NetEase, Inc. (NASDAQ:NTES) Q3 2022 Earnings Call Transcript

NetEase, Inc. (NASDAQ:NTES) Q3 2022 Earnings Call Transcript November 17, 2022

NetEase, Inc. beats earnings expectations. Reported EPS is $11.35, expectations were $7.44.

Operator: Good day and welcome to the NetEase 2022 Third 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 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's business and the 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 of the filings on the website of the Hong Kong Stock Exchange.

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The company does not undertake any obligation to update its 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 2022 third quarter earnings news release issued earlier today. As a reminder, the conference is being recorded. In addition, on the 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 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.

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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 RMB. We saw healthy growth across our businesses in the third quarter with solid gains in each of our core business segments. Our total net revenues for the period were RMB24.4 billion, an increase of over 10% year-over-year despite a high base effect in the third quarter of last year. This demonstrates the resilience and improving operational efficiency of NetEase through different macro cycles. Our online games continues to be our primary growth driver with net revenues from our games and related value-added services coming in at RMB18.7 billion for the third quarter, up 9% year-over-year.

Our flagship titles delivered another quarter of solid growth. In the third quarter, with new expansion packs launched for the summer holidays, our legacy PC side , including Fantasy Westward Journey Online and New Westward Journey Online 2 continues to attract players. Even with 2 decades of operations, we are constantly exploring, creating and introducing innovative new elements to our games, keeping our content fresh, boost engagement levels and naturally spirits players continuous willingness to spend. This further proves our long-term operational know-how on franchise titles, a unique strength of NetEase games that we are hoping to replicate to our other self-developed proprietary titles. For our new titles, Diablo Immortal was launched in China in July, topping China's iOS download chart shortly after its release.

Following its launch, Diablo Immortal has enjoyed similar popularity in Western markets. players are enjoying the exciting adventure in the authentic Diablo world and the thrilling MMO RPG social experience. Diablo Immortal is a great strategic importance to us. It showcases our game development expertise on the international stage and further demonstrates that NetEase has the right capabilities to produce AAA games for worldwide audiences. As with all of our other games, our team works very hard to regularly and rapidly introduce exciting new game content to invigorate our players and ensure the longevity of our games. In September, we issued our first major update Forgotten Nightmares after Diablo Immortal's official launch, introducing a new Dungen , an exploration system and battle pass and players love it.

Naraka: Bladepoint maintained strong popularity in the third quarter, amassing a community of fans that are extremely passionate about this title. With the game's 1-year anniversary in August, we released our February 1 major new map, Holo Rock with a wealth of new features such as weather systems, interactive objects and new areas to explore, bringing in both new and returning players in a large scale. As a result, the number of active users for Naraka: Bladepoint hit a record high in this August. To keep this game fresh and engaging, we will follow a continuous rollout schedule, adding new content updates such as more heroes, weapons and new game play to this exciting game. Naraka: Bladepoint introduces a unique mild combat-style gameplay, easy to learn but hard to master to bring more players into the mix we have been introducing more beginner-friendly mechanisms such as a new bigness guide and shortcut keys for combat by helping new players quickly learn the skills to fully enjoy the fund of combat.

We have made the game more accessible to a wider range of players across the world. Simultaneously, we are in active development of Naraka: Bladepoint for mobile and are making very solid progress. We are going through vigorous testing rounds to make sure we can replicate the combat gameplay experience on mobile screens. On the console side, we released Naraka: Bladepoint on Xbox Series X|S and joined Xbox Game Pass in June. Adapting from PC to console is not an easy process, involving a highly different user interface and controls. We are very pleased to have smoothly transitioned Naraka: Bladepoint into the console arena, bringing our users a satisfying game experience. Our next move will be to make the new game available on Xbox One which will expand the fan base for this IP even further.

In addition to Naraka: Bladepoint mobile game, we have a number of other exciting upcoming games in our pipeline. We conducted the first round of testing in October for Justice mobile game and saw very encouraging results with over 10 million players pre-registered, with lots of exciting new technological innovations and the state-of-the-art game design. We hope Justice mobile game can represent what the next-generation game looks like and further boost the user base of Justice franchise as a whole. Equally exciting is our planned global market launch of Harry Porter: Magic Awakened which has filed the Chinese market. Since its launch last September, we are putting great efforts into the global version, leveraging all the lessons we have learned along the way from game development to a year-long operation, we are working intensely to optimize the game's mechanics.

Simultaneously, we are preparing expansion packs ahead of the launch to enable timely, frequent new content updates after the game . With great effort and dedication to its development, we hope to do justice to this great IP and impress fans on a global scale. Harry Porter: Magic Awakened is now expected to be launched globally in 2023. We are confident that this highly anticipated game will stand the test of time with great longevity and stability. Turning to our licensed games. As previously disclosed, we have entered into certain licensing agreements, covering the publication of several Blizzard titles in Chinese Mainland. These licenses will expire in January of next year and will not be renewed. Net revenues and net income contribution from these licensed Blizzard games represented low single digits of our total net revenue and net income in 2021 and in the first 9 months of 2022.

The expiration of such licenses will have no material impact on our financial results. The co-development and publishing of Diablo Immortal mobile game is covered by a separate long-term agreement. In the third quarter, we continued to make great progress with our global operations. At the end of August, we announced our acquisition of Quantic Dream which is now officially our first fully owned studio in Europe, based in Paris. Since our initial investment in the studio 3 years ago, we have been working very closely together and we just realized how like-minded and complementary we are to each other. Having Quantic Dream as a studio of our own exemplifies our vision of supporting innovation and game development around the globe. We will continue to fulfill our promise to support Quantic Dream to realize its full potential.

Also during the quarter, we are very pleased to have announced that Jonathan Morin came on board as a new Creative Director in Montreal. Here, he will be working together with and the team to build up the next exciting game. With more than 24 years of experience making AAA games, Jonathan played a key role in shaping the critically acclaimed Watch Dogs franchise at Ubisoft and was one of the main contributors to the Far Cry Series and many other brands. In Japan, earlier this month, we announced GPTrack50, a new first-party studio in Japan, like by . The studio will primarily focus on producing high-quality console and PC games with the goal of delivering original entertainment content from Japan to users worldwide. We've also announced our investment into startup studios such as Liquid Salt in Sweden and Something Wicked games in the U.S. Both are being led by top industry veterans who are using their creativity to forge their best titles yet to come.

After years of strategic planning, our self-owned overseas studios now stand in multiple regions: Japan, North America, Europe and more to come. Through investments and partnerships, we've welcomed in a great number of best-in-class game developers worldwide who will be pivotal to attracting more talent in their local developers and gamers community. Our investment philosophy attaches a high value to top talent and their passion for games. We will continue to attract, invest in and support these creative minds, combining talent with our powerful resources and execution capabilities. Turning to our education business. Total net revenues of Youdao continues to improve in the third quarter and reached a record high of RMB1.4 billion, led by increased sales of new services and smart devices.

Net revenues of Youdao smart devices reached RMB356 million in the third quarter, up 40% year-over-year, with robust contribution from its flagship products, Youdao Dictionary Pen and Youdao Listening Pod. Meanwhile, we continue to expand Youdao's portfolio with more AI-empowered educational tools in August, we launched the Youdao Dictionary Pen X5, featuring a self-developed operating system that accommodates a variety of external applications such as NetEase Cloud Music and Ximalaya FM, to further enhance our user experience on these products. This new version has been very popular among users as the initial batch of products quickly sold out. In addition, Youdao Smart Learning Pad X10 which is released in October also showcases several user-oriented and customized AI functions to better serve the learning needs of different age groups and we expect more growth opportunities for this product.

We made additional headway with our learning services as well maintaining a healthy trajectory with net revenues reaching RMB888 million. Net revenues for our STEAM costs more than doubled in the third quarter comparing to the same period of last year and now accounts for over 1/4 of the segment's total revenue. In addition to further content upgrade to Youdao gold courses, we have also coordinated with local board game associations to hold open tournaments for students which have been advocated by the General Administration of Sport of China for their positive contribution in expanding the popularity of broad game amongst students. We are very proud of what Youdao has achieved in the last 12 months which confirms that we are swift in transitioning and we are on the right track for future sustainable growth.

Looking ahead, we will continue to serve more learning needs of our users by leveraging our leading technological capabilities while diversifying our content and product offerings. On to Cloud Music. We completed the third quarter on a positive trajectory with our key operational trends and financial performance. During the quarter, we further improved our music-oriented community and content ecosystem as well as continued to advance our monetization efforts and gain meaningful operating leverage. Our total MAU remained steady, while the DAU over MAU ratio stayed well above 30%. Our paying user ratio was also stable quarter-over-quarter. Amid a challenging macro environment, total revenues of Cloud Music grew by 22% year-over-year as we continued to expand our paying user base and optimize our pricing strategy.

We also witnessed the gradual recovery of our advertising business, aided by rapid performance-based ad growth, along with solid momentum in social entertainment services. Our strong top line growth and better operational efficiency drove solid margin gains with gross margin expanding from the fourth quarter in a row, reaching 14.2% in the third quarter. Additionally, Cloud Music's net loss further narrowed in the third quarter, both year-over-year and quarter-over-quarter. Adding to our robust music content, we continue to augment and diversify our copyright library. Since the regulator's antitrust ruling last July, NetEase Cloud Music has been actively in discussion with label companies to secure best content for our music lovers. By now, we have managed to bring back most of the major label content, including those from Modern Sky, Emperor Entertainment Group, China Record Group, Feng Hua Qiu Shi, Yuehua Entertainment, Linfair Records, SM Entertainment, TF Entertainment, YG Entertainment and KAO!INC.

We are still working very hard to get back more titles at reasonable cost. Additionally, we continue to nurture aspiring musicians serving more than 570,000 independent artists as of today. Our in-house music production capabilities are showcased by another hip song, which recorded over 200 million streams within a weak and topped multiple music charts, enhancing our music-inspired ecosystem and user connections with our innovative new product continues to attract users to our community. In the third quarter, we further boosted our community atmosphere through innovative offerings, including Star-rated Comment Section to display high-quality user comments and Fans Space to strengthen bonding between artists and their fans, while encouraging user interaction.

We also added new offerings such as style recommendation that brings users more personalized options in the daily recommendation function to better reflect their taste as well as a Dolby Atmos feature, allowing users more authentic and immersive ways to listen to music. Turning to our private-label consumer brand, Yanxuan. It continues to build its brand awareness by constantly creating highly popular products. For example, were some of the new top-selling products this quarter. In Q3, we saw solid growth in sales from external e-commerce channels, particularly with short-form video platforms. Over the years, Yanxuan has gained increasing recognition for its excellent design and creative style most recently, Shanxi Vinegar and series won the prestigious awards for their unique and elegantly presented Chinese style packaging.

In summary, we are confident in our ability to realize strategic growth across our business lines. The portfolio we have curated of diverse and long-lasting games in China provide a steady base for us to build further upon coupled with our globalization strategy, our prospects are exciting and we believe we are well positioned for continued growth. As we advance each of our businesses with innovative products and services, we will continue to use our strong cash position to buy back shares and pay dividends that directly reward our shareholders. This concludes William's comments. I will now provide a brief review of our 2022 third quarter financials. 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. Net revenue totalled for RMB24.4 billion in the third quarter or US$3.4 billion, representing a 10% increase year-over-year. Total net revenues from our games and related VAS services were RMB18.7 billion, up 9% year-over-year. The growth was primarily due to increased revenue contribution from both mobile and PC games, including our existing games such as Fantasy Westward Journey Online series and , as well as newly launched Diablo Immortal. Net revenues from our mobile games accounted for approximately 69% of our total net revenues from online games operation. Youdao's net revenues were RMB1.4 billion, a moderate increase from last year. Last year's revenue contained a big portion generated from K9 after-school tutoring services which was later terminated in Q4 of last year.

The decreased revenue related to K9 termination is now offset by the increased revenue from Youdao's new services and smart devices as a result of a successful and smooth business transition. Net revenues of Cloud Music were RMB2.4 billion, up nearly 22% year-over-year. The increase was mainly due to increased revenues from social entertainment services and membership subscription. Net revenues for innovative businesses and others were nearly RMB2 billion, up 14% year-over-year, mainly due to increased contribution from Yanxuan in the third quarter. Our total gross profit margin rose to 56.3% in the third quarter compared with 53.2% in the third quarter of last year. Looking at the composition GP margin was 65% for our games and related VAS compared with 61.3% in the same period of last year.

The year-over-year increase in gross profit margin was mainly due to more revenue contribution from our organic channels. Our gross profit margin for Youdao was 54.2% compared with 56.6% in the same period of last year. The year-over-year decrease was mainly resulted from the decline in net revenues from its learning services due to the termination of K9 cost offerings. GP margin for Cloud Music continues to improve in the third quarter, climbing to 14.2% versus 2.2% 1 year ago. The significant margin improvement primarily resulted from strong top line growth as well as improved efficiency in content increasement. For our innovative businesses and others, GP margin was 25.5% compared with 27.2% last year. The year-over-year fluctuations were mainly due to changes in GP margin from advertising services.

Total operating expenses for the third quarter were RMB9 billion or 37% of our total net revenues. If we look at our cost composition, our selling and marketing expenses as a percentage of total net revenues was 15.4% compared with 14.1% for the same period last year. The increase was mainly due to increased spending on certain new games promotions such as the Diablo Immortal during the quarter. Our R&D expenses as a percentage of total net revenue remained relatively stable year-over-year at 16.2%. We remain committed to investing in content creation and product development. We are also seeing leverage in our R&D investment. Our other income was RMB3.5 billion for the quarter compared with RMB785 million last year. The quarter-over-quarter increase was mainly due to investment income arising from the disposal of certain equity investments.

Additionally, the exchange rate of the U.S. dollar against RMB fluctuating over the last couple of periods also contributed to the accounting gain in other income line. Our effective tax rate for this quarter was 19.3%. As a general reminder, the effective tax rate is presented on an accrual basis and the tax credit deferred from each of our legal entities at different time periods depending on applicable policies and our operational results. Our non-GAAP net income from continuing operations attributable to shareholders for the third quarter totalled RMB7.5 billion, or US$1.1 billion. Non-GAAP basic earnings per ADS from continuing operations for the quarter was US$1.61 or US$0.32 per share. Additionally, our cash position remains strong. As of the quarter end, our net cash position was about RMB95 billion compared with RMB86 billion as of the year-end of last year.

In accordance with our dividend policy, we are pleased to report that our Board of Directors has approved a dividend of US$0.08 per share or US$0.435 per ADS. Lastly, we continued to buy back shares during the volatile period under our current share repurchase program for up to US$3 billion which expires in March of next year. Approximately 27 million ADS has been already repurchased as of September 30 for a total cost of approximately US$2.5 billion. And today, our Board announced the approval of a new share repurchase program of additionally up to US$5.0 billion of the company's ADS and ordinary shares in open market transactions for a period not to exceed 36 months. Meanwhile, on the repurchase program for up to US$50 million. Approximately 2.3 million ADS has been purchased for a total cost of about US$20.7 million as of September 30.

In addition, NetEase purchased 0.7 million ordinary shares of NetEase Cloud Music for a total cost of about US$6.9 million during the third quarter. Thank you for your attention. We would like now to open the call to your questions. Operator?

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