NetEase, Inc. (NTES) Q2 2020 Earnings Call Transcript

NetEase, Inc. (NASDAQ: NTES) Q2 2020 earnings call dated Aug. 13, 2020

Corporate Participants:

Margaret Shi — Investor Relations

Charles Zhaoxuan Yang — Chief Financial Officer

William Ding — Founder, Director and Chief Executive Officer

Analysts:

Alex Poon — Morgan Stanley — Analyst

Alicia Yap — Citigroup — Analyst

Alex Yao — JP Morgan — Analyst

Eddie Leung — Bank of America Merrill Lynch — Analyst

Thomas Chong — Jefferies — Analyst

Presentation:

Operator

Good day and welcome to the NetEase 2020 First [Phonetic] 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 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 established by the US 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 and with the Hong Kong Stock Exchange. The company does not undertake any obligation to update this forward-looking information except as required by law.

Read management/analysts’ comments on quarterly results

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 2020 second 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 corporate website at ir.netease.com.

Joining us today on the call from NetEase’s senior management team 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 Zhaoxuan Yang — Chief Financial Officer

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. This is our very first earnings call as a public company on both NASDAQ and the Hong Kong Stock Exchange. With the support of our shareholders, this past June, we celebrated our 20th anniversary on NASDAQ and completed our listing on the Hong Kong Stock Exchange. This dual listing reminds us of our commitments to shareholders, both domestically and overseas of our deep responsibility to continue creating value for our growing base of global stakeholders.

I’m pleased to report a solid second quarter amongst challenging macro backdrop with healthy gains across each of our primary business lines. Once again, we saw steady performances from our flagship titles and franchises and rapid growth from Youdao and NetEase Cloud Music. In total, we grew our net revenues year-over-year by nearly 26% to RMB18.2 billion for this quarter, and our net income from continuing operations attributable to our shareholders grew year-over-year by 35% to RMB4.5 billion.

Our online games was up 21% in the second quarter year-over-year, reaching net revenue of RMB13.8 billion, driven by the impressive strength of our existing titles. Our flagship Fantasy Westward Journey series and Westward Journey series continues to be strong performance in the second quarter as two of the largest and longest-running game IPs in China. Both games consistently attract a loyal crowd. Adding to the success of our Fantasy Westward Journey franchise, we introduced Fantasy Westward Journey H5 in June, a more casual and light version of the legacy IP. This new addition has captivated an untapped audience, enlarging the user base of our Fantasy Westward Journey franchise even further.

While we continue to grow and strengthen our legacy franchises, many of our titles that are launched in more recent years have also shown remarkable success and sustainability for our PC game Justice celebrating its two-year anniversary, we introduced a new character in conjunction with an expansion pack in June. We are very pleased to see its popularity, propelling strong growth billions as well as record high number of both new and returning players.

Similarly, our SLG title Invincible, hit another quarter of record high revenue with strong user engagement in the second quarter. The expertise we have accumulated in SLG over the past five years with this popular title is invaluable. We are carrying on some of this expertise into building other highly anticipated SLG games in our pipeline for China and for the global market. These include titles such as The Lord of the Rings: Rise to War and Infinite Lagrange.

Onmyoji also shows remarkable longevity as we continually introduce new characters to further enlarge the reach of this IP, we are expanding our portfolio of offering in the Onmyoji family. Next month, we target to launch Onmyoji: Yokai Koya, a simulation game that has been long anticipated by the Onmyoji community. Two other new spin-off games are also in the making. Onmyoji Idol project, another simulation game and Project: World, an Onmyoji role playing game. With more and more experience in diverse game genres, we have also tapped into more diverse and larger user pools Many of these games are very popular among younger generation and are showing great longevity as well include in Life-After and Identity V.

Take Identity V as an example. This popular and young IP has gained strong traction with Generation Z users, and we are regularly in reaching this IP through a variety of initiatives including e-sports tournament, IP collaborations and offline activities that cater to this popular base of loyal users. Recently, we launched crossover characters through our collaboration with Detective Conan, a Japanese anime series, which quickly started trending in social media outlets. sparking enthusiastic discussion amongst young generations highlights in the dynamic nature of our games.

Moving on to licensed games. The strong performance of Blizzard Entertainment’s World of Warcraft, carried on well achieving a record number of peak concurrent users in the first half of this year. Beyond our progress in the domestic market, we have also made notable headway with our international initiatives. Our overseas online game net revenues hit a new record high in the second quarter, propelled by robust performances from Knives Out and Life-After in Japan. For example, our collaboration with the Tokyo Ghoul anime series for Knives Out was a huge success, with the game topping the iOS grossing chart for nearly a whole week.

Earlier today we launched EVE Echoes, a next-gen sandbox and a mobile game that has been long awaited by the user community. In addition to the success of our existing games, we have many exciting games in our pipeline with upcoming titles that include Onmyoji: Yokai Koya, The Lord of the Rings: Rise to War, Harry Potter: Magic Awakened, For All Time, Revelation mobile game, Ghost World Chronicle, Nightmare Breaker, Infinite Lagrange, Diablo Immortal and Pokemon Quest.

As for our education business, Youdao continues to scale at a rapid pace. Total net revenue rose 93% year-over-year to RMB623 million with positive operating cash flow again in this quarter. Gross billings for Youdao’s online courses tripled year-over-year to RMB542 million, driven by strong retention and larger scale marketing in the K-12 segment, which increased its gross billing 229% year-over-year. In addition to strong contributions from junior high school maths and physics, we saw more classes growing popular in the second quarter including high scholl Chinese and primary school maths. To better prepare for the new enrollments during the summer months Youdao has significantly build up its servicing capabilities, increasing its total number of instructors and tutors to 179 and 2,699 respectively. As we frequently upgrade our course development system, we are building more personalized and stratified services for students with different grade, increasing their in-class interactions.

During the quarter, net revenues of Youdao’s learning devices reached RMB86 million, up 250% year-over-year. Through continued investment in product and technology innovation, we released Dictionary Pen 2.0 Pro version with more functionality as well as Japanese and Korean languages in the past June. The product became the top selling product of its category on e-commerce platforms during the June 18 event. Looking ahead, we are well poised to continue Youdao’s growth trajectory supported by our strong technology and teaching capability, and as we further amplify our marketing assets to further bolster our student base for the second half of this year.

For NetEase Cloud Music, we continue to see triple-digit revenue growth in the second quarter year-over-year, with both membership and live streaming striking new highs. We are very pleased to have secured a multi-year licensing agreement with Universal Music Group. This directed — this direct partnership further strengthens many NetEase Cloud Music as a go-to-platform for high quality international music and marks a great step forward for China’s music industry as a whole. We are very committed to bringing the rich content to Chinese users by introducing exciting global music and incubating independent musicians.

In the second quarter, we launched numerous paid live shows for independent band giving them more options to stream online during this uncertain time. Also in this quarter, we launched Yinjie, our karaoke app, which allows one click remix capability for limitless created possibilities when seeing our app. Our users can connect through songs and common music interest and share their mood when recording. This fun and easy customizable features greatly appeal to our younger users. Additionally, our annual subscription service is now available for members of Alibaba’s customer loyalty, 88 VIP program, one of the major collaborations after Alibaba’s investment in NetEase Cloud Music last year. And we are working together to explore more possibilities for future synergies.

Turning to Yanxuan. We continued to optimize our operating efficiency in the second quarter in terms of product development, supply chain, and user experience. During this quarter, we introduced a number of popular products, significantly reduced inventory turnover days and further expanded our pro membership, who typically represent the most core and sticky users of our Yanxuan brand. As a private label, one of our key strategic goal is to increase brand awareness and the marketing appeal to a broader audience in China. During the second quarter, NetEase and Yanxuan executive hosted two live broadcasting shows in which we introduced the Yanxuan products and they were all sold out instantaneously. We also entered into new partnerships with top live streamers and KOLs, which led to a rapid growth in sales through live streaming platforms.

NetEase is best known for our content creation capabilities. This rings true across our different business segments. As we look to the second half of this year, we are more confident and committed than ever to further expanding our reach and bringing relevant exciting new products and services to NetEase players, fans and followers around the world. Games in particular with the introduction of exciting new titles and our global initiatives we are expected to lead our next wave of expansion as we continue to build value for all of our stakeholders. This concludes William’s remarks.

I will now provide a brief overview for our 2020 second quarter financial results. Given the limited time on today’s call, I will be presenting some abbreviated financial highlights. We encourage you to read through our press release issued earlier today for further details.

Total net revenues for the second quarter was RMB18.2 billion or USD2.6 billion representing 26% increase year-over-year. Net revenues from online games services were RMB13.8 billion, up 21% year-over-year. The increase was primarily driven by our flagship titles including Fantasy Westward Journey 3D, Invincible and The Fantasy Westward Journey mobile game as well as Blizzard’s World of Warcraft. Mobile games accounted for approximately 72% of net revenues from our online games services in the second quarter. Net revenues from Youdao also increased 93% year-over-year in the second quarter, reaching RMB623 million, primarily due to the increased net revenues from online courses and the rapid increase in K-12 paid students enrollment and increased sales of intelligent learning devices. Net revenues from innovative businesses and others were RMB3.7 billion for the quarter, up 39% year-over-year, mainly due to the increased contribution from NetEase Cloud Music platform.

Overall, gross margin was 53.8% in the second quarter. Gross margin for our online games services for the second quarter was 63.8%. Our gross margin for online games is generally stable, fluctuating quarter-to-quarter within a narrow band based on the revenue mix of mobile and PC as well as self developed and licensed games. Gross margin for Youdao for the second quarter of 2020 was 45.2% compared to 32.9% for the second quarter of 2019. The margin improvement trend was primarily attributable to greater economies of scale and continued optimization over the cost structure. Gross margin for innovative businesses and others was 18.5% compared to 15.8% and 15.5% for the preceding quarter and the second quarter of last year. The increase was due to primarily increased revenues from NetEase Cloud Music.

For the second quarter total operating expenses were RMB5.6 million. Our selling and marketing expenses as a percentage of net revenue were 12.8%. This quarter-over-quarter increase was mainly due to increased marketing related to new games as well as Youdao’s summer promotion spending, which is typical in the online education space. R&D expenses were RMB2.4 billion. We remain committed to investing in innovative content creation and product development. This is what defines us as a technology company. As a percentage of net revenue, R&D expenses represent 13.2% of the total revenue compared with 13.5% for the same quarter last year. We have increased, absolute dollar spent in the operating expenses. We are prudently maintaining a disciplined level of total operating expenses to the overall top line revenue. We are very confident to spend these dollars wisely to further grow the sustainable revenue growth into the near future.

Other income was RMB1.5 billion for the second quarter of 2020. The year-over-year increase was mainly due to gains from fair value changes of our investment holdings and government incentive recognized in this quarter. Effective tax rate was 18.6% for the second quarter.

Non-GAAP net income from continuing operations attributable to our shareholders for the second quarter of the year totaled RMB5.2 billion or USD739.7 million, representing an increase of 24% quarter-over-quarter and nearly 33% year-over-year. Our non-GAAP diluted earnings per ADS from continuing operations were RMB39.82 or USD5.64 for the second quarter of 2020.

Our cash position remains strong. As of June 30, our total cash and cash equivalents, current and non-current time deposits and short-term investment balance totaled RMB103 billion compared with RMB74.4 billion as of the end of last year. In conjunction with our listing on the main board of the Hong Kong Stock Exchange, we completed a global offering of 197,202,000 new ordinary shares, which comprise an international offering and the Hong Kong public offering and the full exercise of the over allotment options. Gross proceeds from the global offering before underwriting fees and offering expenses were approximately HKD24.3 billion USD3.1 billion.

In accordance with our dividend policy, we are pleased to report that our Board has approved a dividend of USD1.485 per ADS. Under the share repurchase program approved by our Board as of June 30, approximately 2.3 million ADS has been repurchased for a total cost of USD755.7 million.

Thank you for your attention. We would like now to open the call to your questions. Operator, let’s go to Q&A, please.

Questions and Answers:

Operator

[Operator Instructions] We will take our first question from the line of Alex Poon from Morgan Stanley.

Alex Poon — Morgan Stanley — Analyst

[Foreign Speech] I’ll translate my question. My first question is related to your progress in Japan. In the last couple of years, the progress has been very great. The grossing ranking has done very well. Can you share with us what’s your next milestone? What’s your next goal in Japan mobile game market? And my second question is related to Harry Potter launch. What’s the launch strategy for the game? Is it a global launch together with China and overseas? And if we have to think about the potential of the grossing of overseas versus China, which side would be stronger? Thank you very much.

William Ding — Founder, Director and Chief Executive Officer

[Foreign Speech]

Charles Zhaoxuan Yang — Chief Financial Officer

Okay. Alex and for the audience, for everyone’s convenience, I’ll quickly translate William’s remarks and apologies for the technical twitch just now. Firstly, regarding our objective for the Japanese market, it’s a very important market for our global initiatives and we have achieved a small milestone there over the last couple of years, but we still think there’s huge upside potential for us to further cultivate into the Japanese market. For instance, we are committed to even diversify more offerings, more genres obtained into that important market. With regards to Harry Potter, this is a highly anticipated game. We focus a lot more on the product itself, on the possible user reactions and feedback and their likeness of this product, whether it’s a simultaneous launch for China plus global market or at a different pace, we don’t think that’s the top priority for us. The good thing is that we’ve got approval already. So we have the flexibility. But for us, the focus is really on the products and making sure users are happy with the product when we are fully prepared, So far, the progress has been very well on track.

Operator, next question please.

Operator

Okay. We would take our next question Alicia Yap. Your line is open. Please go ahead.

Alicia Yap — Citigroup — Analyst

Hello. Thank you. [Foreign Speech] So my first question is actually regarding the margins. So, with the newly signed contract with UNG, how will that change the gross margin and cost profile for the new innovative business? And assuming you may have to pay an upfront fee on that. And also with more contracts and all that, how should that change in terms of the potential monetization. Second question is quickly is on the sales and marketing. So it seems like this quarter other expenses are bit higher than previous quarter. So, wonder if this is one-off or it will be a new norm for the rest of the second half? [Foreign Speech]

William Ding — Founder, Director and Chief Executive Officer

[Foreign Speech]

Charles Zhaoxuan Yang — Chief Financial Officer

Alicia, and for a quick translation of William’s remarks with some added comments from my end. So first of all, William commented that the multiple year [Technical Issues] in nature this changes the sub licensing format into a direct partnership. So in essence, it’s not really changing the margin trend on the business side. The big, positive impact from a direct partnership is that beyond music content, subscription revenues that we are now in a director partnership to possibly explore other formats of monetization with a record label provider and that gives us more confidence that NetEase Cloud Music would explore and try out more interesting and innovative ways of monetization potential, which in the longer term will lead to a much more healthy user experience on the platform, which then naturally would result in a much more healthy financial profile of NetEase Cloud Music.

For your second question, specifically on selling and marketing expenses. Yes, like in my earlier comment, this is represent to increase absolute dollars primarily for two reasons. One is the selling and marketing aspect for new game launches in particular, the Fantasy Westward Journey H5 game and also partly due to the summer promotion initiatives of Youdao spending, which is again, kind of a seasonal — seasonality for the overall online education industry. However, if you look some different aspects, this quarter, selling and marketing represented about 12.8% of my overall top line revenue, of course there is some gaps of spending first and reaping the sustainable revenue growth into the coming quarters. All in all, this percentage level represent a very prudent and disciplined level comparing to our historical level on an annualized basis in the last three years. Hopefully that answers your question Alicia.

Alicia Yap — Citigroup — Analyst

Okay. Yes. Thank you.

Operator

We will take our next question from the line of Alex Yao from JP Morgan. Your line is open. Please go ahead.

Alex Yao — JP Morgan — Analyst

[Foreign Speech] Thank you, management for taking my question. I have two questions. The first, wanted to follow-up on Alicia’s question on music monetization. William, you mentioned, you guys are considering to diversify the music monetization. So in addition to the current subscription based on monetization model, what are the monetization model that you guys are trying or contemplating? So that’s the first question. The second question is regarding the international gaming expansion strategy. You guys have quite a number of gaming titles with very famous of Western IP. Those games are very suitable for global, including both domestic and international publishing. So, given the current geopolitical tension between China and the US especially, what’s going on between US government and some of the China Internet companies? Would you reconsider your international gaming strategy? Let me stop here.

William Ding — Founder, Director and Chief Executive Officer

[Foreign Speech]

Charles Zhaoxuan Yang — Chief Financial Officer

So, Alex, I’ll provide a brief translation of William’s remarks. For the first question on the possible monetization format around NetEase Cloud Music, obviously that would require some innovation. There are certain monetization format that’s been proven, but what’s more interesting is what are the other more innovative ways that the online music streaming industry can further explore. We are very confident on that front, because that’s our DNA on content development innovation and the one commitment that’s unchanged is that we are dedicated to invest more resources and capability into native content into supporting independent musicians to create a more healthy and sustainable industry trend for China music industry by and large.

Second question. We recognize the complexity around the current background of geopolitical uncertainty. But what we believe as a content developer is that, high quality content, great game content, is universally appealing. This is universal and we are committed to remain highly selective and serious in developing good game content not only for Chinese users, but for the global audience. We think as long as we are committed and focused on content development, and a universally appealing content goes beyond geopolitical complexity.

Operator, next question please.

Operator

Okay. We will take our next question from the line of Eddie Leung from Merrill Lynch. Your line is open. Please go ahead.

Eddie Leung — Bank of America Merrill Lynch — Analyst

[Foreign Speech] So I’ve got two questions. The first one is about the Cloud Music thesis. How do you think about the positioning of the short-video companies in the online music market in the long-term. It seems like some of these are sub-medium companies have been adding music related video contents to the platforms. So just I wonder whether they might become competitors in the long-term. And then secondly is about the performance of your legacy hit games. Some of them still generating free good revenue and even seeing some growth. So in general, would like to know whether it’s more driven by paying user growth or ARPU growth. Thank you.

William Ding — Founder, Director and Chief Executive Officer

[Foreign Speech]

Charles Zhaoxuan Yang — Chief Financial Officer

Eddie, I will provide a brief translation of William’s remarks. Firstly on your question, we believe short-format video and music actually are very synergistic verticals. However, they are fundamentally different, because usually for short-format video, firstly it is short. It’s usually less than a minute, whereby a full complete song typically requires three to four minutes of listening. So and also short-format video usually takes the highlight part of a particularly strong, and as a predominantly UGC content platform it’s highly dependent on the music or the background music, whereas the product itself doesn’t require so much of a professional touch. On the other hand, on the music platform it’s mostly PCC or professional content creation, and it’s a much longer format. So short-format video is a very, very conducive channel to promote a high quality music content. However, if you are a user — as a true music enthusiast who wants to enjoy the full length of the song, the kind of the music oriented patch, then short-format video cannot replace the importance and relevance of the music platform. That’s how we look at the relationship of the two. We do not think it is a replacement per se.

Secondly on the game growth William’s remark is that, he does think that the spending habits or the structural changes is that more users are willing to pay now, pay for high quality content, pay for a better experience in the games that would mean as a whole, the number of overall paid users is on the increasing trend. At the same time for games, at least for certain genres of the games, you would also note a very distinct polarization of the spending pattern. Some people are more like such — a kind of a subscriber right. They spend, not so much but they spend consistently, whereby some users spend a lot more on certain games and typically for these types of games, they are more picking, they are more selective on the highest quality of the games, best in-game experience. So by and large we think number of users are going to grow.

ARPU may not necessarily grow at the same noticable trend. However, if our content is relevant and represents a higher quality of the respective genre, we have the potential to grow both the ARPU as well as the number of the users in our — on our products.

Operator, next question please.

Operator

Okay. We would take our next question from the line of Thomas Chong from Jefferies. Your line is open. Please go ahead.

Thomas Chong — Jefferies — Analyst

[Foreign Speech] Thanks management for taking my questions and congratulations on a very strong set of results. I have a question about our overseas games strategies. Given that we have IP licensing, we have our strong in-house development as well as we get the cash proceeds coming from our Hong Kong listing. So how would be — think about overseas strategies in terms of M&A, IP licensing as well as in-house development? Thank you.

William Ding — Founder, Director and Chief Executive Officer

[Foreign Speech]

Charles Zhaoxuan Yang — Chief Financial Officer

Okay. Thomas, I’ll provide a brief translation. So we actually with Hong Kong IPO. It doesn’t really change our mentality or approach towards a content focused global initiative. We are always very active and open-minded on all the strategies you mentioned. Actually, there is no force ranking in terms of priorities. IP licensing represents a very, very critical element of our global initiative, because that show — is the endorsement of our content creation capability, operation publishing capability. At the same time self development remains the core of our competence. M&A, we are very oportunistic, but we are also highly open-minded and active particularly in genre that supplementary to our core in-house R&D capability.

Thomas Chong — Jefferies — Analyst

[Foreign Speech] Thanks, William and Charles. I have a follow-up question. It is about the paying ratio and ARPU. If we try to compare Japan versus China. So we expect China is heading towards the Japan level in the long run. Thank you.

William Ding — Founder, Director and Chief Executive Officer

[Foreign Speech]

Charles Zhaoxuan Yang — Chief Financial Officer

Okay. Thomas, I’ll provide again a translation of William’s remarks. So first of all, it is very common that different geographies, different economies, demonstrate different kind of consumer behavior. But on the longer term trend, we do see that the Chinese consumers’ willingness to spend and the ability to spend is on the rising trend. One — for instance one small example, if you look at today, the cost of a movie ticket in China is already comfortable to a movie a cinema movie ticket spending in the state. Just a decade ago, there was a huge gap right for some of us. To recall, there is a huge gap, which means Chinese consumers are more willing to pay entertainment as Chinese economy further advance, people are more willing to pay a broad format of entertainment to enrich the lifestyle. We think that trend is on the rise.

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Operator, I think in the interest of time, let us wrap up this call.

Operator

Okay. Due to time limit that concludes today’s question-and-answer session. At this time, I will turn the conference back to Margaret Shi for any additional closing remarks.

Margaret Shi — Investor Relations

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

Charles Zhaoxuan Yang — Chief Financial Officer

Thank you, everyone.

Operator

[Operator Closing Remarks]