Earnings Call Transcript - NTES Q4 2022

Margaret Shi, IR Director

Thank you, operator. Please note the discussion today will contain forward-looking statements relating to future performance of the company and are intended to qualify for 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 fourth quarter and full year earnings news release issued earlier today. As a reminder, this 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 senior management team is Mr. William Ding, Chief Executive Officer; and Mr. Charles Yang, Chief Financial Officer as well as other members of the senior management team. 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 calculated based on RMB. 2022 marked another year of solid growth for NetEase. Healthy development in each of our core businesses paved the way for meaningful financial gains. We achieved another record high net revenues of RMB96.5 billion for the full year, up 10% year-over-year with games and related value added services coming in at RMB74.6 billion for 2020 also up 10% year-over-year. This demonstrates NetEase's unique ability to deliver solid and sustainable growth throughout different macro cycles with a time-proven track record. In the fourth quarter, players continued to show their strong passion for our legacy titles, including Fantasy Westward Journey Online and the Westward Journey Online series. With our consistent rollout of content updates, these games have been staying at the forefront of the market for almost two decades acclaimed for their robust ecosystem and depths in game design. Adding to their success, we will soon introduce Westward Journey Returns, a more casual and light version of the Legacy IP. This game is designed to retain the essence of the franchise and has sparked a resurgence of interest amongst older fans, giving them an opportunity to relive cherished memories. With this new addition, we anticipate a further expansion of our user base of the Westward Journey Online franchise. Our new game Eggy Party took the market in China by storm in the fourth quarter. The game was initially launched in May of last year and the number of daily active users has been continuously growing after a few months of operation and fine-tuning. During the Chinese New Year, Eggy Party further grew its user base exponentially through word of mouth and scaled new height to the number three position in China's iOS growth. Its daily active users have now exceeded 30 million, making it the largest game in NetEase's history in terms of user scale. Adding to the dynamic and interactive gaming experiences that we produced in-house, Eggy Party distinguishes itself from other party games through the unique contribution of user-generated content. Players of Eggy Party are encouraged to take advantage of a diverse toolset available in editor mode to design and publish new levels on the platform. As a result, player engagement with user-generated content has further enriched the content spectrum on top of our in-house PGC content. This setup creates a virtuous cycle that continually adds fresh content to the platform and enhances player engagement and loyalty. With a goal of cultivating a thriving and self-sustaining ecosystem with long-lasting potential, we will continue to provide these players with tools and incentives to inspire and empower them to generate even more content. While Eggy Party represents a huge breakthrough for us in terms of our efforts to expand into casual games, we have been steadily building up our capabilities through many great games over the past few years. For example, our award-winning adventure mobile game Sky, which was launched in 2019, also delivered a strong performance in the fourth quarter. Sky offers players a heartwarming gameplay experience and has established a dynamic and passionate fan community. With a cool Halloween update during the quarter, Sky also surged to the top position on China's iOS top growth chart. While experiencing significant progress in casual games, we have also maintained our strong preference in the hardcore genre. This is evidenced by the sustained popularity of our key titles such as Invincible and the mobile version of New Ghost. Now let's move on to our pipeline. 2023 is exciting. We are set to expand our reach even further with a host of new titles. We have already received license approvals in China for a number of exciting titles such as Justice mobile games, Racing Master, and Badlanders. Starting with the Justice mobile game, it complements the success of the PC version and is aimed to be rolled out later this year. The mobile version will recreate the vivid world of the Song Dynasty on mobile devices with cutting-edge game technologies such as real-time ray tracing for amazing graphics that bring in-game scenes to life. With the extensive support of a highly skilled and experienced development team, Justice mobile game boasts a wealth of exciting and engaging content that players can enjoy for a sustained lifecycle. Equally importantly, as a next-generation MMO, this game represents a major evolution beyond the conventional norms of player interaction within the MMO genre, offering a truly unique gaming experience. We think the captivating and immersive open-world experiences we have created with Justice mobile game will continue to raise the bar for both MMOs and the broader mobile game industry. Second, the launch of Racing Master is also on track. As our second car racing game, Racing Master boasts a AAA quality racing simulation. Players can expect an authentic racing experience with dynamic car handling and performance. With a range of over 100 licensed vehicles from renowned car brands globally, players can fully immerse themselves in the thrilling world of racing and experience it like never before. As for Badlanders, it is our next-generation looter shooting mobile game, featuring a brand new escape mechanism and exciting looting experience on the battlefield. We will go through rounds of testing and hope we can bring this game to live soon. On the international front, we are preparing the highly anticipated global launch of our Harry Potter Magic Awakened. Our team is making dedicated efforts to continue enhancing and refining its gameplay and user experience, ensuring that our global players will live the amazing wizardry life on both mobile and PC. At the same time, we are also working on a series of expansion tags that will be ready to go, so that our global players will always have plenty of engaging content. Looking beyond these launches, we continue to enhance our robust pipeline and are actively working on a variety of exciting new game titles, including Naraka: Bladepoint mobile version. These pipeline games are making solid progress and show great potential. In the fourth quarter, we have also made further progress in our global expansion efforts. For example, we are thrilled to welcome Canadian-based SkyBox Labs to the NetEase games family. SkyBox Labs has an impressive track record in game development and has contributed to some of the industry's most renowned franchises such as Halo Infinite, Minecraft, and Fallout 76. Earlier this month, we also announced the establishment of Spliced, a new global game studio. Spliced is driven by a talented group of passionate industry gurus from a variety of backgrounds, including participating in the development of major game franchises like GTA, Call of Duty, The Things, Rocket League, and Red Dead Redemption. We value their dedication and innovative approach and look forward to supporting the development of their latest project, which seeks to redefine gaming and how we engage with it. We are excited to see what Spliced will bring to the industry and the impact they will have on the gaming landscapes. After years of planning, we've built up a robust portfolio of NetEase's global game studios, spanning multiple continents and establishing strong connections with the best-in-class talent within the global developer community. As we further expand our global ambition, we are unwavering in our commitment to providing the support and resources needed to unleash the full potential of games and, more broadly speaking, interactive entertainment. In 2023, we will remain dedicated to fostering an environment where our talented developers can harness their full ability and bring their innovative ideas to life with the ultimate goal of creating uplifting experiences and next-generation blockbuster game franchises for our global players. Moving on to Youdao. During the fourth quarter, Youdao achieved record-breaking net revenues of RMB1.5 billion, and for the first time ever, a positive income from operations, which totaled RMB25 million. This impressive outcome is a testament to our constant effort to provide cutting-edge updates for our smart devices and enhance our learning services. Net revenues from smart devices hit RMB407 million, up 8% year-over-year in Q4, thanks to the successful launch of new products. Our new product, Youdao Dictionary Pen X5 now has translation capabilities across more than 100 languages and expands our dictionary vocabulary in 16 professional fields such as economics, law, medicine, and computer science. Its user experience is further improved with even greater recognition accuracy, leveraging our natural language processing technology. We also launched the Youdao Smart Learning Pad X10 with an improved learning dashboard supported by AI for better personalized learning experiences. These sharpened iterations of our smart devices have garnered robust demand from customers, translating directly to substantial growth in sales. Our STEAM courses delivered another quarter of strong growth. In Q4, we collaborated with Minecraft Education Edition and successfully launched enriched updates to Youdao literature. Youdao literature is an online learning app that provides an immersive learning experience aimed at developing a comprehensive range of skills. Using artificial intelligence technology, Youdao literature delivers a wealth of engaging learning materials that combine literature, traditional culture, and stories, as well as tools of iconic architecture globally. The highly positive reception from learners and parents is evidenced by the app's impressive subscription rate and renewal rate. In addition, we strengthened our Youdao Gold course offerings by introducing the Champion class led by a World Champion in Gold Tournament. Our champion class is part of a comprehensive learning task that covers everything from entry level to advanced and culminates in the champion level classes. This new offering was NetEase's great success bolstering growth billings by more than 50% in Q4 year-over-year, along with a remarkable retention rate. Looking ahead, we will continue to focus on technological innovation and leverage our cutting-edge technology to ensure the long-term success of our smart devices and learning synthesis amongst others. Now, let's look at our cloud music business. In 2022, we achieved record financial results while enhancing our music-inspired offerings and differentiated music ecosystem. Total net revenues for cloud music in 2022 were RMB9 billion, representing 29% growth year-over-year. Due to the steady sales growth rate and an optimized cost structure, we continue to see strong gross margin expansion, which reached 14.4% for the year and 17.8% in Q4, up from just 2% and 4.1% respectively from the previous year, with continued efforts to provide better user experiences and bring music lovers broader music listening choices. Our total MAUs for 2022 reached RMB189.4 million, up 4% year-over-year, and our paying ratio rose to 20.2% in 2022, up from 15.8% in 2021, underpinned by our high-quality and young user community, ongoing content enhancement initiatives and continual innovation to our unique features. Recently, we signed several licensing agreements with major labels, and additionally, we renewed our collaboration with one of Japan's largest music labels. Throughout 2022, we also established partnerships with other leading Asian labels, including several prominent entertainment companies. By continuously expanding our music library, we are working to provide even broader selection of offerings to our community of music enthusiasts. Digital albums, particularly those from well-renowned artists, witnessed impressive sales in Q4, demonstrating high-quality audience base, deep user engagement, and user increasing willingness to pay for premium content on our cloud music platform. Meanwhile, the top 10 best-selling digital albums of 2022 on our platform span diverse music categories showcasing the personalized music taste of our young and diversified user base. With the unwavering commitment to fostering an inspiring environment in which musicians are encouraged and empowered to create, we introduced several new forums to support this effort. We launched Music Talk, an online column that allows musicians to exchange ideas on professional topics that help with creation. We also wrote our original music zone to help music lovers explore new content and expand independent artist's exposure. By the end of 2022, the number of registered independent artists on our platform has surpassed 600,000. Our in-house music studios also made solid progress, popularizing a batch of hit songs including some notable tracks and demonstrating our ability to produce excellent music content organically. Going forward, we will continue to prioritize product innovation and content creation to further grow our community. Moving on to our private label consumer brand launched in the fourth quarter, our team added more popular products through diversified channels, adding to our concentrated categories like pet supplies, home cleaning products, and home furniture. We released popular items such as detergent, bathroom fragrances, and Chinese New Year gift boxes. We will continue to focus on original design, facilitating pleasant lifestyle options for consumers. Looking at our business as a whole, we are honored to have been recognized for our contributions to society in terms of our environmental, social, and governance practices. We were recently added to the Dow Jones Sustainability indexes and continue to obtain outstanding ESG scores. Furthermore, our dedication to diversity and equality has led to our second year of inclusion in the Bloomberg Gender Equality Index. We remain committed to continuing the work of advancing equality, diversity, and inclusion and building a company where people are treated with the respect and dignity they deserve. We believe a truly inclusive workplace will be viewed with creativity, innovation, and development, and this motivates us to push forward. During 2022, we continued strong performance in each of our business lines and made new progress in each major vertical we operate in. Our extensive portfolio of products and services is reaching audiences on a broader scale as we move forward to our global aspirations, and with the solid ground we gain in our businesses, we believe that we are well-positioned to achieve even more in 2023 and beyond. Looking forward, we will continue to innovate, diversify, and expand our reach to generate value to our users and the broader stakeholder community. This concludes William's comment. I will now provide a very brief review of the 2022 annual results with a focus on the fourth quarter. 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. Our total net revenues for 2022 were RMB96.5 billion or USD14 billion, representing a 10% increase year-over-year. For the fourth quarter, total revenues were RMB25.4 billion or USD3.7 billion, up 4% year-over-year. For 2022, our net revenues from games and related value-added services were RMB74.6 billion, up 10% from 2021. Despite the high base in 2021, total net revenues from our games and related services continued year-over-year growth in the first quarter, reaching RMB19.1 billion, an increase of 2% year-over-year. The growth was primarily due to increased revenue contributions from both our existing games and our new blockbuster hit Diablo Immortal. Revenues from mobile games continue to make up the lion's share of our game business, accounting for 66% of our total net revenues in the fourth quarter and 67% for the full year. Youdao's net revenues for 2022 reached RMB5 billion and in the fourth quarter were up 9% year-over-year to reach RMB1.5 billion, primarily due to increased sales of our new services and smart devices. NetEase's cloud music's net revenues were RMB9 billion for the full year, up 29% year-over-year and up 26% year-over-year in the fourth quarter to reach RMB2.4 billion. The increase was mainly due to the contribution from membership subscriptions and digital album sales. Total revenues for innovative businesses and others were RMB7.9 billion for the year, up 7% year-over-year, and in Q4, this segment recorded RMB2.4 billion net revenues, up 3% year-over-year, mainly due to increased revenue contribution from our private label products. Our total gross profit margin was relatively flat in the fourth quarter at 52.2% compared with 53% for the same period in 2021. Looking at our fourth quarter margins in more detail, the gross profit margin was 59.1% for our games and related services compared with 60.9% in the same period last year. The slight decrease was mainly due to the one-off recognition of royalty fees related to certain licensed games. Improved margins in our smart device segment drove Youdao's gross profit margin expansion to 53.3% in the fourth quarter compared with 50.7% in the same period last year. The year-over-year increase was mainly due to the robust sales of new smart devices, which carry higher gross profit margins. Gross profit margin for music continues to improve in the fourth quarter, climbing to 17.8% versus 4.1% in the same period a year ago. The significant margin improvement primarily resulted from strong pipeline growth as well as improved efficiency in content investment. For our innovative businesses and others, the gross profit margin was 31.5% in the fourth quarter, slightly improved from 30.5% in the same period of the previous year. Total operating expenses for the fourth quarter were RMB8.8 billion, or 35% of our total net revenues. Taking a closer look, our selling and marketing expenses as a percentage of total net revenues were largely stable year-over-year, both for the fourth quarter and for the full year at 13.5% and 13.9% respectively. Our R&D expenses as a percentage of total net revenues also remained stable year-over-year at 16.1% in the fourth quarter, compared with 15.8% for the same period last year. On a full year basis, R&D expenses as a percentage of full year net revenue slightly improved to 15.6% compared with 16.1% in 2021. We remain committed to investing in content creation and product development. We are also seeing leverage in our R&D investments in the longer term. Our other income was RMB343 million for the fourth quarter compared with RMB3 billion last quarter. The high base from last quarter was mainly due to one-off gain resulting from the disposal of an investment and financial gains resulting from fluctuations in the exchange rate. The effective tax rate was 20.7 for the full year and 20.2 for the fourth quarter. As a general reminder, our effective tax range is presented on an accrual basis and the tax credit is deferred from each of our legal entities at different time periods, depending on applicable policies and our operations. Our non-GAAP net income from continuing operations attributable to shareholders for the fourth quarter totaled RMB4.8 billion or USD698 million. Non-GAAP basic earnings per ADS from continuing operations for the fourth quarter was USD1.08 or USD0.22 per common share. Additionally, our cash position remains strong. As of the year-end, our net cash position was about RMB95.6 billion compared with RMB85.6 billion at the end of 2021. In accordance with our dividend policy, we are very pleased to report that our board of directors has approved a dividend of USD0.054 per common share or USD0.27 per ADS. Lastly, we continue to buy back shares during the period. Under our prior share repurchase program for up to USD3 billion, which was completed on January 09, 2023, approximately USD34 million ADS have been repurchased under this program, and our board has announced a new share repurchase program of up to USD5 billion of the company's ADS and ordinary shares in open market transactions for a period not to exceed 36 months commencing on January 10, 2023. Meanwhile, under NetEase's purchase program for up to USD15 million of Youdao's ADS, NetEase has purchased approximately USD2.7 million of Youdao's ADS for a total cost of about USD22 million as of December 31, 2022. Thank you for your attention. We would like now to open the call to your questions.

Operator, Operator

Your first question comes from Alicia Yap with Citigroup. Please go ahead.

Alicia Yap, Analyst

Can management comment on the domestic gaming landscape? With domestic game approvals normalizing, will we be reallocating more resources to domestic game development, or will we focus more on content aimed specifically at the Chinese gamer? Or will you continue to prioritize overseas game development? Thank you.

William Ding, CEO

The process of licensing has started normalizing, which is very good news for us. So I think in the past we've always had the same focus on both the China market and the global market. So there's no real change in direction. We'll continue to place equal emphasis on both the China market and the global market. Thank you.

Operator, Operator

Thank you. Your next question comes from Yang Bai from CICC. Please go ahead.

Yang Bai, Analyst

Can you comment on the competitive landscape in the overseas gaming market? What are the current advantages and the gaps between NetEase's overseas game and other leading game companies? Also, as NetEase has continued to make much progress in overseas markets these years, what kind of synergies can be created between domestic and overseas? Are there any products under development to share with us? Thank you.

William Ding, CEO

We are observing currently that overseas games are actually very different. The Western game players prefer PC games and console games. For them, mobile games are more of the casual types. For the Japanese market, we think the players will accept both PC games and mobile games. For the China market, it is obvious they are more inclined to play mobile games. So in terms of content creation, PC games and mobile games are very different in design and development. So it is a challenge, but I'm very confident that NetEase will find a solution to create games that appeal to both the China market and the international audience. Thank you.

Operator, Operator

Thank you. Your next question comes from Lincoln Kong with Goldman Sachs. Please go ahead.

Lincoln Kong, Analyst

My question is about the Justice mobile game. So, we're testing this game having gotten the approval. Can management provide an update in terms of the development and progress and the launching time for Justice mobile? And how does this game compare with the PC version? We have also seen this game sort of impact us with so much excitement. Thank you.

William Ding, CEO

Thank you. Yes, we got the license approval in January, and we're going through the final phase of testing now, and hopefully we'll be able to introduce the game to you in the third half of this year. In terms of our mobile game version, I think we are more focused on the game experience, trying to create a game that appeals to different types of gamers, whether it's RPG gamers or other types. We think we've achieved a lot of breakthroughs on top of a traditional MMO RPG user experience through advanced technologies such as AI, and the aim is to create a more personalized experience for our gaming users. I think this is a game that is built on our 20 years of MMO experience, and on top of that, we have delivered more innovative experiences. So, I think it's a very exciting game for our gamers. Thank you.

Operator, Operator

The next question is from Natalie Wu with Haitong International. Please go ahead.

Natalie Wu, Analyst

Eggy Party recorded quite a success recently. Just wondering how should we think about the success? As a matter of fact, we noticed that NetEase has been giving us positive surprises with the successful launch of new titles more frequently in the past several years. Should we view Eggy Party as simply a single-title success or is it a result of our refined development and operation skills? Just wondering if there are any kind of new games in your pipeline that compelled Eggy Party this year that we can expect. Another question about the longevity of games—actually some of your games enjoy quite great longevity like FWJ, but some titles may fade in several months. So, just curious from management's point of view if there is a good way for us to have a better judgment on the games' longevity moving forward? Let's say, how should we think about the longevity of Eggy Party? Thank you.

William Ding, CEO

Yes, Eggy Party is one of the very successful games we recently launched, and this is the type of game that you have fun with, with your friends and family. So, we think, whatever you worry about probably will not happen, because we learn from our mistakes. We hope this is a game that will continue to bring joy to our gamers. We will dedicate more resources to the game to ensure the longevity of that game. When we talk about longevity, we need at least 10 years. Games like FWJ have been running for more than two decades. So, we hope to replicate similar types of longevity across all of our games. Thanks.

Operator, Operator

Thank you. Your next question comes from Alex Poon with Morgan Stanley. Please go ahead.

Alex Poon, Analyst

Thanks, management, for taking my question. My first question is related to Naraka: Bladepoint, the console performance on Xbox and our future plans with PS4, PS5 and mobile version and international launch. My second question is related to our overall margin trend in the next two years, considering we have Youdao and Yanxuan; they are improving their margins and gaining business. We are investing more R&D and G&A in overseas markets. Thank you very much.

William Ding, CEO

Our Naraka: Bladepoint was launched last June on Xbox, and we are pleased to have joined the FCP program. We have seen a huge number of gamers in China now, and we have been optimizing the user experience based on their feedback. We have been working tirelessly with our Montreal office to ensure we can deliver the best experience for our users. Based on those efforts, we have an even more improved version for our PS5 version. In terms of mobile games, we are also going through testing stages for that game, and we hope that the mobile game will replicate the same level of user experience as one would on the original PC version. Thank you.

Charles Yang, CFO

And, Alex, to your second question on the margin outlook for the next two to three years, our game margin will remain relatively stable. You are right that for our overseas studios, they are in an investment phase, and likely the games developed by our overseas studios will only come into the market in 2025 and beyond. However, we have a very strong and sizable existing portfolio of games that provides strong support to cash flow, profitability, and margins. For our subsidiaries like Cloud Music and Youdao, they have already demonstrated a clear trend of narrowing down their losses. We are very confident that in another six to eight quarters, both businesses will be self-sustainable and breaking even. So all in all, I think in the next two to three years, our margins will be steady and slightly improving with positive surprises coming in 2025 and beyond, which will then primarily be filled by the commercial launch of our overseas games currently in the development phase.

Operator, Operator

Thank you. Your next question comes from Felix Liu with UBS. Please go ahead.

Felix Liu, Analyst

Thank you, management, for taking my question. You mentioned the improved regulation outlook in China about game licenses. We're definitely happy to see that. Outside of the licenses gained that you already mentioned, if we look into the second half of this year and maybe 2024, could you give us some insights on the big titles or big genres that you have a good pipeline for? Thank you.

William Ding, CEO

I'm sure this year and next year and many years ahead, we will continue to see more new games launched from NetEase. The subject of innovation is perpetual, and we will continue to focus on innovating our gameplay and our game quality. You've seen we have launched amazing blockbusters year after year, and this year we have Eggy Party. So those are breakthroughs that have been very successful in both the work-type barbecue games, and we are equally successful in the casual games that you play with family and friends. I'm very confident you'll continue to see new exciting, innovative games coming from different genres from NetEase. Thank you.

Operator, Operator

Thank you. And 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, IR Director

Thank you again for joining us today. If you have any further questions, please feel free to contact us directly or financial communications. Have a great day. Thank you.

Operator, Operator

Thank you. That does conclude our conference for today. Thank you for participating. You may now disconnect.