users to record traditional radio DJ experiences while enjoying a more personalized music accompaniment as part of their listening experience. Building on our iconic comments section, our Comments Square has emerged as a vibrant gathering place for users to express and find connections with one another. Moving on to Yanxuan. In the third quarter, our private-label consumer brand launched more popular products through diversified channels. We saw robust sales growth in selected categories like pet supplies and home cleaning products and sellers like ergonomic chairs, bathroom fragrances, and cat food, consistently outperformed competitors across various platforms. Our strategic efforts, including efficient warehouse and distribution management and personalized packaging, have also proven successful. Thanks to the innovative marketing campaign, our Down Jacket series, which is highly acclaimed for its exceptional quality at an affordable price, gained immense popularity during this year's Double Eleven online shopping event, driving the collection to hit top positions on multiple bestselling charts on several e-commerce platforms. In summary, innovation is at the core of all of our businesses, driving our growth and our competitive edge. We believe that great content, products, and services stem from new and creative ideas. This principle lies at the heart of NetEase; whether it is games, Cloud Music, Youdao, or Yanxuan, we consistently strive to reach new heights. In doing so, we help to drive the industries we serve forward, while delivering value to our growing global community, our partners, our team members, and our stakeholders. This concludes William's comments.

Charles Yang, CFO

I will now provide a brief review of our 2023 third quarter 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 RMB27.3 billion or US$3.7 billion, representing an increase of approximately 12% year-over-year. Total net revenues from our games and value-added services were RMB21.8 billion, up 16% year-over-year. The growth was primarily due to increased revenue contribution from newly launched games such as Justice Mobile Game, Racing Master, and Eggy Party. Net revenues from our mobile games accounted for nearly 78% of our total net revenues from online game operations. Youdao's net revenues were RMB1.5 billion, a year-over-year increase of nearly 10%, primarily due to increased revenue contribution from learning services and online marketing services. Net revenues from Cloud Music were RMB2 billion, a 16% decline compared to the same period last year. As we explained earlier, this result reflects declining revenue of social entertainment services as we adjust our focus to improve profitability in a sustainable manner. Net revenues for innovative businesses and others were relatively flat in the third quarter at RMB2 billion. Our total gross profit margin continues to grow, exceeding 62% in the third quarter compared with 56% in the third quarter of 2022. Looking at our third quarter margin in more details, the gross profit margin was 69% for our games and related value-added services compared with 65% in the same period last year. The increases were primarily attributable to changes in the revenue mix of the NetEase self-developed and co-developed and licensed games. GP margin for Youdao was 55.9% compared with 54.2% in the same period last year. The increase mainly resulted from increased revenue contribution from its learning services and online marketing services segment. Gross profit margin for Cloud Music improved in the third quarter reaching 27.2% versus 14.2% in the same period a year ago. The margin improvement primarily resulted from increased revenues, scale from membership subscriptions, and continued improvement to our cost management measures. For innovative businesses and others, gross profit margin was 27.3% compared with 25.5% in the third quarter of last year. The increase was primarily the result of margin improvement in Yanxuan and some of our innovative businesses. Total operating expenses for the third quarter were RMB9.4 billion or 35% of our total net revenues. Taking a closer look at our expense composition, our selling and marketing expenses as a percentage of total net revenues were 13% in the third quarter compared with 15.4% for the same period last year. This reflects our ongoing efforts to consistently enhance marketing efficiency. Our R&D expenses as a percentage of total net revenues also remained stable quarter over quarter at 16%. As always, we are committed to ongoing investments in content creation and product development. We are also seeing leverage in our R&D investments in the longer term. Our G&A expenses as a percentage of total net revenues were 5.5%. The slight increase from the previous quarter was primarily due to certain one-off items. Our other income was RMB1.5 billion for the third quarter of 2023 versus RMB2.8 billion in the previous quarter. The decrease was mainly due to the exchange rate of the U.S. Dollar against the RMB fluctuating over the period. As per applicable accounting standards, we are required to reflect these fair value changes. The effective tax rate was 14.2% for the third quarter. As a reminder, the effective tax rate is presented on an accrual basis and the tax credits differ for each of our entities at different time periods depending on applicable policies and our operations. Our non-GAAP net income from continuing operations attributable to our shareholders for the third quarter totaled RMB8.6 billion or US$1.2 billion. Non-GAAP basic earnings from continuing operations per ADS for the quarter was US$1.84 or US$0.37 per share. Additionally, our cash position remains robust with net cash of approximately RMB104.4 billion as of September end compared with RMB95.6 billion as of the 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$0.0990 per share or US$0.4950 per ADS. Lastly, under our current US$5 billion share repurchase program starting in mid-January this year, we had repurchased approximately 7 million ADS as of September 30, 2023, for a total cost of approximately US$588 million.

Operator, Conference Operator

Thank you for your attention. We would like now to open the call to your questions. Our first question comes from Ritchie Sun with HSBC. Please go ahead.

Ritchie Sun, Analyst

I will translate these questions myself. Thank you, management, for taking my questions. I have a question about the competitive landscape for Party games. Does management believe it's a winner takes all market, or is there room for two players? Additionally, we have observed that Eggy Party has a strong user base and user-generated content already. Considering the potential competition from other platforms, what steps will NetEase take to maintain its leadership? Thank you.

William Ding, CEO

We believe that competition is a standard aspect of the industry. Therefore, we will continue to focus on innovation and delivering quality services to our users, which is our approach to leading the market. We are confident in retaining our users in the Party game genre. Thank you. Next question, please.

Operator, Conference Operator

Our next question comes from Yang Bai with CICC. Please go ahead.

Yang Bai, Analyst

My question is about the flagship games. Could management share more details about how the flagship games like the Racing Master game are performing? Thank you.

William Ding, CEO

I want to emphasize that the most crucial aspect of a game is innovation and consistently delivering high-quality content for our users. It's essential for us to concentrate on the long-term sustainability of our games and to avoid making any short-term decisions. Based on our 20 years of experience in the industry, we believe that having a long-term perspective is vital. Thank you. Next question, please.

Operator, Conference Operator

Our next question comes from Felix Liu with UBS. Please go ahead.

Felix Liu, Analyst

Thank you, management, for taking my question, and congratulations on the strong third quarter results. My question is regarding the pipeline. Among the three completed games, including Studio, Where Winds Meet, and Project Zero, how is the R&D progress for these titles? When do you anticipate they will be available in the market? Additionally, for the other games still awaiting Banhao, such as Naraka Mobile and Project Mugen, do you have any updates on their R&D progress? Thank you.

William Ding, CEO

Thank you. Just a quick translation for William. Yes, for each of our games, we always make careful adjustments and moderations before we are ready to release them to the market. For games such as Studio, we are still in the final stage of preparation, and we hope to release them to the market no later than the second quarter of next year. Thank you. Next question, please.

Operator, Conference Operator

Our next question comes from Thomas Chong with Jefferies. Please go ahead.

Thomas Chong, Analyst

Thank you, management, for addressing my questions. I would like to inquire about our strategies for international markets. Considering our strong performance in the domestic market and a robust pipeline, how should we approach our overseas expansion and investment strategies in the upcoming years? Thank you.

William Ding, CEO

On the global market, we will continue to focus on a high-quality strategy and look for partners who share our mindset and passion for games. We will also invest in strong teams to create great content for users worldwide. Thank you. Next question, please.

Operator, Conference Operator

Our next question comes from Lincoln Kong with Goldman Sachs. Please go ahead.

Lincoln Kong, Analyst

Thank you, Mitchell, for taking my questions. This year, we have seen success with our titles Eggy Party and Justice Mobile, which differ from traditional legacy games and have garnered a significant user base and daily active users. As we look towards our upcoming game launches next year, particularly Weemings and Xiaodao, can we expect similar features and any strategies to replicate past successes? When can we anticipate the next milestone for Justice Mobile?

William Ding, CEO

Thank you. Let me provide some insights. The large daily active user games are definitely a significant area for us. We will keep identifying key elements from successful games to help us develop more in this genre. At the same time, it's crucial to also focus on creating high-quality games in specific niche categories to cater to the diverse needs and preferences of various users. For instance, this year, we introduced a basketball game and racing games, which are strong examples in their respective categories. We have multiple teams specializing in large daily active user games as well as teams dedicated to niche interests. We encourage them to leverage their unique strengths and experiences. Thank you. What is your next question?

Operator, Conference Operator

Our next question comes from Ritchie Sun with HSBC. Please go ahead.

Ritchie Sun, Analyst

Dunk City Dynasty has seen considerable success even though it launched without the Android App Store. While this could lead to increased channel costs, the Android platform has the potential to attract more users, which can help keep the game running for a longer period. How does management evaluate the return on investment of not utilizing the Android store? Additionally, what types of titles would benefit from a strategy focused on single launches in the future? Thank you.

William Ding, CEO

Thank you. For games aimed at a large user base, such as party games suitable for all ages, distribution platforms are more effective in reaching a wider audience. However, for titles like the basketball game, it attracts a specific community of players. We identify these players through various platforms and channels. Our goal is to bring them to the NetEase platform and operate the game over an extended period, allowing us to understand these users better and provide improved services and experiences. Additionally, users on the Android platform can download our games via our website, TapTap, and other channels. Thank you. Next question, please.

Operator, Conference Operator

Our next question comes from Alex Poon with Morgan Stanley. Please go ahead.

Alex Poon, Analyst

Congratulations on a very strong quarter. My question is about AIGC. Can AIGC enable us to make our future game updates and expansion packs more frequent, possibly moving from the current three to six months to a monthly or even weekly basis? This could enhance user engagement and improve monetization. Thank you.

William Ding, CEO

Yes, we believe that AI significantly enhances R&D efficiency, especially in areas like game design, storyline development, mission design, and art. Each year, we see improvements in R&D efficiency. However, while our productivity is rising, the frequency of our expansion packs isn't solely reliant on that. It’s important for our users to fully enjoy our content, so the timing and number of expansion packs are largely influenced by our gamers' preferences. We aim to sustain each of our games over a long period. With greater efficiency, we can deliver higher quality content within the same timeframe. Thank you. Next question, please.

Unidentified Analyst, Analyst

My second question is about Naraka: Bladepoint mobile and Project Mugen. Are they likely to be released in 2024? Thank you very much.

William Ding, CEO

For Naraka: Bladepoint mobile game, it has been in translation for some time, and we are ready to proceed once we obtain the license approval. Regarding Project Mugen, it is highly anticipated by both us and the gaming community. We plan to invest more resources into its development to ensure next-generation quality content. However, we do not have a release timetable at this moment. Thank you. Please proceed with the last question.

Operator, Conference Operator

Our last question comes from Alicia Yap with Citigroup. Please go ahead.

Alicia Yap, Analyst

My question is about Justice Mobile. For the existing NetEase gamers, where did they come from? Which NetEase game were they playing prior to Justice, and which non-NetEase game did they play before? Is the paying ratio and ARPU for Justice significantly higher than for other NetEase games? Thank you.

William Ding, CEO

For Justice Mobile, based on our stats, about a third of our users are new to NetEase games, and this game has attracted players from other major daily active user products in the market, indicating its broad appeal among various user types. This year, other games we launched, like the basketball game and Racing Master, have also attracted a significant number of players who had never engaged with NetEase games before. Regarding the paying ratio and monetization of Justice Mobile, we intentionally selected a lighter monetization model. This choice results in a lower average revenue per user, but with a much higher pay-in ratio. We opted for this monetization model to foster a healthier and more balanced in-game environment, reducing payment pressure on our players and providing them with a long-term enjoyable gaming experience. Thank you. That concludes our questions for today.

Operator, Conference Operator

Thank you. That concludes the question-and-answer session. I would like to turn the conference back over to management for any additional or closing comments.

Margaret Shi, Senior IR Director

Thank you once again for joining us today. If you have any further questions, please feel free to contact us directly at Piacente Financial Communications. Have a great day. Thank you.