NetEase, Inc. (NASDAQ:NTES) Q2 2020 Earnings Conference Call August 13, 2020 7:30 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
Alicia Yap - Citigroup
Alex Yao - JPMorgan
Eddie Leung - Merrill Lynch
Thomas Chong - Jefferies

Operator

Good day and welcome to the NetEase 2020 Second 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

Thank you, operator. Please note the discussion today 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 affect NetEase’s business and financial results is included in certain filings of the company with the Securities and Exchange Commission, including its annual form on Form 20-F and with the 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 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 the 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 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. 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 commitment to shareholders, both domestically and overseas, of our deep responsibility to continue creating value for our growing base of global stakeholders.

I am 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, continued their 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 2-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 gross billings as well as record high numbers 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 SLGs over the past 5 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 offerings in the Onmyoji family. Next month, we target to launch on Onmyoji: Yokai Koya, a simulation game that has been long anticipated by the Onmyoji community. Two other new spinoff 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 generations and are showing great longevity as well includes the 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 enriching this IP through a variety of initiatives, including e-sports tournaments, IP collaboration, 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 discussions amongst young generations, highlighting 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 multiple 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 MMO 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 Pokémon 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 classes tripled year-over-year to RMB542 million driven by strong retention and larger-scale marketing in the K-12 segment, which increased its gross billings by 229% year-over-year. In addition to strong contributions from junior high school math and physics, we saw more courses growing popular in the second quarter, including high school Chinese and primary school math. To better prepare for the new enrollment during the summer months, Youdao has significantly built 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 grades, 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 capabilities. And thus, we further amplify our marketing efforts to further bolster our student base for the second half of this year. For NetEase Cloud Music, we continued 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 multiyear licensing agreement with Universal Music Group. This direct partnership further strengthens 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 richest 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 bands, 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 creative possibilities when singing on our app. Our users can connect through songs and common music interest and share their mood when recording. These 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 members, who typically represent the most core and sticky users of our Yanxuan brand. As a private label, one of our key strategic goals is to increase brand awareness and marketing appeal to a broader audience in China. During the second quarter, NetEase and Yanxuan executives hosted two live broadcasting shows in which we introduced the Yanxuan products, and they were all sold out instantaneously. We also entered in 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 $2.6 billion, representing 26% increase year-over-year. Net revenues from online game 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 record increase in K-12 paid student 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 game 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 billion. 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 to 13.5% for the same quarter last year. We have increased absolute dollar spend 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. Year-over-year increase was mainly due to gains from fair value changes of our investment holdings and government incentives 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 $739.7 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 $5.64 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 a Hong Kong public offering and the full exercise of the over-allotment options. Growth proceeds from the global offering before underwriting fees and offering expenses were approximately HKD24.3 billion or $3.1 billion. In accordance with our dividend policy, we are pleased to report that our Board has approved a dividend of $1.485 per ADS. Under the share repurchase program approved by our Board, as of June 30, approximately 2.3 million ADS have been repurchased for a total cost of $755.7 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.

Question-and-Answer Session

Operator

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

Alex Poon

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 Porter 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?

William Ding

[Foreign Language]

Charles Yang

Okay. Alex and for the audience, for everyone’s convenience, I’ll quickly translate William’s remarks and apologies for the technical glitch just now. Firstly, regarding our objective for the Japanese market, it’s a very important market for our global initiatives, and we’ve 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 diversifying more offerings, more genres of games 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 feedbacks and the 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 product 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 will take our next question. Alicia Yap. Your line is open. Please go ahead.

Alicia Yap

Hello, thank you. [Foreign Language]. So my first question is actually regarding the margins. So with the newly signed contract with UMG 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? So – and also, with more contracts and all that, how should that change in terms of the potential monetization? Second question quickly is on the sales and marketing. So it seems like this quarter, the spend is a 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.

Charles Yang

Alicia, and for quick translation of William’s remarks, we’ve added comments from my side. So first of all, William commented that the multiple year contracts, in In nature, this changes the sublicensing formatting for direct partnership. So in essence, it’s not really changing the margin trend or on the business side. The big, positive impact from direct partnership is that beyond music content subscription revenues, that we are now in a direct 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 represents the increased absolute dollars primarily for two reasons. One is the selling and marketing effort for new game launches, in particular the Fantasy Westward Journey H5 game, and also partly due to the summer promotion initiative of Youdao spending, which is, again, kind of a seasonality for the overall online education industry. However, if you look from different aspects, this quarter, selling and marketing represented about 12.8% of my overall top line revenue. Of course, there are some gaps of spending first and repeated, sustainable revenue growth into the coming quarters. All-in-all, this percentage level represents a very prudent and disciplined level comparing to our historical level on an annualized basis in the last 3 years. Hopefully, that answers your question, Alicia.

Alicia Yap

Okay. Yes, thank you.

Operator

We will take our next questions from the line of Alex Yao from JPMorgan. Your line is open. Please go ahead.

Alex Yao

I have two questions. The first one is to follow up Alicia’s question on music monetization. William, you mentioned that you guys are considering to diversify the music monetization. So in addition to the current subscription-based monetization model, what are the monetization models 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 a 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 U.S., especially what’s going on between U.S. government and some of the China Internet companies, would you reconsider your international gaming strategy? Let me stop here.

Charles Yang

So Alex, I will 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 formats, 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, 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’s 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 remaining 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 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

So I have two questions. The first one is about the cloud music pieces. How do you think about the positioning of the soc media companies in the online music market in the long-term? It seems like some of these soc media companies have been adding musical-related video contents to their 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 gains, some of them still generating pretty good revenue and even seeing some growth. So in general, I would like to know whether it’s more driven by paying user growth or ARPU growth. Thank you.

William Ding

[Foreign Language]

Charles Yang

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 chopped. It’s usually less than a minute, whereby a full complete song typically require 3, 4 minutes of listening. So – and also, short-format video usually takes a highlight part where that’s 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 PGC 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 and a true music enthusiast who wants to enjoy the full length of the song or the kind of a music-oriented touch, then a 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 if it does seem 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 game, that would mean as a whole the number of overall paying 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 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 picky, they are more selective on the highest quality of the games, the best in-game experience. So by and large, we think our number of users are going to grow. ARPU may not necessarily grow at the same noticeable trend. However, if our content is relevant and represents the highest quality of the respective genre, we have the potential to grow both the ARPU as well as the number of users on our products. Operator next questions please.

Operator

Okay. We will take our next questions from the line of Thomas Chong from Jefferies. The line is open. Please go ahead.

Thomas Chong

Thanks management for taking my questions and congratulations on a very strong set of results. I have a question about our overseas game 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 we think about our overseas strategies in terms of M&A, IP licensing as well as in-house development? Thank you.

Charles Yang

Thomas, I will provide a brief translation. So actually, with the 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’s no forced ranking in terms of priorities. IT licensing represents a very, very critical element of our global initiative because that showcase is the involvement 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 optimistic, but we are also highly open minded and active particularly in genres that’s supplementary to our core in-house R&D capability.

Thomas Chong

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

Charles Yang

Okay. Thomas, I will 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 think that the Chinese consumers’ willingness to spend and the ability to spend is on the rising trend. For instance, one small example, if you look at today, the cost of a movie ticket in China is already comparable to a cinema movie ticket spending in the States. Just a decade ago, there is a huge gap, right. For some of us who can recall, there’s a huge gap, which means Chinese consumers are more willing to pay on entertainment. As Chinese economy further advances, people are more willing to pay a broad format of entertainment to enrich their lifestyle. We think that trend is on the rise. Operator, I think, in short of time, let us cut this call.

Operator

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

Margaret Shi

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

Charles Yang

Thank you everyone.

Operator

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