NetEase, Inc. (NASDAQ:NTES) Q1 2021 Results Conference Call May 18, 2021 8:00 AM ET

Company Participants

Margaret Shi - Investor Relations-Director
William Ding - Chief Executive Officer
Charles Yang - Chief Financial Officer

Conference Call Participants

Alex Poon - Morgan Stanley
Jialong Shi - Nomura
Thomas Chong - Jefferies
Eddie Leung - Bank of America
Alicia Yap - Citi
Elsie Cheng - Goldman Sachs

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

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

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 up Onmyoji's position as a top ACG game in China. Celebrating its third year anniversary in April identifies, continues to draw the attention of young players bringing them a thrilling competitive experience with a distinctive gothic art style.

Between January to 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 new ones since the beginning of this year. We started with 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 car 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 market, 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 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, brought 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 with time. This game will be next available in the U.S. and other overseas markets over the coming months.

As our very first next-gen SLG, we have 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, two days later, 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 foreign covering topics like game design, art and technology. The event brought together our internal developers as well as external industry partners, including gurus in the Western games industry and developers community to share their in-depth game development philosophies and experiences, starting wide attention from developers game players 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 the optimum teaching quality, we continue to strengthen our servicing team, which comprises 197 instructors and over 4,000 well-trained tutors by the end of the first quarter.

Given that different syllabus is used in different parts of China, one of the most important agenda for us is to ensure localized content for cases 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 very welcomed 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 languages to meet the demand of a wider range of language learners. Youdao also further integrated the functions of our dictionary pen and the Youdao Dictionary app, making the off-line/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. And 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 certain creative new 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 that is seen as a cultural emblem among particularly 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 pieces from around the world and 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 a second direct licensing arrangement that we have signed with the big three labels. And 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, developing products that revolve around their needs, centered around this notion and along with Yanxuan's fifth year 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, starting 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 smooth path for us to smooth 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 earbud, 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 the 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 as well. 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 contribution 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 games 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 contribution from NetEase Cloud Music as well 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 fluctuation 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 of last year. The significant growth was primarily attributable to the improved gross margin from learning services due to the economies of scale and the continuous optimization effort of its cost structure. It is also due to the substantial sales growth of the 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 first quarter of last year. While the margins for NetEase Cloud Music and Yanxuan has improved year-over-year significantly, 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, was 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, fluctuation in selling and marketing as a percentage of revenue largely depends on the number of new games launches in a particular quarter. The genres risk they are in and the most suitable marketing plan adopted for each new game launches.

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 noncurrent 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 has 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.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Alex Poon with Morgan Stanley.

Alex Poon

My question is regarding the press release. We have mentioned these big titles, Harry Potter, Lord of the Rings, Diablo Immortal will be coming in the next few months -- in the coming months. So, I'd like to understand about the launch schedule and details around these three big titles. Thank you very much.

Charles Yang

Thank you, Alex. I'll answer your question directly in English. We do have very, 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. And 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

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

Jialong Shi

Thanks. Good evening management. Thanks for taking my questions. I will ask my question first in Chinese. I will translate myself later.

[Foreign Language] So, I will translate my question. In recent years, there have been some independent game studios which were able to launch very successful self-developed titles. Just like NetEase, these new game studios also published their games on their own instead of going through third-party publishers. So, my question is do you think in China's mobile gaming space, the competition is becoming more intense? And if that is the case, how does NetEase plan to cope with the challenges from these small but quite competitive game studios?

William Ding

[Foreign Language] Okay.

Margaret Shi

You mean -- the companies that you mentioned have had great success in the recent years. It means that the overall environment for creativity, especially in games, is very good in China. At NetEase, we have been a business for over 20 years. We will continue to innovate to thrive. And we are happy with -- for the success that the smaller gaming companies have achieved, and we will continue to rise and continue to exceed. Thank you.

Operator

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

Thomas Chong

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

Okay. Thomas, do you want to translate your question in English? Okay. Thomas, I will answer your question directly in English.

Yes, there are -- as we've been mentioning in the past couple of quarters, there are plenty of possibilities in terms of product innovation, in terms of monetization streams that centered around this music vertical. And we are very encouraged to see strong continued and robust growth in both subscription, live streaming, advertising, and new possibilities as we continue to innovate and try out.

So right now, NetEase Cloud Music, despite the fact that it's been eight years old now, it is still in its relatively early nascent stage. So, lots of possibilities. Revenue growth in the multiple formats that you mentioned have all been very strong. And specifically, you asked about long format audio. That's a very important vertical. In fact, we are a forerunner and the pioneer in this particular long format audio. Majority of our live streaming revenues actually come from long format audio.

And there are more players that's been following suit and coming into this vertical. It has just proven one more time that how the potential upside of this vertical, and I think NetEase Cloud Music, just like many other product lines under the NetEase brand umbrella, will focus on unique product features powered by product innovations, targets specifically to this vibrant younger generation of music enthusiasts. With that, we are actually very confident on multiple fronts both in terms of product features as well as monetization potential.

Operator

[Operator Instructions] We'll take our next question from Eddie Leung with Bank of America.

Eddie Leung

[Foreign Language] So my question is actually a bit of a follow-up on the game industry. So number one, congratulations on the continuous success of Fantasy Westward Journey and Westward Journey series. But it seems to be interesting to observe that globally, no matter whether it's a successful PC, mobile, or console game developers, it seems to be relying to some extent, new versions or new games on some of the old IPs while actually some of the new companies are able to come up with big iconic IPs. So, just wondering as a leading global game company, how we think about this kind of like issue? And is there any indication when we developed our game strategy? Thank you.

William Ding

[Foreign Language]

Margaret Shi

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 do what we are doing. Over the past years, we've launched a number of very great innovative industry-leading titles, including in Onmyoji, Justice and NARAKA: BLADEPOINT, to name a few. So, we think we will continue to do what we're doing and to create new games as well as maintaining a long-term stability of our existing titles.

Charles Yang

And Eddie, just to add one more point, as you can witness in the past couple of quarters, when there are fewer new game launch in a particular quarter or two, NetEase financial performance has been steady. It is, again, something we talked earlier in the past. NetEase is a very, 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 very steady and gradually improving financial profile for over two decades.

Eddie Leung

I guess that's very true.

Operator

[Operator Instructions] We'll take the next question from Alicia Yap with Citi.

Alicia Yap

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

William Ding

[Foreign Language]

Margaret Shi

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

Operator

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

Elsie Cheng

My first question is about international games. We noticed that there are a lot of exciting titles for this year. And it seems for different international markets, we actually have different genres. That's the first of the key plan to touch base with the audiences over there. So I just want to follow up a little bit more here that, when we're thinking about different international markets, do we actually have the sort of differentiated competitive strategy? And then if there are any further detailed color on how we're positioning ourselves, that would be great.

And then the second question is on innovative businesses. We noticed the seasonal fluctuation in contribution to the revenue of the innovative businesses. And fourth quarter could be -- sorry, the quarter where maybe e-commerce is contributing is contributing more in the first quarter is slow. So I just wanted to understand a bit more so in terms of the growth curve of the two major lines, one is e-commerce, one is the Cloud Music, how would we describe the growth curve and where they are currently on that growth curve for these two? And in the long term, do you have any targets for them to sort of potentially become another major growth driver for the Company?

William Ding

[Foreign language]

Margaret Shi

Yes, we do have -- we have noticed that there are -- because there are different culture and different devices that's used by users in different parts of the world, we need very different products targeted to particular regions and countries that resonate with the user there. And we are confident we will figure this out. For example, in Japan, we have -- we already have a number of very successful titles, including Knives Out and LifeAfter. Recently, we have launched a new PC game, NARAKA: BLADEPOINT on Steam, and that has been performing -- that has resonated very well with the users during the testing phase. It's a mainly combat type of game based on Chinese martial arts. And we are really -- we are very pleased to see that it has responded well by the global users.

Charles Yang

And Elsie, for your second question, I'll answer that directly in English. Our newer businesses, whether it's online education, online music, NetEase Yanxuan, all of them are in relative younger pace comparing to our game businesses. So 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.

When you look at each quarter, however, different BUs might experience different seasonality. For instance, Q1 is a traditional peak season for game performance specifically because of the Chinese New Year where as it's a relatively low season, for instance, for e-commerce. Likewise, education also witnessed strong seasonality in the different semester courses throughout the calendar year.

So all in all, don't be overly concerned about a quarterly fluctuation. But generally speaking, when you look at on the annual trend basis, for instance, innovative businesses and others line as well as -- in 2020, both lines has been growing very strong and much faster than my online game services.

What we want to achieve down the road eventually is that all of our deeply incubated and cultivated verticals will have a very robust and sustainable growth. And as they continue to grow and emerge, what we want to appeal to the users is what NetEase holding common a premium product and services offerings with elevated user experience. That is the corporate DNA in common across the board.

Operator, next question, please.

Operator

Thank you, sir. [Operator Instructions] It appears that there are no further questions at this time. I'd like to turn the call back to the management for closing remarks.

Margaret Shi

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

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