Earnings Call Transcript - NTES Q1 2021

Operator, Operator

Good day, and welcome to the NetEase 2021 First 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 future performance of the Company and are intended to qualify for 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 its discussion. A general discussion of the risk factors that could cause NetEase 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 announcement and filings on our website of Hong Kong Stock Exchange. The Company does not undertake any obligation to update these 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 2021 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 the NetEase corporate website at ir.netease.com. Joining us today on the call from NetEase senior management is Mr. William Ding, our Chief Executive Officer; and Mr. Charles Yang, our 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 renminbi. We began the year with a record quarter exceeding RMB20 billion in revenue for the first time, and net income attributable to the Company's shareholders increased 25% year over year to RMB4.4 billion. Our games business also reached a new record of RMB15 billion in net revenues, up 11% year over year in the first quarter despite a higher comparable base last year. In Q1, our flagship titles continued to demonstrate strong growth after nearly two decades of operation, with revenues from Fantasy Westward Journey Online and Westward Journey Online mobile, all growing at double-digit rates year-over-year. Tianxia III is another exemplary case. It is one of the rare instances where a legacy PC MMORPG game has regained growth after reaching maturity, leveraging our growing knowledge and more recent successes in both MMO and non-MMO genres. We added some casual flavors to this legacy MMORPG, giving our players a fresh feel and creating new content for users to consume and enjoy. We also crafted an in-game event at the end of last year, which quickly generated strong interest and discussion in the players' circle, leading to a large inflow of returning users who rejoined the game. Other games in the spotlight during the first quarter included LifeAfter, Onmyoji, Identity V, and Invincible. LifeAfter has remained an iconic title with strong appeal among young users. The new collaboration with Movie Godzilla vs. Kong in the first quarter was well received by players as they fought off doomsday monsters. Onmyoji also showed remarkable longevity, remaining at the forefront of China's iOS top grossing chart. During the first quarter, we rolled out a highly anticipated IP collaboration with Demon Slayer, a classic Japanese anime, further strengthening Onmyoji's position as a top ACG game in China. Celebrating its third-year anniversary in April, Identity V continues to draw the attention of young players, bringing them a thrilling competitive experience with a distinctive gothic art style. Between January and May, we hosted our annual global championship tournament, Call of the Abyss, with its finale being set in Hangzhou, attracting close to 2 million game players globally to participate in this event. Invincible remained steady in the first quarter with strong user engagement, holding unwavering loyalty from its fan community. Despite numerous Invincible-like games popping up in the market, Invincible has proven to be a trendsetting pioneer in this game genre. This also echoes well with our corporate DNA in product innovation. In terms of new games, we have launched a few since the beginning of this year. We started with the Revelation mobile game in January. As we discussed last quarter, this is our self-developed RPG game based on our flagship PC title, capturing both returning fans and brand new MMO players. We then launched Elysium of Legends in March, a self-developed card RPG game that brings together legendary figures in Chinese history. Shortly after these releases, both games reached the top of the iOS download chart in China. On the license front, in January, we introduced Yu-Gi-Oh! Duel Links, a competitive card game based on the nostalgic IP that we licensed from Konami. And more recently, in May, we brought the highly anticipated casual game, Pokémon Quest, to our domestic audience. Featuring Q-shaped Pokémon, the game invited players to befriend and create their Pokémon team to tap and battle through Tumblecube Islands. Shortly after its release, Pokémon Quest quickly climbed to the top of the iOS downloads chart in China. In overseas markets, we continued our efforts to expand our offerings while maintaining steady operation of our existing titles. Knives Out once again reached the number one spot on Japan's iOS top grossing chart a couple of times during the first quarter. Following a collaboration with the well-known Japanese IP, The Promised Neverland, in February, Identity V was also crowned number two on Japan's iOS top grossing chart. The success of these games has helped us to gain a much better understanding of Japanese users and their preferences, allowing us to be more sophisticated in localization efforts. For instance, we found that Japanese users greatly value the sense of occasion. Users want to feel the grandness and ceremonial appeal in each game event. Take Knives Out as an example, Knives Out Day, the widely anticipated annual celebration officially recognized by the Japanese Anniversary Association since 2019, marked the start of the game’s annual carnival on May 5, which includes the biggest e-sports championship tournament in Japan as well as other exciting activities. We invited all of our users, bringing millions of them online on that day, and the event has become one of the top trending topics on Twitter in Japan for the past two years. With a couple of titles gaining popularity and recognition already in the overseas markets today, we are hopeful that our upcoming releases will bring the next generation of games to the world stage and further expand our footprint in more regions, particularly in the U.S. and Europe. In April, we launched Infinite Lagrange in Europe. Similar to Invincible, we expect Infinite Lagrange, our first globally targeted SLG game, to ramp up its revenue gradually and show a similar upwards trend and longevity over time. This game will also be available in the U.S. and other overseas markets over the coming months. As our very first next-gen SLG, we have had it under development for a number of years. We hope that this title will extend our success in SLG into overseas markets. The highly anticipated Harry Potter: Magic Awakened is also on track to meet eager audiences. We are thrilled to bring this game to wizard fans soon, taking players around the world on a magical adventure. Earlier this month, we announced that we joined hands with our Polish partner, 11 Bit Studios, to develop and publish the mobile version of the world-renowned IP Frostpunk globally. Later this year, players will be able to access this elaborately crafted post-apocalypse social survival game on mobile platforms. In addition, we have a handful of other exciting titles in our pipeline. Adding to those we just mentioned, our pipeline also includes The Lord of the Rings: Rise To War, Nightmare Breaker, Diablo Immortal, and Ghost World Chronicle. For more details on these titles, please join our annual product launch event on May 20, which will be hosted online this year and will have a dedicated English section for our global game players and business partners for the first time. We are proud of our world-class R&D infrastructure, which has been pivotal in maintaining a competitive edge in this market and delivering long-term value. The most important element is our people. With that in mind, we encourage our talents to share and exchange ideas with industry veterans worldwide. We just hosted the 2021 NetEase Game Developer Summit in April with a three-day forum covering topics like game design, art, and technology. The event brought together our internal developers as well as external industry partners, including leaders in the Western games industry and the developers' community to share their in-depth game development philosophies and experiences, garnering wide attention from developers, gamers, and many others in the industry. Now turning to our education business, Youdao achieved strong and sustainable growth in the first quarter. Total net revenues from Youdao increased by 147% year-over-year to RMB1.3 billion, and overall gross margin significantly improved to 57%, reaching a new record since its IPO back in 2019. Gross billings from Youdao's K-12 segment was up 130% year-over-year despite a high base last year due to the outbreak of COVID-19. K-12 paid student enrollments doubled year-over-year to 306,000. In order to match the growing scale and ensure optimal teaching quality, we continue to strengthen our servicing team, which comprised 197 instructors and over 4,000 well-trained tutors by the end of the first quarter. Given that different syllabi are used in different parts of China, one of the most important agendas for us is to ensure localized content for the courses we offer. We took our junior high school Chinese as a pilot case. During the past spring semester, we launched up to 31 versions of junior high school Chinese, meeting the needs of students in 31 different provinces. The localized classes have turned out to be very effective and well-received by our students. Net revenue of Youdao's learning devices also continued a year-over-year growth of 280%. In March, we introduced a Dictionary Pen 3.0 Pro version, further supporting bilingual translation of Chinese and Korean to meet the demands of a wider range of language learners. Youdao also further integrated the functions of our dictionary pen and the Youdao Dictionary app, making the offline/online transition even more efficient and effortless. Looking ahead into 2021, we are confident that Youdao will continue to grow its position as a leading provider of intelligent learning services and products. Our diversified business models, products, and technologies will give us the upper hand in the evolving after-school tutoring and ed-tech market. For our Cloud Music business, we have come a long way, celebrating its 8-year anniversary last month. We are proud to say that we have opened up new creative possibilities for music in this digital era. Our platform, which features a vast and highly interactive content community, has become a widely recognized household name and a cultural emblem among the post '90s or younger generation. With a large base of young music lovers on our platform, we are more willing to explore and discover music. We have been the creative outlet and a natural stage for independent musicians to shine. We strongly believe independent artists are a crucial driving force for the music industry, and our platform uniquely positions us to nurture them in the modern era. In April, we held our annual signature event, the indie music artist ceremony for the third time, celebrating the past year of their music and encouraging independent musicians to continue creating their remarkable work. In addition to our original music, we want to continue bringing together a library of new, unique, and influential music from around the world, providing music fans with the ultimate audio experience. We have just announced a direct digital distribution partnership with Sony Music Entertainment, one of the world's three largest recording companies. Following UMG, this is our second direct licensing arrangement with the big three labels. We are proud to see these positive changes happening in the music industry in China. Moving on to Yanxuan. As a private label consumer brand, we further strengthened our brand appeal among the young middle class by developing products that revolve around their needs. Centered around this notion and along with Yanxuan's fifth-anniversary, we developed a new value proposition, 'live the way you like,' through a promotion intended to express the voice of the new middle class. This campaign resonated strongly with its intended audience, sparking lively discussions. During the last year, we rolled out a range of highly popular Yanxuan products, which have sold well since their introduction. Our strategy to incubate more hit products has paved a path for us to strengthen Yanxuan's product portfolio. We recently introduced a number of new star products, such as our proprietary laundry pods, wireless earbuds, and bathroom fragrance, which quickly became top-selling products on multiple platforms and some of the most recognized products in those emerging categories. We see potential in many of our proprietary products, and we are working to introduce a greater number of signature products this year. Additionally, we continue to optimize our operating efficiency in the first quarter. During the quarter, both our inventory turnover days and fulfillment efficiency were improving. In summary, we are off to a strong start in 2021. Our game portfolio is getting ready for exciting new titles for both domestic and global players, while our existing games continue to hold strong. Our online education, music and e-commerce businesses are each on solid footing. Premium and diverse content creation across our businesses continue to be our primary objective as we move forward, entering a new phase of growth and generating additional value for all of our users and stakeholders. This concludes William's comments. I will now provide a very brief overview of our first-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 first quarter were RMB20.5 billion or $3.1 billion, representing a 20% increase year-over-year. Our net revenues from online game services were RMB15 billion, up 11% year-over-year. This year-over-year increase was primarily due to increased revenue contributions from newly launched Revelation mobile game, Fantasy Westward Journey H5 as well as PC games such as Fantasy Westward Journey Online. Net revenues from our mobile games accounted for approximately 73% of net revenues from online game services in the first quarter. Youdao's net revenues reached RMB1.3 billion, up 148% year-over-year, driven by fast growth of both its online costs and sales of intelligent learning devices. Net revenues from innovative businesses and others were RMB4.2 billion for the first quarter, up 40% year-over-year, mainly due to increased contributions from NetEase Cloud Music as well as Yanxuan and PC live streaming. Our total gross profit margin was 53.9% in the first quarter, with the breakdown as follows: GP margin for our online game services was 64.6%. As a reminder, this number is generally stable, with some narrow fluctuations based on the revenue mix of mobile and PC titles as well as self-developed and licensed games. Gross margin for Youdao was 57.3%, compared with 43.5% in the same period last year. The significant growth was primarily attributable to the improved gross margin from learning services due to economies of scale and the continuous optimization effort of its cost structure. It is also due to the substantial sales growth of smart learning hardware such as Youdao Dictionary Pen, which carries a higher gross margin than other hardware product lines. GP margin for innovative businesses and others was 14.4%, compared with 15.8% in the first quarter of last year. While the margins for NetEase Cloud Music and Yanxuan have improved significantly year-over-year, the impact was partially offset by the decrease in GP margin from the rest of the business segments in this line. For the first quarter, total operating expenses were RMB6.8 billion, representing 33% of the total net revenues. Our selling and marketing expenses as a percentage of net revenue were 13.5% in the quarter. Excluding Youdao, our selling and marketing expenses as a percentage of net revenue were below 10%, lower than the previous quarter. As a reminder, fluctuations in selling and marketing as a percentage of revenue largely depend on the number of new game launches in a particular quarter. R&D expenses were RMB3.1 billion, largely stable from the previous quarter. We remain committed to investing in content creation and product development, which is core to our revenue growth. As a percentage of net revenue, R&D expenses were 14.9%, compared with 15.3% last quarter. Effective tax rate in this quarter was 22%. The effective tax rate represents certain estimates by the Company regarding the tax obligations and benefits applicable to it in each quarter. Non-GAAP net income attributable to our shareholders for the first quarter totaled RMB5.1 billion or $776 million. Our non-GAAP basic earnings per ADS were RMB7.58 or $1.16. Our cash position remains strong. As of the quarter end, our total cash and cash equivalents, current and non-current time deposits, and short-term investment balance totaled RMB106 billion, compared with RMB100 billion as of the year-end last year. In accordance with our dividend policy, we are very pleased to report that our Board of Directors has approved a dividend of $0.06 per share or $0.3 per ADS. Lastly, under the share repurchase program approved by our Board, approximately 3 million ADS have been repurchased in the first quarter for a total cost of approximately $330 million. Thank you for your attention. We would like now to open the call to your questions. Operator, please go ahead to Q&A.

Operator, Operator

We'll take our first question from Alex Poon with Morgan Stanley.

Alex Poon, Analyst

My question is about the press release. We mentioned that major titles like Harry Potter, Lord of the Rings, and Diablo Immortal will be released in the coming months. I would like to know more about the launch schedule and details for these three big titles. Thank you.

Charles Yang, CFO

Thank you, Alex. I'll answer your question directly in English. We do have very strong visibility and confidence for a rich pipeline, including highly anticipated games like Harry Potter, Lord of the Rings, Diablo Immortal, and a few others that I mentioned just now. Many of these games have already obtained the license approvals already from the regulators. Most of these games will be launched in the second half of this year. In fact, two days later, on our annual gala game day, May 20 event, we will be disclosing more details on existing games as well as some of the exciting new titles. I would encourage you and the investor community to join our event online to get more details just in two days' time, so a little bit more patience, please.

Operator, Operator

We'll take our next question from Jialong Shi with Nomura.

Jialong Shi, Analyst

Thanks, good evening management. I appreciate you taking my questions. I will start by asking my question in Chinese and translate it later. [Foreign Language] Now, I'll translate my question. In recent years, some independent game studios have successfully launched their own titles, similar to NetEase, by publishing their games independently rather than through third-party publishers. My question is whether you think the competition in China's mobile gaming market is becoming more intense? If so, how does NetEase plan to address the challenges posed by these smaller yet competitive studios?

William Ding, CEO

Okay.

Margaret Shi, IR Director

The companies you mentioned have experienced significant success in recent years, indicating that the overall environment for creativity, especially in games, is quite favorable in China. At NetEase, we have been in this industry for over 20 years. We will continue to innovate to thrive. We are also pleased with the achievements of the smaller gaming companies and remain committed to our growth and success. Thank you.

Operator, Operator

We'll take our next question from Thomas Chong with Jefferies.

Thomas Chong, Analyst

Hi, management. Thanks for taking my question. Can you comment about our online user strategies, in particular, subscription and live streaming, and any thoughts on the long format audio strategies?

Charles Yang, CFO

Okay. Thomas, I will answer your question directly in English. Yes, there have been numerous opportunities for product innovation and monetization streams centered around the music vertical. We are very encouraged by the strong and robust growth in subscription, live streaming, advertising, and new opportunities as we continue to innovate. NetEase Cloud Music, despite being eight years old, is still in a relatively early stage, so there are many possibilities ahead. Revenue growth in the various formats you mentioned has been very strong. You specifically asked about long format audio, which is a significant vertical for us. We are pioneers in this area, and the majority of our live streaming revenues come from long format audio. More competitors are entering this space, highlighting the potential upside. NetEase Cloud Music, like many other products under the NetEase brand, will aim to offer unique features powered by innovations targeting the vibrant younger generation of music enthusiasts. We are confident in both product features and monetization potential.

Operator, Operator

We'll take our next question from Eddie Leung with Bank of America.

Eddie Leung, Analyst

So my question is a follow-up on the game industry. First, congratulations on the ongoing success of the Fantasy Westward Journey and Westward Journey series. It’s interesting to note that globally, whether it’s successful PC, mobile, or console game developers, there seems to be a tendency to rely on new versions or games based on older intellectual properties. Meanwhile, some new companies are creating major iconic intellectual properties. I’m curious how, as a leading global game company, we approach this situation and if there are any insights into how we develop our game strategy. Thank you.

William Ding, CEO

It is noteworthy to see that worldwide, whether it concerns successful PC, mobile, or console game developers, there appears to be a dependence on releasing new versions or games based on established intellectual properties. At the same time, some emerging companies are creating significant new intellectual properties. As a prominent global game company, how do we view this situation? Additionally, is there any insight into how we approach our game strategy development? Thank you.

Margaret Shi, IR Director

We do not entirely agree with your comments. We think, obviously, it's important for new companies to create new IP, new titles. But we think, more importantly, it's a long-term operation of good flagship titles. From NetEase perspective, we will continue to innovate and create new games as well as maintain the long-term stability of our existing titles.

Charles Yang, CFO

And Eddie, just to add one more point, as you can witness in the past couple of quarters, when there are fewer new game launches in a particular quarter or two, NetEase's financial performance has been steady. It is, once again, something we talked about earlier. NetEase is a very unique combination of continuous innovation to come up with new titles as well as the operational know-how to extend the longevity and effective monetization of the old titles. It is because of this combination that we are able to deliver a very steady and gradually improving financial profile for over two decades.

Eddie Leung, Analyst

I guess that's very true.

Operator, Operator

We'll take the next question from Alicia Yap with Citi.

Alicia Yap, Analyst

My question is related to Cloud Music. So with NetEase now currently signing directly with all the three major music labels, will that change the overall track business of the content selection for users? And also will that help in driving the music subscription growth, any material change on the gross margin impact? And also, can management elaborate on the music strategy into the IoT partnership, any interest that you are extending the partnership with the OEM?

William Ding, CEO

My question is related to Cloud Music. With NetEase now signing directly with all three major music labels, will that alter the content selection for users? Will it also contribute to the growth of music subscriptions, and is there any significant impact on gross margins? Additionally, could management provide insights into the music strategy concerning the IoT partnership and whether there is any interest in extending the partnership with the OEM?

Margaret Shi, IR Director

As the streaming platform or social community for music enthusiasts, NetEase Cloud Music is actively seeking partnerships with content providers or label companies in order to help them promote their music in China. That's the answer to the third question. In terms of IoT or furnishing or home furnishing, again, it's another important growth area for NetEase Cloud Music.

Operator, Operator

We'll take our next question from Elsie Cheng with Goldman Sachs.

Elsie Cheng, Analyst

My first question is about international games. We noticed many exciting titles this year, and it appears that for different international markets, we have various genres, which is the first key plan to connect with the audiences there. I would like to follow up on whether we have a differentiated competitive strategy for these international markets and if there are any further details about how we're positioning ourselves. My second question concerns innovative businesses. We've observed seasonal fluctuations in the revenue contribution from innovative businesses, particularly noting that e-commerce seems to contribute more in the first quarter while the fourth quarter may see slower contributions. I want to gain a better understanding of the growth trajectory for the two main segments, e-commerce and Cloud Music. How would we describe their current positions on this growth curve? Additionally, do you have long-term targets for these segments to potentially become major growth drivers for the company?

William Ding, CEO

Could you provide more insight into the growth trajectory of your two main segments, e-commerce and Cloud Music? I'm curious about their current positions on that growth curve. Additionally, do you have any long-term goals for these segments to potentially become significant growth drivers for the company?

Margaret Shi, IR Director

Yes, we have noticed that different cultures and devices used by users in various parts of the world require us to create products that are tailored to specific regions and countries, resonating with local users. We are confident that we will find the right approach. For instance, in Japan, we already have several successful titles, such as Knives Out and LifeAfter. Recently, we launched a new PC game, NARAKA: BLADEPOINT on Steam, which has been performing well and has connected with users during the testing phase. It's primarily a combat game grounded in Chinese martial arts. We are very pleased to see that it has received a positive response from global users.

Charles Yang, CFO

And Elsie, for your second question, I'll answer that directly in English. Our newer businesses, whether it's online education, online music, or NetEase Yanxuan, are all in relatively younger phases compared to our game businesses. By and large, we think these younger business verticals have a very promising growth trajectory. They should grow faster than my game BU in general. However, when you look at each quarter, different BUs might experience different seasonality. For instance, Q1 is a traditional peak season for game performance specifically because of the Chinese New Year, whereas it's a relatively low season for e-commerce. Likewise, education also witnesses strong seasonality in the different semester courses throughout the calendar year. So all in all, don't be overly concerned about a quarterly fluctuation. When you look at an annual trend basis, both lines have been growing very strong and much faster than online game services. What we want to achieve down the road eventually is that all of our deeply incubated and cultivated verticals will have very robust and sustainable growth. As they continue to grow and emerge, what we want to appeal to the users is what NetEase has in common: premium product and service offerings with elevated user experiences. That is the corporate DNA in common across the board.

Operator, Operator

Thank you, sir. It seems there are no additional questions at this moment. I will now hand the call back to management for their 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 our Investor Relations. Have a great day.

Operator, Operator

This concludes today's call. Thank you for your participation. You may now disconnect.