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NetEase, Inc. (NASDAQ:NTES)
Q3 2017 Earnings Conference Call
Nov. 15, 2017, 8:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, everyone, and welcome to the NetEase 3rd quarter 2017 Earning Conference. Today's call is being recorded. At this time, I'd like to turn the conference over to Brandi Piacente. Please go ahead, ma'am.

Brandi Piacente -- Investor Relations

Thank you. Please note the discussion today will contain forward-looking statements related 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 this discussion.

A general discussion of the risk factors that could cause 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. 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 2017 third quarter financial results news release issued earlier today.

As a reminder, this conference is being recorded. In addition, an investor presentation and a webcast 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, is Mr. William Ding, Chief Executive Officer, Mr. Charles Yang, Chief Financial Officer, and Mr. Hilton Huang, Co-president of NetEase Game. I will now turn the call over to Mr. Yang, who will read the prepared remarks on behalf of Mr. Ding.

Charles Yang -- Chief Financial Officer

Thank you, Brandi. 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. With that said, I am pleased to deliver opening remarks on William's behalf.

Since establishing NetEase in 1997, our focus has been on innovation, high-quality content, and community. 20 years later, we are pleased to be implementing these same values as we develop and operate some of China's most popular mobile and PC-client games, as well as some of the country's most prominent advertising, communication, and e-commerce services.

The cornerstones of our future success are based on these principles, along with our ability to continue to broaden and diversify our portfolio of online products and services, enhance our brand equity, and extend our global footprint.

During the third quarter, we did exactly that. We advanced each of core business segments year-over-year, growing our quarterly net revenues by nearly 36%. Our growth was spearheaded by our online game services sector and in particular our mobile games, which accounted for approximately 68% of this segment's net revenues, led by our self-developed mobile games, including Onmyoji, New Ghost, Land of Glory, Invincible, and Demon Seals.

The popularity of several of our legacy games continues to grow and our PC-client game, Fantasy Westward Journey online, and mobile game, Invincible, achieved another record quarterly revenues during the third quarter.

In addition to our legacy titles, Players are also responding enthusiastically to our newer hit games, such as Onmyoji. Although Onmyoji's performance in China slowed down in the third quarter, this popular title regained traction when we introduced new content and game play supported by promotional activities through media, literature, and merchandise collaborations.

To further expand the success of the Onmyoji brand, and to captivate players, we are developing a Battle Arena game based on the Onmyoji IP. The initial testing for this game is progressing well and on track with our expectations.

In line with our expansion strategy to bring exciting titles overseas, Onmyoji's international presence remains strong. After being introduced in Japan and Southeast Asia, Onmyoji was also successfully launched in Korea, followed by promising user feedback during closed beta testing in the US and Canada.

We also strengthened our portfolio in the third quarter by introducing a number of new expansion packs that extend the life cycles of our games as well as launched new mobile titles.

The highly anticipated release of Minecraft in China went exceptionally well as we introduced the game for PC Java and IOS in the third quarter, and Android shortly thereafter in October. On its first day of release, Minecraft was ranked the number one downloaded mobile game on both the iPhone and iPad. Minecraft has received considerable accolades in China and, by the end of October, the game had accumulated nearly 30 million registered users.

Early monetization efforts for Minecraft are underway with server rental and partial content monetization for the PC Java version, which began in mid-September. We have also initiated monetization taxing for high pixel server and we plan to commerce small scale monetization for the mobile version in early 2018.

Our renowned portfolio of games continues to delight Chinese players. In addition to Minecraft, we also introduced Index, a Japanese-themed ARPG to millions of gamers and fans during the third quarter.

We are focused on growing our portfolio with a number of new, exciting games in our pipeline that broaden and diversify our offering in a variety of genres. We have a rich pipeline that leverages our top resources in R&D and talented pool of developers and an optimal strategy to license and operate marquee games.

In the coming quarters, we are looking forward to bringing new titles across different genres to gamers, including MMORPG such as Chu Liu Xiang and Tribes and Empires: Storm of Prophecy, Japanese-themed ARPG Forever 7 and card game Kari‐ri-sei Million Arthur, as well as a battle arena game based on Onmyoji IP and our 3D PC-client game Conqueror's Blade.

In addition to our domestic offerings, we are bringing our vision to audiences across the globe to markets where mobile games are growing at a steady pace. International expansion allows us to grow our brand worldwide and introduce our games to audiences around the world. Eager for the thrilling, high-quality game experience that NetEase players love -- games like Onmyoji and Crusaders of Light are performing very well overseas. Crusaders of Light has now been recognized as one of the top growing games in more than 20 different countries since its launch.

Now, turning to our other business segments. Leveraging our technology advantage, premium brand, and larger user base, we continue to strengthen our market position with NetEase Media. During the third quarter, we grew our advertising services net revenue by approximately 12% year-over-year with automobile, real act stage, and Internet services as our top performing verticals.

Our entertainment marketing program is supporting a growing number of high profile projects and we are also seeing an increase in demand for performance-based advertising to support our growth in an otherwise mature market. Investment in both original and third-party high-quality content, customized smart push technology, video content, and innovative marketing solutions amid an evolving advertising climate support our ability to remain one of the most sought-after advertising platforms in China.

Our email, e-commerce, and other business also continue to grow in the third quarter with net revenues increased by nearly 80% year-over-year, primarily due to increased revenue contribution from our e-commerce business, such as Kaola and Yanxuan. These e-commerce platforms are prospering the net revenues from Kaola and Yanxuan of RMB2.7 billion, accounting for approximately 71% of the segment's net revenues.

Each of our business lines is integral to our growing brand. As we continue to amass one of China's preeminent game portfolios, we are simultaneously focused on advancing our Internet service offerings to support our healthy business platform. We will continue to invest in the growth of each of these business segments. Together, they strengthen not only the NetEase brand but our commitment to our investors and user community.

This concludes William's comments.

I will now provide a review of our third quarter 2017 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 detail.

Our gross profit for the third quarter of 2017 was RMB5.9 billion, US$893.9 million compared to RMB6.7 billion and RMB5.3 billion for the preceding quarter and the third quarter of 2016 respectively. Our gross profit grew year-over-year for our online game segment in the third quarter. However, as mobile games become an increasing revenue contributor, gross margin for our online games business decreased slightly. For the third quarter of 2017, gross profit margin for our online games was 62.5% compared to 63.1% and 65% for the preceding quarter and the third quarter of 2016 respectively.

Gross profit margin for our advertising services business increased year-over-year and quarter-over-quarter in the third quarter of 2017 with gross margin of 68% compared to 67.6% and 65.3% for the preceding quarter and the third quarter of 2016 respectively.

Gross profit decreased year-over-year for our email, e-commerce, and other businesses for the third quarter of 2017 with gross margin of 11.9% compared to 11.3% and 33.5% for the preceding quarter and the third quarter of 2016 respectively. This is mainly a result of a change in product mix with Kaola and Yanxuan representing increasingly significant revenue contribution.

Total operating expenses for the third quarter of 2017 were RMB3.4 billion or US$510.7 million compared to RMB3.3 billion and RMB2.5 billion for the preceding quarter and the third quarter of 2016 respectively.

For the third quarter of 2017, we recorded a net income tax charge of RMB225.5 million or US$33.9 million compared to RMB703.5 million and RMB427.2 million for the preceding quarter and the third quarter of 2016 respectively.

The effective tax rate for the third quarter of 2018 was 8.1% compared 19% and 13.3% for the preceding quarter and the third quarter of 2016 respectively. The changes in the effective tax rate were mainly due to the recognition of tax credit related to key software enterprises for certain subsidiaries in the current quarter and the third quarter of 2016.

Our net income attributable to shareholders for the third quarter of 2017 totaled RMB2.5 billion or US$379.9 million compared to RMB3.0 billion and RMB2.7 billion for the preceding quarter and the third quarter of 2016 respectively.

Non-GAAP net income attributable to our shareholders for the third quarter of 2017 totaled RMB3.0 billion or US$454.6 million compared to RMB3.5 billion and RMB3.0 billion for the preceding quarter and the third quarter of 2016 respectively.

For the third quarter of 2017, our basic and diluted earnings per ADS were US$2.88 and US$2.86 respectively. This compares to basic and diluted earnings per ADS of US$3.39 and US$3.37 respectively for the preceding quarter and US$3.14 and US$3.12 respectively for the third quarter of 2016.

Our non-GAAP basic and diluted earnings for ADS for the third quarter of 2017 were US$3.45 and US$3.43 respectively. This compares to US$3.96 and US$3.94 respectively in the preceding quarter and US$3.46 and US$3.43 respectively for the third quarter of 2016.

Our cash position remains strong. As of September 3, 2017, our total cash and cash equivalent, current and non-current time deposits, and short-term investment balance total RMB40.7 billion or uS$6.1 billion. This compares with RMB36.9 billion as of December 31, 216.

Our cash flow generated from operating activity was RMB1.7 billion or US$248.8 million for the third quarter of 2017 compared with RMB2.3 billion and RMB3.7 billion for the preceding quarter and the third quarter of 2016 respectively.

Returning value to our shareholders remains a top priority. For the third quarter of 2017, we plan to pay a dividend of US$0.72 per ADS in accordance with our 25% dividend distribution policy. Under our current share repurchase program, we repurchased approximately 1.1 million ADS for approximately US$306.1 million as of November 14, 2017, the last day of this program. To continue this activity, our board has approved a new 12-month share repurchase program beginning on November 16, 2017, for up to US$1.0 billion.

...

Thank you for your attention. We would like now to open the call to questions. Operator, please go ahead.

Questions and Answers:

Operator

Thank you. Ladies and gentlemen, we will now begin the question and answer session. [Operator Instructions] We'll go first to Hillman Chan with Citigroup.

Hillman Chan -- Citigroup -- Analyst

Good morning, management. Thank you for taking my question. This is Hillman on behalf of Alicia. My first question is regarding the monetization strategy and potential for Wilderness [speaks Mandarin] and also Minecraft, please, for both PC Java and mobile. And, regarding [speaks Mandarin] Wilderness how do we see the competition from several games of similar genre in the market? [Repeats questions in Mandarin] And then I have another follow-up question.

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

Okay, so let me translate the response from William. Firstly, to address the competition. Wilderness is a SimBot battle arena game. Currently, it's in the internal testing stage, so we will continue to optimize this game to inject innovation and bring this exciting new game to our global audience. In terms of monetization, for Minecraft this is a sandbox platform. Essentially, you can think of this as a marketplace. We encourage developers to come to this marketplace, this platform, to come up with exciting, innovative molds and users willing to pay for these molds to get enhanced user experience on Minecraft platforms.

For Wilderness, as you know, this is an FPS game. It is also based on a sandbox concept. You should take full confidence in NetEase's almost two decades of experience in developing games and bringing innovations. We have full confidence in this game and we think of this quite many opportunities in terms of monetization in this game without compromising the user experience of this fair battle arena game. At this stage, we are not really rushing out for any of the monetization initiatives for these games.

Operator

Next, we'll move to Natalie Woo with CICC.

Natalie Wu -- China International Capital Corporation -- Analyst

Good morning, management. Thanks for taking my questions. I actually have three questions. The first one is regarding your deferred revenue as we noticed that your total deferred revenue this quarter increased to 2.7 sequentially. So, what are the drivers behind this sequential increase? My second question is about international expansion. Can management please share your current progress and future plans for the overseas expansion? What are the rough contributors from the overseas market at the current state and how should we expect this contribution going forward?

My third question is regarding your music business. Could management please elaborate more about your current strategy for this business, especially the competition of music copyrights are getting fierce among major players. Can management please share your thoughts for current competition landscape? Any comments would be helpful. Thanks.

Charles Yang -- Chief Financial Officer

Natalie, let me answer your first two questions on financials and then I will translate the third question to William and the management. On deferred revenue, this quarter's deferred revenue has been stabilized. This is largely because of our game grossing performance has been stabilized in the recent quarter. As you know, deferred revenue -- we never changed any accounting policy for the revenue deferral. So, the numbers reflect the stability of the performance of the games.

For your second question on international expansion, as you know, we are continuing with this initiative. Overseas revenue this quarter accounted for approximately 2.4% of the total revenue, which has been quite stable comparing to the preceding quarter and the significant improvement comparing to prior year.

For your third question, I will translate for the management.

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

Okay. So, our cloud music is quite unique in terms of a competitive landscape. Our smart push technology is the best in class. But, beyond that, we've also been quite focused on original music. There are millions of independent musicians in China that create very exciting music. And cloud music, this platform, is dedicated to be the priority choice of the platform to help these independent musicians to broadcast and distribute their music to a broader audience of music lovers.

Operator

Next, we'll move to Jialong Shi with Nomura Securities.

Jialong Shi -- Nomura Securities -- Analyst

[Questions in Mandarin] I will translate my questions. My first question is about the e-commerce business. I was quite impressed by the strong growth of NetEase e-commerce service in the past quarters. NetEase e-commerce revenue -- e-commerce business has reached such a big scale and I just wonder if NetEase may consider partnering with any external strategic investors. If yes, what types of investors does NetEase like to work with?

My second question is about a recent media report that is based on the report where NetEase recently reviewed one of the game live broadcasting platforms for live streaming NetEase online games. I just wonder what's the rationale for NetEase to take this action and how does NetEase think of its relationship with this external game live broadcasting platforms.

Charles Yang -- Chief Financial Officer

The first question, for our e-commerce. As you know, e-commerce remains one of our pivotal focuses of broadening our Internet products and services. We remain openminded. We welcome all strategic partnerships, particularly on the business level. At appropriate times, we will also consider bringing in external strategic shareholders. For now, I think our top priority is to continue to build up Kaola and Yanxuan brand equity among the users by focusing on the user experience by bringing in a new e-commerce concept to the Chinese users.

The second question I will defer to the management.

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

So, to your second question, Jialong, this incident was actually referring to three years ago, in 2014, when that platform was broadcasting Fantasy Westward Journey. During the broadcasting, they inserted an advertisement that directed the audiences to a suboptimal quality web game. We think that is not appropriate. We have been following written communications with the platform because we did not get the reasonable response within a reasonable timeframe. So, we have initiated this litigation process.

But, overall, in terms of our relationship to all of the live streaming platforms, we remain very openminded. We, in fact, welcome all of these partnerships and broadcasters to come and experience our NetEase games. We have a lot of exciting games. Minecraft, Overwatch, Hearthstone, as well as our own self-developed games. All of these are very suitable content for game live streaming. But, of course, we will require reasonable and rational restrictions not to do things inappropriate and jeopardize the user experience when other platforms are broadcasting our games.

Operator

And we'll move next to Ji Sing with HSBC.

Wing Wong -- HSBC -- Analyst

Hi, thank you for taking my questions. This is Wing Wong speaking on behalf of Ji. I have a question regarding the monetization of Wilderness. As management has mentioned that they will come up with some interesting ideas about monetization, so I have noted that. There recently some advertisement for Wilderness -- for example, the advertisements on the plane. Will that be the majority main monetization approach in going forward? Will that be included in the advertising services segment or online games segment? Also, in this quarter -- in margin, you have need to recover. So, what's our long-term expectation about the email segment margin to get Q-on-Q slightly improved? So, how should we see the long-term indication about the second margin or maybe the e-commerce margin going forward? Thank you very much. [Questions repeated in Mandarin] 

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

So, let me first translate for William's comments. First of all, for Wilderness -- or, more broadly, for these survival category games. This is a new genre and we will take a holistic approach in terms of monetization, just like this high-quality game as surprised users. Just give us some patience and confidence. As you know, we will have a very comprehensive approach to monetize this game in due course. At this stage, do not worry too much and we are not overly rushed out in terms of this monetization asset.

To your second question on the margins, overall, we are happy to see that email, e-commerce, and other segments, the margin has now been stabilized. I think, going forward, we remain -- the margins will be stabilized at this level as we further grow our e-commerce and other business units within this segment. Over the longer term, we think the scale factor will start to kick in. But, that would also require some time.

Operator

Next, we'll move to Tian Hou with T.H. Capital.

Tian Hou -- T.H. Capital -- Analyst

Okay, so good morning, management. I have a question not really related to your game. I do believe you guys have a strong capability of coming out with surprising good content. The question is really related to what is really the bad word -- AI, big data. At NetEase, you have lots of lots of data. Emails, dictionaries, games, commerce, and news. I haven't heard a word from you about the big data, about AI. I wonder how NetEase actually benefits, or uses, such property to benefit your own content creation. That's my question, William.

Charles Yang -- Chief Financial Officer

Okay. Let me translate for the management.

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

So, to answer your question, AI -- we also agree in recognizing the importance of AI toward the future success. However, we are also a little bit concerned that, in media in particular, AI, big data, and these buzz words have been overly exaggerated. To NetEase, we invest significantly into AI, big data, and all of these new trends of technologies. But, ultimately, we believe these technologies are best reflected out of the product -- the user experience of the product. To give some concrete example, for instance, our Youdao dictionary. We have been adopting the AI technology into this product and it can now utilize this app for verbal translation as well as translating the contents when you take a photo, for instance.

In this regard, we think we are very advanced. Another cloud is in our cloud music. We've also been embedding AI technology into our daily push. So, this is our belief. We think, instead of overexaggerating AI as a mysterious science, our approach is that we take this very modern technology, embed them into the products, and the users eventually will feel the difference because they don't necessarily need to recognize the science behind it. What they get is the product experience they ultimately have and it represents an elevated and enhanced user experience. 

Operator

Next, we'll move to Han Joon Kim with Deutsche Bank.

Han Joon Kim -- Deutsche Bank -- Analyst

Great. Thank you for taking my questions. I have two. One is on Wilderness versus Terminator II. I think they're similar games, but why do you think we're seeing better responses from one of the other, apart from the IP? If you could just give us some qualitative color on that, that'll be great. And then, the second one is on Minecraft KPI. If you could just give us a little bit more on TAU or time spent or any other metrics apart from registration. That would be helpful. Thank you.

Charles Yang -- Chief Financial Officer

Let me translate for the management.

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

To answer your first question, Wilderness and Terminator II -- broadly speaking, they fall into the same genre, the same category. But, there are very subtle differences in terms of user experience. On the technology perspective, both games are self-developed and we utilized two different self-proprietary engines for these games. They bring different -- subtle, but they bring different experiences catering to different user demands. So, in terms of the data we see, the user profiles of playing these two games are actually quite different. [Speaks Mandarin]

For Minecraft, as you all know, this is at a relatively early stage and we are starting early monetization in recent months, as well as in early 2018. So, at this stage, other than accumulated users, we don't plan to disclose any other additional KPIs. But, to reiterate, we have full confidence in this game in the longer run.

Operator

Next, we'll move to Fan Liu with Goldman Sachs.

Fan Liu -- Goldman Sachs -- Analyst

Hi, management, this is Seth asking on behalf of Fan. Thank you for taking my question. I have two questions. The first question is on e-commerce. Given the rising revenue contribution, perhaps when could we expect maybe a separate disclosure of the segment on a quarterly basis? And the second question is on whether management could share some color on the game performance of Blizzard. [Repeats questions in Mandarin]

Charles Yang -- Chief Financial Officer

So, for the first question, let me answer you. We are actively exploring the possibility of separating out our e-commerce. We're actively discussing that among our auditors and counsel. We hope to materialize that as early as next quarter. 

For the second question, let me defer to the management.

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

With respect to Blizzard, they are a very close business partner with us. A couple of key titles that we license from Blizzard are performing well in China. We expect to further deepen our strategic relationship with Blizzard. With Starcraft II, we are in the process to make it free-to-play mode. Overall, because of this close partnership with Blizzard, we are actually keeping a very active dialogue to collectively bring the best product experience and user experience to the Chinese gamers.

Operator

Next, we'll move to Marcus Yang with Macquarie.

Marcus Yang -- Macquarie -- Analyst

Thanks for taking my question, management. I have two questions. First of all, regarding survival territory games, can you share the rationale behind the popularity of this genre, in your view? I guess, one thing could be the social community element. Do you think that factor will continue for the upcoming potential new hit sharers? Anything that you can share regarding the key element for the next potential sharers. My second question is regarding how are the regulation issues being fixed here? Regarding the survival game genre -- from your perspective, is this a winner-take-all genre or market? That is my question. [Repeats questions in Mandarin]

William Ding -- Chief Executive Officer and Director

[Response in Mandarin]

Charles Yang -- Chief Financial Officer

First of all, I would like to correct a concept. This genre -- we don't agree to call this genre as a survival type of game. To us, this broadly falls into a sandbox category. One important element of this sandbox category is that you enjoy the total freedom every time you're entering into the game. You have the total freedom to experience the game with endless possibilities. This is the same for Minecraft, for instance, and same for our Wilderness and Terminator II. We don't' encourage anyone to view this game as, so to speak, a survival type of game. So, that's something we would like to elaborate here.

Operator

And due to time constraints, there are no further questions. I will turn the call back over to management for any closing or additional remarks.

Brandi Piacente -- Investor Relations

Thank you once again for joining us today. If you have any further questions, please contact Julia Yang, NetEase's Senior IR Manager or Hangzhou at ir@serve.netease.com or TPG Investor Relations. Thank you.

...

Operator

And everyone, that does conclude our conference call for today. Thank you all for your participation. You may now disconnect.

Duration: 58 minutes

Call participants:

Brandi Piacente -- Investor Relations

Charles Yang -- Chief Financial Officer

William Ding -- Chief Executive Officer and Director

Alicia Yap -- Citi -- Analyst

Jialong Shi -- Nomura Securities -- Analyst

Natalie Wu -- China International Capital Corporation -- Analyst

Han Joon Kim -- Deutsche Bank -- Analyst

Fan Liu -- Goldman Sachs -- Analyst

Hillman Chan -- Macquarie -- Analyst

Tian Hou -- T.H. Capital -- Analyst

Wing Wong -- HSBC -- Analyst

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