Earnings Call Transcript - NTES Q4 2021

Operator, Operator

Good day, and welcome to the NetEase 2021 Fourth Quarter And Full Year 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, ma’am.

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 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 the website of the Hong Kong Stock Exchange. The company does not undertake any obligation to update this forward-looking information, except as required by law. During today’s call, management will also discuss certain non-GAAP financial measures for comparison purposes only. For a definition of non-GAAP financial measures as a reconciliation of GAAP to non-GAAP financial results, please see the 2021 fourth quarter and the full year 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 corporate website at ir.netease.com. Joining us today on the 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 remarks on behalf of William.

Charles Yang, CFO

Thank you, Margaret, and thank you everyone for participating in today’s call. Before we begin, I would like to remind everyone that all percentages are based on RMB. 2021 was an eventful year for NetEase in online games; we introduced a number of prolific games, breaking new records in various categories for Youdao. We quickly and successfully restructured our business in line with the new regulations in the online education industry and Youdao is now ready for its next phase of growth. For our Cloud Music business, we are extremely pleased to have completed an initial public offering on the Hong Kong Stock Exchange in December. We look forward to growing this business further with augmented content and features to create and bring more quality music to our users. For online games, we finished the year with strong project revenues coming in at RMB17.4 billion representing 30% year-over-year growth. Our flagship titles continue to demonstrate strong year-over-year growth after two decades of operations. The revenues from our Fantasy Westward Journey and Westward Journey Online saga continue to grow remarkably at double-digit rates year-over-year, further strengthening their positions as China’s biggest MMO titles. In terms of our new game launched during the year, Naraka: Bladepoint was a clear standout with international success. The game quickly broke the sales record for buy-to-play games made by Chinese developers and gained acclaim as a top seller on Steam’s Best of 2021 games list. Some of the excitement surrounding Naraka: Bladepoint in the fourth quarter followed our rollout of content updates. For example, in our crossover with Bruce Lee, we brought a series of themed items based on the legendary martial arts figure into the Naraka world, allowing players to unleash the fury of the dragon against their opponents and invigorating the global player community. Keeping our games fresh with frequent updates, Naraka: Bladepoint's user base continues to hit new records. The strong engagement and retention we are seeing today brings us great confidence that Naraka: Bladepoint will continue to attract users from all over the world. We are now working diligently to bring players the console version and mobile version of the game, which we look forward to bringing to our players in the very near future. The highly anticipated release of Harry Potter: Magic Awakened also took the market by storm as one of the most successful games in China last year, attracting millions of players and dominating both top download and grossing charts in China, following its launch in September. Harry Potter: Magic Awakened utilizes the best-in-class development capabilities of NetEase games to bring players a captivating gameplay experience with compelling features and an in-depth collectible card system and beautifully crafted art style. After a strong debut in September, we continued to extend the game's popularity by frequently rolling out captivating updates that bring users fresh gameplay, cosmetic items, and cards every month. The game rose to the top three positions multiple times on China’s iOS top grossing game chart during the fourth quarter. We share equal excitement for the overseas versions of Harry Potter: Magic Awakened and our localization for other geographies is progressing smoothly. Two weeks ago, we kicked off closed beta testing for overseas players. Leveraging the talents of two gaming and online entertainment powerhouses, we will work very closely with Warner Bros. Games to co-publish this amazing game globally, including in the U.S., Europe, and Japan later this year. We believe worldwide audiences will be delighted to embark on immersive adventures, taking a fantastical journey into the wizarding world of magic and infinite possibilities. In addition to these two blockbuster games, we are proud to have also launched a number of other titles in various brand new genres, growing our reach with new players and opening up new possibilities. We launched Ace Racer in July, our very first self-developed racing game. Ace Racer’s realistic art style and real-life racing tracks create an exciting and differentiated racing experience. Players can travel to Hangzhou, Chongqing, and other places to enjoy the unique and beautiful scenery. The strong viewership of Ace Racer marks another leap in our genre expansion, giving us more confidence in our ability to create successful titles outside of our comfort zone. Infinite Lagrange, our space-themed SLG game launched in the third quarter, is a great example showcasing how we expand SLG genres with its strong debut in China as one of our next-generation SLG titles. Infinite Lagrange features an iconic space simulation experience, captivating hardcore sci-fi players with its intense and exciting travel through time and space. After six months of operation, Infinite Lagrange continues to show a healthy upward trend with gradually ramping revenue. With our strong R&D capabilities and relentless pursuit of innovation, we are constantly looking to break into new territories, capturing new users that reach beyond our traditional genres. Moving into 2022, we have an abundance of new pipeline projects planned for Naraka: Bladepoint and Harry Potter: Magic Awakened, as well as a number of other strong titles ready for launch in China and globally. Diablo Immortal has been long anticipated by players worldwide. In our pursuit of top quality, the game has taken great efforts to create and refine. We strive to bring our players the most authentic Diablo experience by restoring the popular combat style and immersive exploration features, while also creating a new story and gameplay for the mobile platform. Luckily for players, the wait is almost over. We have concluded the latest round of testing in January with highly positive feedback from players in both China and overseas markets. We are on track for its global launch this year, and in China alone, we already have over 10 million players preregistered for this exciting title. Additionally, Ghost World Chronicle, our self-developed Chinese style sci-fi RPG, is also in development. We creatively integrated sci-fi style with elements from modern cities and traditional Chinese culture, creating an engaging Chinese style sci-fi world with a distinct artistic style. We are diligently working on its development. I’m hoping to bring a fresh and differentiated RPG experience to players. In the overseas market, we will be launching Dead by Daylight Mobile in Asia, which is the mobile version of the famous asymmetrical battle arena PC game. We have worked jointly with Behavior Interactive to build this mobile version, and we are confident that players will find unrivaled asymmetrical competitive experiences following the game's release in the coming months. As we create a larger presence on the international stage with our top-quality games, we are also attracting global top talents into NetEase. In January, we announced that we have teamed up with master producer Toshihiro Nagoshi, former producer of Yakuza, one of the most famous and best-selling game franchises in Japan. Together we are building Nagoshi Studio in Tokyo for the development of high-quality games for global audiences. We are committed to unleashing the potential of creativity in an open and inclusive environment. The new studio will have full authority to manage and create the kinds of games that they are passionate about, and we will be there to provide support. Over the past few years, we have also attracted top producers, including Tetsuya Akasaka and Goichi Suda. With these top talents joining us, we will gain new inspiration and a global vision to reach passionate gamers around the globe with high-quality and engaging content. Now turning to Youdao, we have completed a smooth business transition in compliance with requirements from regulators and achieved steady growth throughout 2021. Total net revenues for Youdao were RMB1.3 billion in the fourth quarter, representing 21% year-over-year growth. Additionally, we achieved positive non-GAAP net income for the first time since our IPO, along with a continuing operating cash flow inflow of RMB142 million. In the fourth quarter, we continued to upgrade our steam cost offerings. Gross billings from Youdao Go and Youdao wage fee increased by around 130% year-over-year. Recently we launched Youdao game academy, which enables Go and chance learning through AI or person-to-person matches. Complementary to our online offerings, we opened our first offline theme center in Beijing last November, offering courses such as Youdao Go, Youdao Icon programming, and Youdao Drosophila Science to help improve children’s skills in logical thinking and explore the scientific world. We expect to expand the learning center with more diversified content in the coming periods. Growth momentum from our leading smart devices also remains strong with new and improved content and features. Net revenues from the segment grew 34% year-over-year to RMB317.7 million in the fourth quarter. Through a partnership with the commercial press Zhonghua, the oldest and most influential publishing agency in China, exclusive content, including that from the Xinhua Dictionary, was added to our Dictionary Pen. Additionally, in our new upgraded pro version of the Dictionary Pen, personalized writing assessment and improvement suggestions are available for students at various stages of learning based on vocabulary, grammar, and composition. These features are powered by our strong AI technology, such as optical character recognition and natural language processing. As for education digitization solutions, we have secured strategic partnerships with a number of local municipalities, including various districts and recently Suzhou, to provide schools and teachers with our Youdao smart learning terminal and solutions, empowering them to effectively track students learning progress and optimize teaching guidelines. Turning to our Cloud Music business, throughout the year we continue to make progress on our financial, operational, and corporate goals. The various product and content enhancements we made strengthened our overall position amidst a healthier industry environment. MAU of online music services remained stable in 2021. In the fourth quarter, net revenues increased 24% year-over-year to RMB1.9 billion, with a continued increase in membership paying ratio. We managed to improve profitability along with enhancements to our content library, attributed to copyright cost optimization. In the fourth quarter, we enhanced our margins both year-over-year and quarter-over-quarter, achieving positive growth margins for the full year of 2021. To foster our growth within the growing music community, we continued our product innovation initiatives in the fourth quarter. Some of our upgrades included more personalized capabilities on the homepage. Users can now better showcase their personalities and music preferences. We also added a new music co-notation function in November, providing music enthusiasts with professional and accurate scores and services across our music offerings. In addition, we launched our brand new beat trading platform in mid-December, accommodating transactions between beat makers and musicians, as well as music fans. The beat platform has the potential to not only allow beat makers to realize commercial value but also liberate individual musicians in creating content, enriching our ecosystem, and bonding our users together even more. On the content side, we secured more high-quality music from large IP owners and continued to nurture independent artists. By the end of the fourth quarter, we were servicing more than 400,000 independent musicians. Meanwhile, we have been making progress on our initiatives to produce music in-house, which further diversifies and differentiates our content offering. Going forward, we hope to bring more quality content to our platform, complementing our music library while working together with other industry players to benefit all music lovers. Moving on to Yanxuan, as one of the most loved lifestyle brands catering to the new middle class in China, NetEase Yanxuan is redefining the lifestyles of China’s younger generation by intensifying our focus on certain categories. We continue to launch a variety of key popular products across core categories, including food, electrical appliances, household cleaning, pets, and beauty and skincare. Our useful design-led approach has enabled the products on our platform to gain increasing appeal with younger consumers. As we grow each of our businesses, we are also very conscious of their effects on society, and our emphasis on ESG initiatives has greatly increased over the past years. We are honored to have our efforts acknowledged by MSCI, who upgraded our ESG rating to an A. In addition, we scored 39 points on the Dow Jones Sustainability Indices (DJSI), more than doubling our score in the prior year. On Sustainalytics’ ESG risk assessment scale, NetEase received a score of 14.9 points, indicating a low level of ESG risk. We are recognized by Sustainalytics as an industry top-rated ESG company and also a regional top-rated ESG company. Along with our leading privacy and data security policies and human capital development practices, we’ve made concerted efforts to reduce our carbon emissions, improve our corporate governance and make increased contributions to charitable causes. The global pandemic and environmental challenges have prompted many to find ways to do more for society, and we are no exception. Adding to our recent disaster relief donations following the floods in Zhengzhou and Henan, we also donated an additional RMB10 million to help local residents in Henan in the wake of COVID-19. With our solid financial reserves and continued strong performance, improving shareholder returns is always on our agenda. During 2021, we repurchased around $2 billion worth of shares and paid $551 million in dividends. All in all, we are pleased with our growth in 2021, gaining steady ground across each of our verticals and positioning NetEase for continued growth in 2022. Our focus on content creation and elevating user experiences with NetEase products and services remains our top priority. Moving ahead, we will continue to innovate, diversify and expand our reach to generate further value for our users and investor communities as a whole. This concludes William's comments. I will now provide a very brief review of our 2021 fourth quarter and full-year 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 more details. Total net revenues for the year were RMB87.6 billion or $13.7 billion, representing a 19% increase year-over-year. We closed the year with fourth quarter revenue of RMB24.4 billion or $3.8 billion, representing a 23% increase year-over-year. For 2021, our net revenues from online game services were RMB62.8 billion, up 15% from 2020. Revenues accelerated even faster in Q4 to RMB17.4 billion, up 30% year-over-year. This additional growth was primarily due to increased revenue contributions from the launch of new games, such as Naraka: Bladepoint and Harry Potter: Magic Awakened. Net revenues from our mobile games accounted for approximately 68.3% for the full year and 70.4% for the fourth quarter. Youdao’s net revenues for 2021 reached RMB5.4 billion, up 69% year-over-year. On a quarterly basis, net revenue increased by 21% to RMB1.3 billion in Q4. Both increases were driven by fast growth of both Youdao learning services, as well as increased sales of smart devices. Net revenues from NetEase Cloud Music were RMB7 billion for the full year, up 43% year-over-year. Q4 net revenue from Cloud Music increased 24% year-over-year to RMB1.9 billion. Both increases were primarily due to increased revenues from social entertainment services, particularly audio-based live streaming and paid user expansions. Total revenues for innovative businesses and others were RMB12.4 billion for the year, up 13% year-over-year. For the fourth quarter, total revenues were flat year-over-year at RMB3.8 billion. Our total gross profit was 53% in the fourth quarter compared with 50.2% in Q4 of last year. Looking at our fourth quarter margin in more detail, gross profit margin for our online game services remained stable at 64.1%. 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 the revenue mix of self-developed and licensed games. Gross margin for Youdao in the fourth quarter was 50.7%, compared with 47.5% in the same period of the prior year. The growth was primarily attributable to our improved learning services gross margin, due to improved economies of scale and continuous optimization of our faculty compensation structure. The substantial sales growth of smart learning hardware, such as the Youdao Dictionary Pen 3.0, also contributed to these gains. Gross profit margin for NetEase Cloud Music was positive at 4.1%, versus a negative margin of 7.1% in the year-ago period. This is our third consecutive quarter of positive gross margin. The significant increase was primarily due to the strong top-line growth as well as improved cost control measures. Gross profit margin for innovative businesses and others was 26.8% compared with 28.2% in Q4 of 2020. The decrease was mainly due to the decreased GP margin from advertising services. For the full year, total operating expenses were RMB30.6 billion or 35% of our total net revenues. For the fourth quarter, total operating expenses were RMB8.3 billion or 34% of net revenues. Looking at the fourth quarter, selling and marketing expenses as a percentage of net revenues were 13.5% compared with 14.1% in the prior quarter. The quarter-over-quarter decrease was mainly due to decreased marketing spending related to Youdao. R&D expenses were RMB3.8 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 and sustainable future. The effective tax rate was 19.6% for the full year and 14.2% for the fourth quarter. As a reminder, the effective tax rate is presented on an accrual basis and varies from each of our entities at different time periods, depending on applicable policy and our operational results. Our non-GAAP net income attributable to our shareholders for the fourth quarter of 2021 totaled RMB6.6 billion or $1.04 billion. Non-GAAP basic earnings per ADS for the quarter was $1.858 or $0.32 per share. Our cash position remains strong. As of the year-end, our total cash and cash equivalents, current and non-current time deposits, and short-term investment balances totaled RMB103.4 billion compared with RMB100.1 billion as of December 31, 2020. In accordance with our dividend policy, we are pleased to report that our Board of Directors has approved a dividend of $0.081 per share, or $0.405 per ADS. Lastly, under our share repurchase program, approximately $18.5 million ADS had been repurchased as of December 31, 2021, for a total cost of approximately $1.8 billion. Meanwhile, under the NetEase Youdao Go share purchase program, approximately 0.6 million ADS have been purchased for a total cost of $8.2 million as of the year-end. Thank you for your attention. We’d now like to open the call to your questions. Operator, please go to Q&A.

Operator, Operator

Thank you. We’ll take our first question from Jialong Shi with Nomura.

Jialong Shi, Analyst

Good evening management. Thanks for taking my questions. Congratulations on the solid quarter. My question is about the game pipeline. I would like to know if management can provide an update on the latest game pipeline for this year, specifically how many of the new games have already received licenses and will be released this year. Also, regarding one of the new games, the upload model, which has already received the license in China, can management provide an update on its launch timeline? Thank you.

William Ding, CEO

Sure. We are aiming to launch Diablo in the first half of this year, and we have already received the license approval for it. We will launch it in China as well as globally. Additionally, we will also release and introduce the overseas versions of Harry Potter. Thank you.

Operator, Operator

Thank you. We’ll take our next question from Kenneth Fong with Credit Suisse.

Kenneth Fong, Analyst

Thank you to the management for addressing my questions, and congratulations on achieving another strong set of results. With the success of Harry Potter: Magic Awakened in China, what is our perspective on the game's longevity, as well as our strategies and timeline for overseas launches? Thank you very much.

William Ding, CEO

At NetEase, we have significant experience in managing our games over long periods, with examples like Onmyoji. For Harry Potter, the game's longevity depends heavily on the amount of content available to players. We will continue to provide exciting content to keep our users engaged. We aim to launch the overseas versions around the middle of the year. Thank you.

Kenneth Fong, Analyst

Thank you.

Operator, Operator

Thank You. We’ll take our next question from Alicia Yap with Citi.

Alicia Yap, Analyst

Hi, thank you. I have two questions. The first is about the metaverse. Can management share their thoughts on the metaverse? Would you consider incorporating some metaverse elements into existing games or releasing additional versions of those games in a metaverse environment? The second question pertains to Cloud Music. Can you provide insights on the pricing trends for the subscription and the overall growth target for subscriptions, as well as the margin trends for the business? Thank you.

Charles Yang, CFO

For the metaverse, we believe it represents the connection between the virtual world and reality. At NetEase, we have extensive experience in operating MMORPG games that feature significant social interactions and complex economic systems, which can serve as a model for the metaverse. We will continue our work in this area and explore potential new games for the metaverse using our current technology. Thank you. Regarding Cloud Music, we aim to grow by offering a wide range of content. A key focus for us is to produce high-quality, exclusive content, much of which will be created in-house. We are confident that this strategy will help us provide exceptional Chinese pop music to our consumers. This content strategy is central to our growth and expansion efforts. Thank you.

Operator, Operator

We’ll take our next question from Natalie Wu with Haitong International.

Natalie Wu, Analyst

I will translate briefly. Thank you for taking my question and congratulations on a solid quarter. This upcoming year will be crucial given the strong names in your pipeline. My question is about the headcount plan for this year. Which business line has the most significant talent growth plan, and which regions are your primary target markets for global expansion? Thank you.

Charles Yang, CFO

In terms of our headcount plan, our focus this year will be on global talent. As we mentioned in our prepared remarks last year, we attracted many top talents globally, and we will continue to invest in this area. Very soon, you will likely see more global talent joining NetEase. Regarding hiring plans in China, there should be no change from previous years. Thank you.

Operator, Operator

We’ll go next to Thomas Chong with Jefferies.

Thomas Chong, Analyst

Thanks management for taking my questions. Can we discuss the upcoming new games to be developed on multiple devices like console, PC, and mobile, targeting global audiences in different regions? My second question is about our core competence in consistently developing high-quality games like Harry Potter and Naraka. Thank you.

William Ding, CEO

Okay, thank you. So, Thomas, in terms of new types of games, in addition to mobile games, consoles will also be an important area for us. Any media you can imagine playing games on is an area that we want to explore. That is where we want to create game content. In terms of regional focus, both China and international markets are very important to us, with overseas being our next new focus. Regarding your second question on our core competence, over the last two decades, you can see that NetEase is a company that’s very focused and dedicated to content creation. We value our talents, and we are highly quality-driven. When we think about creating games, we’re considering not only the Chinese market but also looking at global markets. Talent is perhaps the most essential factor for our sustainable growth, and we want to continue to attract and retain talents who share our passion for game creation. Thank you.

Thomas Chong, Analyst

Thank you.

Operator, Operator

We’ll take our next question from Alex Poon from Morgan Stanley.

Alex Poon, Analyst

Thank you for management for taking my question. I have two questions. The first is about our legacy titles. Recently, the macro environment has not been very good, and consumption advertising has been weak. Does this weaker macro environment impact our legacy titles, particularly those with high-paying users? Additionally, there have been some daily limits on loot boxes; does this change influence the growth of our legacy titles? My second question concerns the status of Lord of the Rings and the Roblox-like platform we discussed in December. Is there any possibility that these two games will be released in Asia in the first half? Thank you very much.

William Ding, CEO

So, Alex, regarding your first question, our legacy titles are actually experiencing strong growth throughout last year. The price reduction you mentioned has had minimal impact on us because we've been very cautious in how we monetize. For games like FWJ, which is a time-based game. For your second question about Lord of the Rings, we intend to release that game in Hong Kong, Macau, and Taiwan. We are also working on some games focused on user-generated content that will be introduced to the players.

Alex Poon, Analyst

Thank you very much.

Operator, Operator

Moving next to the next topic.

Unidentified Analyst, Analyst

Thanks to the management for addressing my question, and congratulations on your excellent performance. My question is about the expected impact of Activision, which was acquired by Microsoft, on their collaboration with NetEase, particularly concerning the past licenses of games and your work on Diablo and potential future IP licenses. Thank you.

William Ding, CEO

Yes. Both Microsoft and Activision Blizzard have maintained a close partnership with NetEase over the years, and we have worked together on Minecraft, achieving strong results. We congratulate Microsoft and Activision Blizzard on their collaboration. Microsoft is among the largest gaming platforms globally, while Activision Blizzard is one of the top game developers. We believe that their partnership will generate significant synergy and positively influence the gaming industry. In China, NetEase has strong ties with both companies, and we are confident that the collaboration between Microsoft and Activision Blizzard will also benefit us in this region. From our viewpoint, we are eager to explore additional opportunities to collaborate with Microsoft. Thank you.

Operator, Operator

Thank you. I’ll take our next question from Guanran Wang with CITIC.

Guanran Wang, Analyst

Hello. Can you hear me? Yes. Under the current situation in the gaming industry, we have observed that many gaming companies have optimized their resource allocation. I would like to ask how well-developed are the key game categories within the current gaming market, and what are your strategies regarding resource allocation and the feature pipeline structure?

William Ding, CEO

It has been a while since we saw new license approvals for NetEase; however, we are already a game content creator and have been preparing for the overseas market for a long time. Over the past couple of years, we've seen some highly successful games in Japan and have attracted some of the biggest global talents to NetEase. We are committed to investing in global markets. Hopefully, in the next two to three years, you will see some huge blockbuster titles produced by NetEase on the global stage, whether self-developed by us or in partnership with some of our partners. Over the last 20 years, we have accumulated significant experience in game development in terms of marketing operations and R&D engines, and all of those years provide us a strong edge in creating globally successful games. Thank you.

Operator, Operator

That will conclude our question-and-answer session at this time. I’d like to join the call back over to management for any additional or closing remarks.

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 TPG investor relations. Thank you. Have a great day.

William Ding, CEO

Thank you, everyone.

Operator, Operator

That will conclude today’s call. We appreciate your participation.