NetEase, Inc.

Good day and welcome to the NETEAST 2022 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 NETEAST. Please go ahead, ma'am.

Thank you, Operator. Please note that 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 Education Reform Act. Such statements are not guaranteed of future performance and are subject to certain risks and uncertainties, assumptions, and other factors. Some of these risks are beyond companies' 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 financial results is included in certain filings of the company with the Securities and Exchange Commission's including its annual report on Form 20F and in announcements and filings on the website of Hong Kong Stock Exchange. The company does not undertake any obligation to update this forward-looking information except as required by law. During today's call, management will also discuss certain non-GAAP financial measures for comparison purposes only, for a definition of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results please see the 2022 second quarter earnings news release issued earlier today. As a reminder, this conference is being recorded. In addition, the investor presentation and the webcast replay of this conference call will be available on NetEase corporate website at ir.netease.com. Joining us today on the call from NetEase Senior Management is Mr. William Ding, Chief Executive Officer, and Ms. Charles Yang, Chief Financial Officer. I will now turn the call over to Charles, who will read the prepared memo of Tom Williams.

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 are very pleased to report another solid quarter with net revenues growing to RMB 23.2 billion, up 13% versus the same period last year, Our online games continues to be our primary growth driver with net revenues from our games and related value added services coming in at RMB 18.1 billion for the second quarter, up 15% year over year. Please note, we changed our segment categorization this quarter. The expanded games and related VAS segment now includes game-related value-added services such as CC live streaming, game-related accessories and merchandises, et cetera. We believe this revised segment categorization better reflects the performance of our well-rounded capabilities around the broadly defined game ecosystem and value chain. Players continue to gravitate to our long-lasting franchises In the second quarter, revenue from our Fantasy Westward Journey saga kept on growing, further impressing the industry with their strength and longevity. Through the solid foundations we've built and continuous iterations we release every few months, these flagship sagas are still among the most well-crafted games in today's market, remaining highly attractive to users even after nearly two decades of operation. Over the years, we have built complex and intricate ecosystems within the games, constituting well-balanced, comprehensive economic systems and intimate user networks. We see these games as a work of art and science, and it is ever-evolving as we dynamically adjust the finest details. In terms of newly launched titles, we were extremely excited to see Diablo Immortal enchant tens of millions of players, dominating the iOS top download chart in multiple regions. Diablo Immortal boasts fantastic gameplay that relishes the authentic Diablo experience, which also featuring an MMORPG social experience. where players can share a massive world with others as they explore. We are working hard to keep it fresh and plan to continuously introduce exciting new content for Diablo Immortal in a fast-paced manner to keep players engaged. Diablo Immortal's debut was also a huge opportunity for us to showcase our world-class development capabilities. Leveraging Messiah, our robust self-developed game engine, Diablo Immortal underscores our proficiency in producing top-quality games on mobile devices. Over the years, our team has worked hard to recreate the Diablo sensation on mobile, putting great effort into every detail of the game and overcoming countless barriers along the way. In the second quarter, Naraka BladePoint maintains strong engagement levels as we introduce a series of content updates. By the end of May, the game has sold 10 million copies worldwide since its release about a year ago, turning it into one of the best-selling PC games in the world. Along with its one-year anniversary, we recently announced an array of exciting updates for Naraka BladePoint. including a brand new map for the game called Holoroth. Holoroth brings fresh combat experiences to players and a wealth of new features such as weather systems, interactive objects, and new areas to explore, winning wide praise from players. On June the 23rd, we debuted Naraka Bladepoint on Xbox Series XS and joined Xbox Game Pass. In its first two weeks on the market, an impressive one million new players jumped into the game, enjoying the exciting gameplay which had been optimized for the console. The game will next be available on Xbox One. Simultaneously, we are working to bring Naraka Blade Point's authentic melee combat to mobile platforms. Development is progressing smoothly, and pre-registration has been very encouraging, with more than 3 million users already registered without much marketing. Another exciting title that tops the chart in the second quarter was Infinite Lagrange. With new creative social media marketing initiatives, we greatly expanded the game's user base, which triggered wide player interest in our sci-fi SLG title, we are also seeing strong retention of new players, further bolstering our confidence in this promising category. We continue to introduce new gameplay and all-rounded graphic updates on ships, stars, and space stations to further strengthen our leadership in the SLG category. Moving on to our pipeline, In addition to the aforementioned Naraka Bladepoint mobile version, our strong pipeline is bursting with other exciting titles in the making. Harry Potter Magic Awakened is under preparation for global launch following its debut in China last September. With our latest round of beta testing in July, we received very positive feedback from the player community. Together with Warner Brothers Games, We look forward to co-publishing this amazing title for global audience soon. Domestically, our development of Justice mobile game is well on track. Building on the success that our PC phenomenon Justice created back in 2018, Justice mobile game will recreate a vivid world of the Song Dynasty on mobile devices with our cutting-edge game technologies. such as motion capture and global illumination. As a leader in the MMO category, we will keep pushing boundaries and continue to raise the bars for the industry. Justice Mobile Game will no doubt introduce a brand new game experience to the MMO universe and offer players a world of greater freedom and more imagination. We are determined to become a well-respected premium global game content provider on the international stage. Our globalization strategy will be an essential part of the next chapter of our growth story. Our world-class R&D infrastructure coupled with our top talents from all over the world will serve as a strong foundation to build the next sensational blockbusters for players worldwide. we always follow an innovative first approach and look for creative minds with the same passion for games. Through strategic investment and partnership, as well as setting up first-party overseas studios, we've successfully built a strong connection with top talents across the global stage. In the second quarter, we made further progress in our globalization efforts, successfully bringing internationally renowned game veterans to NetEase. During the quarter, we are pleased to have announced that renowned industry veteran, Jerry Hook, a founding member of Xbox Live, and one of the key masterminds behind the Halo and Destiny franchises. Jerry will be heading our newest first-party studio, Jar of Sparks, based in Seattle, We also announced the onboarding of Emil Liang, who had previously spent over 23 years with Ubisoft and was a producer of the Far Cry and Assassin's Creed franchises. We are excited for him to join as a lead producer in our Montreal studio, bringing us more expertise in AAA game production. In Japan, we are also excited to welcome another master producer, Hiroyuki Kobayashi, who was a 27-year Capcom veteran and the producer of Resident Evil, Devil May Cry, Sengoku, Asara, and many other well-known game series. Same as our previously announced overseas studios, our new studios and producers have great autonomy over the games they want to build, allowing these top-notch talents to rise organically and maximize the creative genius in each of them. Now turning to our education business, total net revenues for Youdao were RMB 956 million in the second quarter, and we achieved positive operating cash flow of RMB 104 million in this quarter, despite the challenges faced during the COVID resurgence and business transition. For the second quarter, net revenues from smart learning devices were RMB 240 million, up 16% year-over-year, demonstrating our resilience despite the pandemic's impact on the supply chain and logistics. Our flagship products maintained their remarkable popularity while we released a variety of diversified new products to cover a broader range of learning scenarios. Youdao Dictionary Pen Series and Youdao Listening Pod both led their respective categories during JD.com's June 18th Shopping Festival. In July, we introduced a new product called Youdao Smart Learning Pack our very first learning pack equipped with AI diagnosis and adaptive learning functions. The product satisfies users' needs for reading, listening, writing, and practicing all on one consolidated device. We continue to diversify our product offering in the STEAM education sector, in which we achieved sustainable growth. with gross billions expanding by more than nine-fold in the second quarter year-over-year and over 180% quarter-over-quarter. For example, in the second quarter, gross billions from Youdao International Chess increased by over 60% quarter-over-quarter with an aim to create a comprehensive and user-friendly online learning community We also launched the Youdao Board Game Academy application at the end of last year to better serve our students of Go, chess, and Chinese chess courses. As a result, the monthly average DAUs on this platform has increased over seven times compared with that of the first quarter. Looking ahead, Youdao will continue to upgrade its diversified products and services to empower more efficient learning experiences for Chinese students. Driven by our proprietary technologies, we remain confident in Youdao's development trajectory in the second half of this year. On cloud music, again, a more challenging industry environment and macro headwind. We maintained strong growth in the second quarter and total revenues improved by 29% year-over-year to RMB 2.2 billion. Our membership paying ratio also reached 21%, demonstrating the resilience of our business and high demand for the cloud music immersive music experience, along with users' increasing willingness to pay for premium content. Our online music services MAU stood at 182 million with our DAU over MAU ratio staying well above 30% during the period. Growth margins have continued to improve and reached 13% in the second quarter compared with just 4% in the same period last year. By enhancing our product and community features, And through technological innovation, we are bringing music lovers and artists alike the premium experience they crave. During the period, we launched our new high-resolution audio feature, offering users higher audio quality for an immersive audio experience. Coupled with our seamless listening function, we are committed to bringing users superior sound quality through the latest technology. User interaction is also a key component to the music experience we aim to provide. With our new music-inspired social networking app, Muse, we are utilizing music content to connect users. Within this app, users can connect with others who share similar music tastes based on their listening preferences and personality insights. On the content side, To satisfy the music needs of our younger users, we continue to build our content and give users increasing choices to express themselves. As of June 30, 2022, Cloud Music was also home to over 500,000 registered independent artists with 2.3 million music tracks created by this group of talented musicians. In addition, We are also working in collaboration with top labels to secure more top talent, content, and simultaneously achieving better commercial terms. As for our recently licensed content, we've added multiple licensing agreements with major overseas and domestic music labels such as SM Entertainment, TF Entertainment, YG Entertainment, all of which provide our users with access to more hits at an improved ROI. This will continue to be our goal as we negotiate with multiple copyright holders to bring in music content that resonates with our community and complements our offering. Looking ahead, we plan to keep growing in the scope, content coverage, and community size. Moving on to Yanshan, Our private label brand continues to launch popular products that consumers love across diversified channels in the second quarter. With a goal of bringing consumers products that facilitate a more leisurely and modern lifestyle, Yanshan focuses on its development of high-quality original product design. During the second quarter, we launched a number of popular products, such as handmade vinegar ergonomic chairs, skin-friendly quilts, and Chinese-style fragrances covering food, home furniture, bedding, as well as personal hygiene and maternity products. Lastly, in June, we published our ESG report for 2021, highlighting that we have officially established a dedicated sustainable development department and formed an ESG committee at our board level consisting of three independent directors. In addition, we remained committed to continuing developing our carbon strategy and enhancing more transparent disclosure. In 2021, as part of our environmental and social endeavors, we successfully reduced over 3,800 metric tons of carbon emissions in warehouses, logistics, and packaging sites and donated over RMB 80 million for flood relief and efforts towards pandemic control. In addition to our ongoing work to help students in remote mountainous areas, we also provided a great number of smart hardware, high quality courses, and online learning platforms to rural schools. We were pleased to learn that with our help, Many students achieved positive results in this year's college entrance exam and were successfully admitted to top universities, including Peking University. Across our business, we strive to serve the greater good of society as a whole and use our technology and other resources to support a better future. So far, we are making steady progress in growing our core game businesses and international presence. With the global launch of thrilling new games across different platforms and the establishment of our overseas studios which afford us access to the best creative minds anywhere in the world, we are getting ready for the next phase of our global ambition. This concludes William's comments. I will now provide a brief review of our 2022 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 were RMB 23.2 billion, or US dollar 3.5 billion, representing a 13% increase year over year. As we disclosed in our earnings release issued earlier today, beginning in this quarter, we've consolidated revenues from certain value-added game services with our online games operations and renamed the category games and related value-added services. We think this is a better depiction of our game businesses ecosystem. In addition to online games, We provide a range of tools and services to our users to enhance their overall gaming experience when they play our games, such as the CC live streaming service, a platform offering various live streaming content with a primary focus on game broadcasting and certain game-related merchandise sales. These revenues were previously included under our innovative businesses and others line items. And historical periods have also been adjusted accordingly. Online game operations are still the primary component of this segment, accounting for nearly 93% of our total games and related value-added services revenue. The ratio is steady with the prior period and same period a year ago. Total net revenues from our games and relative Related VAS were RMB 18.1 billion, up 15% year-over-year. The growth was primarily due to increased revenue contribution from the launch of new games, such as Naraka Blade Point and Harry Potter Magic Awakens, and other exciting games such as Fantasy Westward Journey Online. Net revenues from our mobile games accounted for approximately 66% of net revenues from the operation of online games. Yeodao's net revenues were RMB 956 million compared with RMB 1.3 billion in the same quarter last year. The decline was mainly due to the conclusion of Yeodao's after-school tutoring services for academic subjects under China's compulsory K-9 education system, which were previously included in its learning services back in 2021. Net revenues from cloud music were RMB 2.2 billion, up nearly 30% year-over-year. The increase was mainly due to the increased revenues from membership subscription as well as social entertainment services. Net revenues for innovative businesses and others were nearly RMB 2 billion, up 14% quarter over quarter, mainly due to increased contribution from Yanshan in the second quarter. Our total gross profit margin rose to 55.9% in the second quarter, up slightly compared with 54.5% in the second quarter of last year. GP margin for the games and related value-added services was 64.9%. The majority of our gross profit in this segment is contributed by online games revenue. The contribution from related VAS is relatively much smaller, which carries a lower margin than online games. Therefore, even with adjustments to our line items, Our games and related VAS margin is generally stable, with some narrow fluctuations based on the revenue mix of mobile and PC titles, self-developed, co-developed, as well as licensed games. GP margin for Youdao was 42.8%, compared with 52.3% in the same period of last year. The decline was mainly due to the lower revenue proportion from Yeodao's learning services resulting from the conclusion of the after-school tutoring businesses for K-9 academic subjects. World's profit margin for cloud music continues to improve in the second quarter, climbing to 13% versus 4.1% a year ago. The significant margin improvement primarily resulted from strong top-line growth as well as the improved efficiency of our content investment. GP margin for innovative businesses and others was 25.8% compared with 27.3% last year. The decline was mainly due to the result of decreased revenue from higher margin advertising services. Total operating expense for the second quarter were RMB $8 billion, or 35% of our total net revenues. If we look at our cost composition in more details, our selling and marketing expenses as a percentage of net revenue were 14%, compared with 15% for the same period last year. The change was mainly due to less marketing spend related to Youdao. If we exclude Youdao, our selling and marketing expenses as a percentage of net revenue were 12%, compared with 11% in the same period last year, mainly due to increased spending on certain games promotion during the second quarter. Our R&D expenses were only 3.6 billion, or 15% as a percentage of total net revenue, compared with 17% for the same period last year. 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 RMB 785 million for the second quarter compared with RMB 28 million last quarter. The quarter-over-quarter increase was mainly due to the exchange rate of the U.S. dollar against the RMB fluctuating over the last couple of periods. Our effective tax rate for this quarter was 22%. As a general reminder, the effective tax rate is presented on an accrual basis, and the tax credits differ from each of our legal entities at different time periods, depending on applicable policies and our operations. Our non-GAAP net income from continuing operations attributable to shareholders for the second quarter totaled RMB 5.4 billion or US dollar 808 million. Non-GAAP basic earnings per ADS from continuing operations for the quarter was US dollar 1.23 or US dollar 0.25 per share. This quarter, we also had RMB 625 million of net income from discontinued operations, which was related to the disposal of the Kaola business. Additionally, our cash position remains strong. As of the quarter end, our net cash position was about 88 billion RMB, compared with 86 billion as of the year end last year. In accordance with our dividend policy, we are pleased to report that our board of directors has approved a dividend of U.S. dollar 0.072 per share or U.S. dollar 0.36 per ADS. Lastly, we continue to buy back shares during the period. Under our share repurchase program for up to 3 billion U.S. dollars, Approximately 24 million ADS had been repurchased as of June 30th for a total cost of approximately US dollars 3 billion. Meanwhile, on the NetEase Yodal purchase program for up to 50 million US dollars, approximately 1.7 million ADS had been purchased for a total cost of about 18 million as of June 30th. In addition, NetEase purchased about 0.8 million ordinary shares of Cloud Music for a total cost over US dollar 8 million during the second quarter. Thank you for your attention. We would like now to open the call to your questions. Operator, let's go to Q&A.