Earnings Call Transcript - NTES Q1 2020

Operator, Operator

Good day, and welcome to the NetEase First Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Margaret Shi, Investor Relations for NetEase. Please go ahead, ma'am.

Margaret Shi, Investor Relations

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 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. The company does not undertake any obligation to update 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 the non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results, please see the 2020 first 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; Mr. Charles Yang, Chief Financial Officer; and Mr. Hilton Hui, Co-President of NetEase Games. 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 renminbi. Like every company around the globe, we started the year with a great deal of uncertainty amidst one of the world's worst health crises. I am pleased to say that we have worked very hard to address the effects of the pandemic, providing help where we can and making the appropriate adjustments to our businesses to ensure the safety of our NetEase family. We believe many companies inside and outside of China will overcome this pandemic and come out strong. We had a good quarter, increasing our net revenues by 18% to CNY17.1 billion and our net income from continuing operations attributable to our shareholders was up by 30% to CNY3.6 billion, both on a year-over-year basis. For our online games, net revenues reached CNY13.5 billion in the first quarter on the back of our existing titles' stellar performances, growing 14% year-over-year even though Q1 2019 was itself a very strong quarter for our game services a year ago. Our legacy PC titles such as Fantasy Westward Journey and New Westward Journey Online II continued their strong performances in the first quarter with new expansion packs launched for the Chinese New Year holidays, introducing a series of new content. Quarterly revenues for these games broke new records, hitting another all-time high since their debuts almost 2 decades ago. Momentum for legacy mobile games was also strong as we continued to supply this large and sustainable user base with continual content updates. Take our Fantasy Westward Journey Mobile game as an example, where we introduced a brand-new character which quickly gained popularity and was a strong driver for gross billings. While we continue to dominate the MMO genre, many of our recent titles and categories that are relatively new for us have also shown remarkable success and sustainability, providing us with steady revenue streams in what is now a very diverse game portfolio. Invincible, Onmyoji, Identity V, and Life-After, launched in 2015, '16, '18, and '18, respectively, serve as good examples of our superior game longevity within different game genres. Invincible, our 2015 launch, hit another quarter of record high gross billings and active users. We are pleased to see the game's strong traction in the SLG market. After more than 5 years of successful operations with Invincible, we have accumulated a solid SLG fan base and extensive expertise in this field. We look forward to developing more innovative games to delight our users in this engaging and thought-provoking genre. Onmyoji continues to show remarkable longevity as we consistently introduced new characters. These additions are resonating well with new game players, further solidifying the reach of Onmyoji as a leading ACG game. As the first of our younger IPs that we have created in-house, our goal for Onmyoji is to have an even larger and deeper impact on the vibrant community of young users. In addition to Onmyoji: The Card Game, the collectible card game we launched last year, and the upcoming simulation game, Onmyoji: Yokai Koya, planned for later this year, we have more exciting new games in store based on the Onmyoji IP. Later today, this evening, Beijing time, at our May 20 game day event, we will introduce 2 new Onmyoji spin-off games in brand-new genres. Launched in 2018, Identity V and Life-After are also a few of our newer titles, attracting a large base of young fans and starting to demonstrate sustained longevity.

William Ding, CEO

Alex, I will summarize my comments briefly. First, regarding games. During the pandemic, we observed that games became a key activity for families spending time together at home, providing joy, excitement, and a form of relief. This has also led to an increase in new game users in the past quarter. As we move forward, this will inform our strategy to focus more on the research and development of games that foster connections among family members. As for music, I want to reiterate my previous points: our mission at NetEase Cloud Music is to create a supportive environment for the growth of independent musicians in China. We aim to help talented individuals express themselves and share their music with passionate fans, exploring diverse genres. For the foreseeable future, this will be our main area of focus. Regarding our margin trend, we believe that as we expand and diversify our music revenue streams, we will benefit significantly from economies of scale, leading to improved margin trends. We are quite optimistic about this outlook. I hope this answers your question, Alex.

Alicia Yap, Analyst

Good morning, William and Charles. Congrats on the results. My question is on your gaming business. As many other companies are seeing the normalizing trend of gamers' traffic and activity post the lockdown lift-off, how does that trend look for NetEase games? And how should we think about the offsetting factor with your deferred revenue for the second quarter and also the lockdown in overseas that might benefit the overseas gaming market?

Charles Yang, CFO

Okay. Alicia, do you want to translate your question yourself?

William Ding, CEO

I will provide a brief translation of my remarks. So I commented, Alicia, I think your observation is right. However, that is a short-term volatility, I think, across the board, as you mentioned, other game companies and us might be seeing; however, I emphasize that the growth engine of NetEase games is our ability to continuously produce in-house and launch new game titles as well as our ambition of becoming a more globalized game company with more exciting titles launched into overseas markets such as Japan and hopefully very soon in the mainstream Western market. With all that, we are not overly concerned about these short-term volatilities, and we are very, very optimistic about the outlook of NetEase games growth driven by the diversification of new titles as well as diversification of new geographies.

Natalie Wu, Analyst

Congratulations on a very solid quarter. I have two questions. First one is regarding the PC game. So your PC game outperformed the industry despite a slowdown in the operation of the net cafe, which is quite encouraging. It would be great if management can share with us some thoughts of the future outlook for that segment. And second one is regarding Harry Potter. Just wondering if the game is ready but still needs time to get approval in the domestic China market? Will you decide to wait for the license or will you launch it firstly in overseas regions?

William Ding, CEO

Okay. Yes, Natalie, I will translate my comments for everyone's broader benefit for the first question and I will answer the question on Harry Potter. Firstly, what we observed is that during the global pandemic, PC and console games, in general, have seen an increasing trend as more people are spending time at home. It is not so much correlated to the Internet cafe's operation as you can see from our game results because our PC games are legacy titles running for over a decade. In the case of FWJ, we see a record quarter since its debut almost 17 years ago. We are very confident about the sustained gross billing popularity of our flagship PC games. For the time being, our main concentrated focus of new game development is tilted towards mobile games. The launch of new PC games will be opportunistic. We do not have a regular agenda like we regularly launch new mobile games. So that's to your first question. Second question, Harry Potter. We are very excited about Harry Potter. It is a strong IP globally and we are confident in our R&D ability to convert this IP into an exciting game title. I think it's too early to predict the situation on regulatory approval in China. When it comes to the stage when the game is ready for launch, whether we will do a global simultaneous launch or whether we will do overseas launch first followed by domestic upon the approval, both are possibilities and we will decide that later when the game is more advanced.

Shi Jialong, Analyst

First of all, congratulations on a very solid quarter. I have two questions. First question is about NetEase online gaming business. Just wondering how much of NetEase's online gaming revenue was contributed by overseas market in Q1? My second question is about NetEase music business. According to various media reports, it seems to me, NetEase music has accelerated the purchase of licensed content since this year, including the recent licensing agreement with top global record labels as well as the exclusive purchase of some of the highly rated music shows. I was just wondering why it seems NetEase music has become more aggressive on content purchase?

William Ding, CEO

Jialong, first question. Overseas, the first quarter, our overseas revenue accounts for slightly more than 10% of our total game revenue, consistent with our level of last year. But we are very confident to continue to grow and even very strongly grow this revenue contribution from the overseas game market in the next 3 to 5 years. I'll provide a quick translation of my remarks. Our dedication to support and promote independent musicians and native IPs are not mutually exclusive with our deep respect and open-minded, strong collaboration with music label companies. In fact, in the past, there have been obstacles in the industry preventing us from purchasing music content and music IPs directly from label companies. We are very, very active in a collaboration with all these highly regarded label companies in an effort to acquire music IPs, content copyright. We will utilize our efficiency and our massive user scale of NetEase Cloud Music to distribute their music content to a group of music enthusiasts. We also want to reiterate that we hope that the whole industry in China and all the players in China can focus and spend more effort and resources promoting native IP, organic music from independent musicians because I think it is going to be a much bigger ambition for the entire industry to see the rising of Chinese music, Chinese musicians play a much bigger role on the global audience.

Eddie Leung, Analyst

So my question is about the new game launch. Historically, when we have a big year with a lot of new games to be launched, typically, the marketing spending ratio would go up. I am just wondering what could be the pattern this year? And whether there would be different ways to promote new games?

William Ding, CEO

Okay. Yes. Eddie, your question is about our outlook on marketing expenses. I want to reemphasize one point. NetEase games focuses a lot on self-developed in-house-developed games. As such, we are always excited about our lineups of new games. Whenever we consider promoting a new game, it is always a return-driven exercise internally. Depending on our projections of the game's performance and expectations of the gross billing, then we allocate marketing resources in a very sensible way. That is why I think in prior quarters, I also made remarks that try not to look too much into the quarter-over-quarter fluctuations of the marketing spending dollars. In fact, if you look at my marketing dollars as a percentage of the overall revenue on the full year trend, last year, we controlled it at around 10%, a significant decrease from the prior two years. However, absolute dollars are not shrinking. That is because we are more sensible and more conscious about the return generation on my marketing dollars. With more new game titles, yes, we are going to spend more marketing dollars, but we are even more optimistic that with effective promotion, the new games are going to generate even faster return for us at the top line. On the financial planning aspect, NetEase remains prudent and sensible.

Alex Liu, Analyst

I'll translate myself. My first question is on the cash allocation. We have a very good cash flow on our core business and also a very solid cash balance. Just wondering, should we think about the enlarged stock repurchase program and perhaps further stock repurchase programs as a more occurring practice down the road? And the second question is on the deferred revenue. Deferred revenue balance was very strong this quarter. And I was wondering if the management could give some color on this growth and whether it's due to the mix change between PC and mobile games.

William Ding, CEO

Okay. Alex, for your first question, our treasury policy is always very prudent. We are one of the very few tech companies globally that pays a regular dividend. In fact, we've been paying a regular dividend since 2013 and we will continue to do so, returning value to our shareholders, especially long-term shareholders who have been supporting us in the journey of growth over the last 2 decades. The stock buyback program is also a regular exercise for a couple of years. When the situation requires and is within our ability, we will go back to the Board, just like this time, seeking the authorization of enhanced dollar amount for the overall stock buyback. That is on the treasury cash management aspect. For your deferred revenue, we don't further break down exactly on the composition, but I think you are correct. In Q1, if I remember correctly, it was probably another record quarter for both recognized revenue as well as deferred revenue. Again, it is largely underpinned by the gross billings and the growth of both PC lines as well as mobile lines of games, largely consistent with what you are seeing in the year-over-year growth for the recognized revenue. Youdao also contributed to a certain extent, but you can refer to Youdao's public filing for the deferred revenue incremental portion.

Binnie Wong, Analyst

Good morning, William, Charles, and Margaret. After COVID-19, do you believe it changes our perspective on the overseas games expansion plan? What new opportunities do you see? How do you envision our targets over the next 3 to 5 years? Does that change or remain the same? Regarding your upcoming game launches, which ones do you anticipate will be released soon? What is their significance?

William Ding, CEO

So I will provide a brief translation of my remarks. Firstly, how the pandemic situation globally would affect our thinking of game promotions, particularly in the overseas market. I believe that the pandemic situation requires people to spend more time in-house. So it is a structural tailwind for overall activities that happen at home, playing video games, watching drama, etc. That, we think, is going to benefit our game promotions because this content is having more user time, so to speak, on a global scale, and we are not particularly concerned about the pandemic situation disrupting our plan, our original plan of game launches. Especially for these mature overseas markets, users are more attracted and emphasize a lot on game quality. I think that is our biggest selling point. Regarding your query on the approval process and our expectations for the overseas games, it is really difficult for us to do a force ranking, which one is number one, which one is number two, because for all these projects, since the inception of the project business planning, we think they are all great products, representing the highest quality in their respective genres targeting different segments of target users. We are very excited. Some of the games can be launched as early as the middle of this year and some might have to wait until the second half, later part of this year. I personally, throughout this period and in response to the pandemic situation, have been giving more thought in terms of how game content can be designed and developed and how game content can be distributed to fulfill better social responsibility and value to families, as well as to people around the globe.

Thomas Chong, Analyst

William, Charles, and Margaret, I have a question, back to the music business. Given the fact that we have been also monetizing for the live streaming business models, can you comment about how we should think about the competition in the live streaming space as well as the competition with short form video?

William Ding, CEO

In the interest of time, I will provide a brief translation of my remarks just now. Broadcasting is just one way of us thinking about how we can monetize our NetEase Cloud Music platform. It is not the only way, and we will continue to explore different, innovative, and diversified ways of monetization in a sensible and user-appealing way. The essence of our biggest ambition and mission with the NetEase Cloud Music platform is that we want to contribute whenever we can within our ability to help promote and better enhance the Chinese music industry as a whole. It might look very different from mature markets in the Western world, but we think the Chinese music market is huge with significant upside potential, allowing multiple players to develop differentiated competitive advantages in collectively making China's online music industry better and more promising.

Margaret Shi, Investor Relations

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

Charles Yang, CFO

Okay. Thank you, everyone.

Operator, Operator

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