NetEase, Inc.

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 Shee, IR Director of NetEase. Please go ahead.

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 financial results is included in certain filings of the company with the Securities and Exchange Commission, including its annual report on Form 20S and the announcements and filings on the website of the 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 third quarter earnings news release issued earlier today. As a reminder, the 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 Yan, Chief Financial Officer. I will now turn the call over to Charles, who will read the prepared remarks on behalf of William.

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 RMB 24.4 billion, an increase of over 10% year over year despite 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 continue to be our primary growth driver with net revenues from our games and related value added services coming in at RMB 18.7 billion for the third quarter of 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 titles, including Fantasy Westward Journey Online and New Westward Journey Online 2, continued to attract players. Even with two decades of operations, we are constantly exploring, creating, and introducing innovative new elements to our games. Keeping our content fresh boosts engagement levels and naturally spurs 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 MMORPG social experience. Diablo Immortal is of great strategic importance to us. It showcases our game development expertise on the international stage and further demonstrates that Nadiz 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 dungeon, an exploration system, and a battle pass and players loved it. Naraka Blade Point maintained strong popularity in the third quarter, amassing a community of fans that are extremely passionate about this title. With the game's one-year anniversary in August, we released our very first major new map, Holoross, 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 Playpoint 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 gameplay to this exciting game. Naraka Bladepoint introduces a unique melee 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 beginner's guide and shortcut keys for combat. By helping new players quickly learn the skills to fully enjoy the fun 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 melee combat gameplay experience on mobile screens. On the console side, we released Naraka BladePoint on Xbox Series XS 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 a next generation game looks like and further boosts the user base of Justice franchise as a whole. Equally exciting is our planned global market launch of Harry Potter Magic Awakened, which has fascinated the Chinese market since its launch last September. we are putting great effort 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 steps up. 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 Potter 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 nine 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 continue 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 three years ago, we have been working very closely together, and we just realized how like-minded and complimentary 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 new creative director in Montreal. Here he will be working together with Emile Liang 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 AAA brands. In Japan, earlier this month, We announced GP Track 50, a new first party studio in Japan, led by Hiroyuki Kobayashi. The studio will primarily focus on producing high quality console and PC games with a goal of delivering original entertainment content from Japan to users worldwide. We've also announced our investment into startup studios such as Liquid Sword in Sweden and Something Wicked Games in the US. 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 span 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 Yodal continues to improve in the third quarter and reached a record high of RMB 1.4 billion, led by increased sales of new services and smart devices. Net revenues of Yodao's smart devices reached RMB 356 million in the third quarter, up 40% year-over-year, with robust contribution from its flagship products, Yodao Dictionary Pen and Yodao Listening Pod. Meanwhile, we continue to expand Yodao's portfolio with more AI-empowered educational tools. In August, we launched Yodao Dictionary Pen X5, featuring a self-developed operating system that accommodates a variety of external applications, such as NetEase Cloud Music and Shimalaya FM, to further enhance our user experience on these products. This new version has been very popular among users, and 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 RMB 888 million. Net revenues for our STEAM courses more than doubled in the third quarter, comparing to the same period of last year, and now accounts for over a quarter of the segment's total revenue. In addition to further content upgrades to your Dow 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 Sports of China for their positive contribution in expanding the popularity of board games amongst students. We are very proud of what Yodao 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, , Entertainment, , SM Entertainment, TF Entertainment, YG Entertainment, and . We are still working very hard to get 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 hit song, Ruobani, which recorded over 200 million streams within a week and topped multiple music charts. Enhancing our music-inspired ecosystem and user connections with our innovative new products 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 Adobe Atmos feature allowing users more authentic and immersive ways to listen to music. Turning to our private label consumer brand, Yanshan, It continues to build its brand awareness by constantly creating highly popular products. For example, pork buns and goose down duvet 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, Yansha has gained increasing recognition for its excellent designs and creative style. Most recently, Shanxi Vinegar and Oriental Sand series won the prestigious Pent 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 gains in China provides a sturdy 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 totaled for RMB 24.4 billion in the third quarter, or USD 3.4 billion, representing a 10% increase year over year. Total net revenues from our games and related VAS services were RMB 18.7 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 Infinite Lagrange, 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 operations. Yeodao's net revenues were RMB 1.4 billion, a moderate increase from last year. Last year's revenue contained a big portion generated from K-9 after-school tutoring services, which was later terminated in Q4 of last year. The decreased revenue related to K-9 termination is now offset by the increased revenue from Yeodao's new services and smart devices, as a result of a successful and smooth business transition. Net revenues from Cloud Music were RMB 2.4 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 RMB 2 billion, up 14% year-over-year, mainly due to increased contribution from Yanshan 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 K-9 course offerings. GP margin for Cloud Music continues to improve in the third quarter, climbing to 14.2% versus 2.2% one 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 RMB 9 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 promotion such as 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 RMB 3.5 billion for the quarter, compared with RMB 785 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 lines. 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 totaled RMB 7.5 billion or USD 1.1 billion. Non-GAAP basic earnings per ADS from continuing operations for the quarter was U.S. dollar 1.61 or U.S. dollar 0.32 per share. Additionally, our cash position remains strong. As of the quarter end, our net cash position was about 95 billion RMB compared with 86 billion RMB 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 dollar 0.087 per share, or US dollar 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 dollar 3 billion, which expires in March of next year, Approximately 27 million ADS has been already repurchased as of September 30th for a total cost of approximately 2.5 billion US dollars. And today, our board announced the approval of a new share repurchase program of additionally up to US dollar 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 NetEase YoDOS 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 30th. 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?