NetEase, Inc.

Good day and welcome to the NetEase 2023 Second Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Margaret Chee, Senior IR Director of NetEase. Please go ahead, ma'am.

Thank you, Operator. Please note the discussion today will contain forward-looking statements relating to the future performance of 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 guaranteed for 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 20-F and the announcements and the 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 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 2023 second quarter earnings news release issued earlier today. Please note that certain financial information regarding Cloud Music we'll be discussing on this call has been prepared in accordance with IFRS. For additional information, please refer to Cloud Music's interim report for the first half of 2023. 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 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 Mr. Charles Yan, Chief Financial Officer. We 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. Our total net revenues came in at RMB 24 billion, an increase of nearly 4% year over year, and our net income attributable to shareholders increased by 56% year over year to RMB 8.2 billion. Our long-standing franchises are still resonating well with our users. In the second quarter, revenues from our fantasy Westward Journey saga continues to grow year over year, further impressing the industry with this IP's longevity and sustainable popularity. Westward Journey franchise recently celebrated its 21st anniversary since its commercial launch. Games from our flagship series crafted on solid foundations and continual iterations every few months maintain their top-tier positions and alluring charm in today's market, even after nearly two decades of operation. In addition to these legacy titles, we are proactively cultivating an expanding array of long-lasting franchises. We believe our recent portfolio additions such as Agipati and Naraka BladePoint, are showing similar popularity with potential longevity. Continuing its successful streak after more than a year of operation, Agipati achieved another record high for active users this summer, surpassing the peak it reached during the Chinese New Year period this year. In the second quarter, It was the most downloaded game in China, which speaks to the game's strong reputation and user engagement. Additionally, we have our sights set on long-term success, and we are deeply committed to fostering a thriving UGC ecosystem. In June, we successfully hosted our very first Creators Conference and introduced a series of new incentives providing even better support and rewards for creators. Furthermore, we've diligently upgraded our game editor by introducing a series of advanced components and interactive functions, such as an NPC and plot editor. These additions not only offer increased flexibility, but also push the boundaries of creative possibilities. To build on the domestic popularity of Aggie Party, our plan to launch it in the global market is well underway. We went through our first round of testing outside of China in April, which has given us valuable insights. Our development team is working hard to optimize the game experience based on this feedback. We plan to test Aggie Party in a few more regions including the Europe, North America, and Japan markets, before we officially introduced Aggie Party to worldwide audiences. For Naraka BladePoint, we proudly announced that we added another 10 million new users in the past year, reaching a new milestone of 20 million users in total after two years of operation. To celebrate the game's two-year anniversary, we increased an area of captivating new content, featuring fresh weapons, heroes, and engaging gameplay features. Most notably, during its two-year celebration, Naraka BladePoint made some exciting moves, transitioning into a free-to-play model and debuting on the PlayStation 5 to expand its accessibility to a wider audience. resulting in a remarkable surge in active users and being voted as PlayStation's best new game in July. Furthermore, the development of Naraka Bladepoint's mobile version is making steady progress. We have a firm focus on preserving the game's hardcore essence on mobile devices to further its reach to a broader audience in China and potentially globally. The huge success we have seen with our June new releases, Justice Mobile Game and Racing Master, has been very exciting for us and demonstrates our ability to once again set the bar for the MMO industry and expand genres to brand new categories through first class content innovation. Justice Mobile Game is arguably the first game in the world to bring fresh real game experiences to users by leveraging machine learning technologies. The game has dominated both the iOS download and grossing charts upon its release in China. Within a month, Justice Mobile game attracted over 40 million players, which is unheard of for any MMO game. Notably, it has drawn in massive groups of Generation Z players who were previously unfamiliar with the MMO genre, revitalizing the spotlight on MMOs within the Chinese game industry. As a forerunner in the MMO world, we continuously explore new horizons of innovation that brings all new creative gameplay into the genre. Justice Mobile Game offers a more balanced game experience, which resonates well with younger generation. prompting players to willingly spend on cosmetic items they love within the game. Also, by leveraging our advantage in machine learning technologies, Justice Mobile Games' development team will be significantly more efficient in producing new and frequent expansion packs that keep our game players super engaged. Turning on to Racing Master, since the game's June debut in China, it has swiftly risen to the top position on the iOS download chart and claimed the number three spot on the top grossing chart. This milestone launch marks the addition of our second racing car game to our portfolio, expanding our presence in this very popular genre. With Racing Master, we pioneered China's first proprietary AAA standard racing simulator mobile game, introducing an authentic racing experience into the mainstream of China's gaming sphere. Developing a simulation racing game is no small feat. It requires a deep pool of technical expertise, such as understanding dynamic crash physics, aerodynamics, and real-world tracks. These take years to build from the ground up. This kind of undertaking requires a lot of dedication and passion for games, as well as a strong commitment to bring it to life. We have ambitious plans for Racing Master in the global market. We are about to commence overseas testing with a name to bring Racing Master's authentic racing simulation experience to global mobile players around the world. Badlanders, our next generation looter shooting mobile game, has received positive reviews from players and achieved the number two position on the iOS download chart following its launch on June the 8th. We are dedicated to refining the game to fully unleash its long-term potential. At the end of June, we also rolled out Harry Potter Magic Awakened to the global market, including Japan, North America, and Europe, where it tops the download charts in more than 50 regions. The game was well received by Harry Potter fans across the world and has been acclaimed for its world-class design and authentic representation of the original IP. Our most recent addition is Dunk City Dynasty, which we launched just yesterday. The game tops the iOS download charts. Authorized by the NBA Players Association, Dunk City Dynasty marks our debut into the self-developed basketball game domain. Dunk City Dynasty lets basketball fans build their dream team with all-star NBA legends and dominate the court with real-time commands using strategic prowess and leadership skills. Transitioning to our pipeline, Alongside the exciting titles mentioned earlier, such as Naraka Blade Point mobile game, Aggie Party, and Racing Masters for the international market, Whale Wings Meet, our open-world adventure RPG, is counting down to its eagerly awaited 2024 launch. At Gamescom 2023 held this week, Whale Wings Meet unveiled a wealth of thrilling revelations which is now capturing significant attention from players worldwide. Set at the onset of the Song Dynasty, a time of warfare and turmoil, Where Wings Meet allows players to embark on a journey as a mysterious swordsman and immerse themselves in the heart-pounding allure of our interactive open world. Our dedication towards R&D underpins our ability to continue to scale through consistent proprietary game launches. Nevertheless, we remain committed to bringing top quality worldwide games to Chinese market. Since we introduced Minecraft to China in 2017, we have seen an incredible surge in its popularity within Chinese gamers community. where fans have embraced the opportunity to craft and explore their unique world as well as those of others, limited only by imagination. Recently, we are very pleased to have renewed the term of Minecraft license and are dedicated to continuously serving Chinese players in the long term. In the second quarter, we are pleased to announce the establishment of a new game studio named Pinku in Tokyo, which is being led by Ryotaro Ichimura, a 20-year game industry veteran and longtime producer of the Dragon Quest franchise. Pinku plans to leverage its diverse knowledge as an entertainment production company to deliver top-notch entertainment experiences to users worldwide. While it will mainly focus on developing titles for game consoles, Pingu will also venture into various forms of entertainment. Equally exciting, we've welcomed T-0 Entertainment to the NetEase family. The studio is located in Austin, Texas, headed by Rich Vogel, an experienced game developer who has led development on groundbreaking multiplayer and service-based games such as Meridian 59, Ultima Online, Star Wars Galaxies, and Star Wars The Old Republic. T-Zero Entertainment is developing an online multiplayer-focused third-person action game that takes place within a sci-fi universe. Now let's move on to Youdao. The company's net revenues resumed its robust growth trajectory following the pandemic's impact earlier this year, registering a 26% year-over-year increase to reach RMB 1.2 billion, led by strong performance in our learning services and online marketing services. Our differentiated theme courses continues to drive year-over-year increase in our learning services revenue, For our goal and coding courses, their renewal rates have reached close to 70%, demonstrating our users' satisfaction with our course content. Online marketing services for Youdao achieved record revenues in the second quarter, nearly doubling comparing to the same period of last year. This achievement can be attributed to the utilization of our proprietary algorithm which has substantially elevated advertising precision and efficiency. Notably, it operates at a nearly 90% accuracy rate in intelligently targeting tagging KOLs and reduce the time required to produce advertising materials by 80%, all the while enhancing user satisfaction. For smart learning devices, we continued to invest in innovative technology and rolled out new products. We were excited to launch Youdao Dictionary Pen X6 Pro model in August, our first dictionary pen powered by our proprietary Ziyue large language model, which is the first large language model designed specifically for the education sector in China. X6 Pro offers highly personalized tutoring functions for students of varying ages and levels of learning progress. For instance, the platform introduces a digital human language coach named Echo. Echo engages users in interactive English aural practice, which teaches students how to initiate a conversation, express themselves naturally in a native manner, and provides grammar analysis based on students' submitted taxes through scanning. Looking ahead, our focus on technological innovation remains our driving force while we compel long-term success across our business lines. Turning to NetEase Cloud Music. In the second quarter, Cloud Music continues to enrich its music-centric ecosystem and optimized the user experience, resulting in a thriving music community. Total online music MAUs steadily climbed to 207 million for the first half of 2023, marking a 14% year-over-year increase, despite an industry-wide slowdown. Total revenues were already 1.9 billion, remaining stable compared to last quarter, This can be attributed to a combination of strong growth in online music services driven by revenues from subscription-based memberships and declining social entertainment services as we shift towards more sustainable development. Regarding margins, we are making remarkable progress. Our gross margin continues to improve in the second quarter reaching 27% versus 13% for the same period of last year. Cloud Music also achieved positive operating profit for the first time under IFRS in the first half of 2023. We continuously enrich our music library to offer a comprehensive music selection for our diverse audience base. In addition to the partnerships we established earlier this year with Being Music and Comix Wave Films, we were happy to announce our collaboration with the country's top pop singer Chris Lee, leading brand Yu Ding Mi, and renowned Mandarin label Rise Entertainment, which represents a number of highly acclaimed international pop stars, including Jackson Wong. Furthermore, we have also extended our collaboration with popular Korean labels, including Dreamers, SLL, and JTBC. Our collaboration efforts with copyright holders have also proven to be successful in terms of digital album sales. Notably, the digital album, I Feel, by the leading Korean girl group, Giddle, achieved over RMB 10 million in gross sales and 430,000 copies sold after its release in May. We continue to empower and support independent artists. By the end of June, we were serving a growing community of more than 640,000 registered independent artists. In addition to our support programs for nurturing music talent, We actively harness cutting-edge technology to provide tools that aid in music creation. During the second quarter, we introduced Cloud Music X Studio, a voice synthesis software developed in collaboration with Xiaobin, a technology innovator in lifelike interactions. This innovative tool offers 12 natural singing voices covering a variety of singing styles and provides musicians with resources in music creation. Moving forward, we will continue to foster our music-centric ecosystem, further grow our community, and drive healthy long-term monetization and margin expansion for NetEase Cloud Music. Now moving on to Yanshan. In the second quarter, our private label brand continues to thrive by strengthening its portfolio with a focus on premium quality. This coincided with a steady increase in Yanshan's revenues and significantly enhanced its profitability. In particular, the June 18 promotion yielded exceptional results. Our products achieved strong rankings on best-selling charts in diverse categories, including pet food, household cleaning products, and office furnitures, across leading e-commerce platforms. In Q2, we also introduced a campaign that highlights the production journey of some of our popular products. Using short films, we showcased how much detailed attention goes into the making of some of these products, which was heavily validated by our user community, looking ahead we will persist in our dedication to explore and introduce to consumer great, well-crafted products under the Yanshan brand. In summary, innovation through content production continues to be the cornerstone of NetEase and will be what propels our future growth. Superior content, products and services come from fresh ideas. This concept forms the heart of our company where we will always strive for excellence, manifest through hard work and persistence to inspire the industries we serve, from games to music to education to retail. We work to reimagine what is possible, creating value for our global community, our employees, and our stakeholders. This concludes William's comments. I will now provide a brief review of our 2023 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 more details. Total net revenue for the second quarter were RMB 24 billion, or US dollars 3.3 billion, representing a nearly 4% increase year-over-year. Total net revenues from our games and related value-added services were RMB $18.8 billion, up nearly 4% year-over-year. The growth was primarily driven by increased revenue contribution from mobile games, including our strong legacy titles, such as Fantasy Westward Journey series, and our newer games, such as Aggie Party. Net revenues from our mobile games accounted for approximately 74% of our total net revenues from online games operation. Yeodao's net revenue were RMB 1.2 billion, a year-over-year increase of 26%, primarily due to increased revenue contribution from learning services and online marketing services. Net revenues from cloud music were RMB 1.9 billion, a 11% decline compared to the same period last year. As explained last quarter, these results reflected declining revenue of social entertainment services as we adjusted our focus to improve profitability in a sustainable manner. We introduced multiple measures to enhance the listening experience of more dedicated music fans, lowered the revenue sharing ratio to broadcasters and agencies, as well as reinforced risk controls and additional live streaming function optimization. Net revenues for innovative businesses and others were RMB 2.1 billion, up 10% year-over-year with a balanced approach to top-line growth and margin expansion. Our total gross profit margin continues to grow, reaching close to 60% in the second quarter compared with 56% in the second quarter of last year. Looking at our second quarter margin in more detail, gross profit margin was 67.4% for our games and related value-added services sector, compared with 64.9% in the same period of last year. The growth was primarily driven by the termination of certain licensed games with comparatively lower gross margins. Our gross profit margin for Youdao was 47%, compared with 42.8% in the same period of last year. The increase mainly resulted from increased revenue contribution from its learning services and online marketing services, which carry higher margins. GP margin for Cloud Music continues to improve in the second quarter, climbing to 27% versus 13% in the same period one year ago. The quarter-over-quarter and year-over-year increase in Cloud Music's gross profit primarily resulted from the growth of membership services and continuous cost optimization initiatives. For our innovative businesses and others, gross profit margin was 29.5% compared with 25.8% in the second quarter of 2022. The increase was primarily the result of margin improvement in Yanshan. Total operating expenses for the second quarter were RMB 8.3 billion, or 35% of our total net revenues. Taking a closer look at our expense component, our selling and marketing expenses as a percentage of total net revenues were 13.6% in the second quarter and remained relatively stable year over year. Our R&D expenses as a percentage of total net revenue also remain stable year-over-year at 16.3% in the second quarter. As an innovative content and technology-driven company, our commitment to investing in content creation and product development is ongoing. We are also seeing leverage in our R&D investments in the longer term. Our other income was RMB 2.8 billion for the second quarter. The increase was mainly due to the market value appreciation of certain publicly traded securities in our investment portfolio during the quarter, as well as higher unrealized net FX exchange gains. As per applicable accounting standards, we are required to reflect these fair value changes. Effective tax rate was 8% for the second quarter of 2023. The lower effective tax rate for the second quarter was mainly due to tax benefits recognized in this quarter. As a reminder, the effective tax rate is presented on an accrual basis, and the tax credits differ for each of our entities at different time periods, depending on applicable policies and our operations. Our non-GAAP net income attributable to our shareholders for the second quarter totaled RMB 9 billion or US dollar 1.2 billion. Non-GAAP basic earnings per ADS for the quarter was US dollar 1.93 or US dollar 0.39 per common share. Additionally, our cash position remains strong. with net cash of approximately RMB 99.6 billion as of June 30th, compared with RMB 95.6 billion as of the end of last year. In accordance with our dividend policy, we are pleased to report that our Board of Directors have approved a dividend of U.S. dollar 0.105 per share or U.S. dollar 0.525 per ADS. Lastly, on our current U.S. dollar 5 billion share repurchase program starting in mid-January this year, approximately 6.1 million ADS have been repurchased as of June the 30th for a total cost of approximately U.S. dollar 536 million. Thank you for your attention. We would like now to open the call to your questions. Operator, let's move on to the Q&A.