NetEase, Inc. (NASDAQ:NTES) Q2 2023 Earnings Call Transcript

NetEase, Inc. (NASDAQ:NTES) Q2 2023 Earnings Call Transcript August 24, 2023

NetEase, Inc. beats earnings expectations. Reported EPS is $13.88, expectations were $1.33.

Operator: 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 Shi, Senior IR Director of NetEase. Please go ahead, ma’am.

Margaret Shi: Thank you, operator. Please note the discussion today will contain forward-looking statements relating to the 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 20-F and the announcements and filings on the website of the Hong Kong Stock Exchange.

The company does not undertake any obligation to update its 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 have 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’s 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 Yang, Chief Financial Officer. We will now turn the call over to Charles, who will read the prepared remark on behalf of William.

Charles Yang: Thank you, Margaret, and thank you, everyone for participating in today’s call. Before we begin, I would like to remind everyone that all percentages are based on RMB. Our total net revenues came in at RMB24 billion, an increase of nearly 4% year-over-year, and our net income attributable to shareholders increased by 56% year-over-year to RMB8.2 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 a luring 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 Eggy Party and Naraka: Bladepoint are showing similar popularity with potential longevity. Continuing its successful streak after more than a year of operation, Eggy Party 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 creative 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 NPC and blog editor. These additions not only offer increased flexibility but also push the boundaries of creative possibilities. To build on the domestic popularity of Eggy 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 Eggy Party in a few more regions including the Europe, North America, and Japan markets before we officially introduce Eggy 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 array of captivating new content, featuring fresh weapons, heroes, and engaging game-play 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 demonstrate 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 joined in massive groups of Generation Z players who were previously unfamiliar with the MMO genre, revitalizing the spotlight 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 game’s 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 debuted 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 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 this to life. We have ambitious plans for Racing Master in the global market. We are about to commence overseas testing with an aim 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 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. Well, it topped the download chart 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 topped the iOS downloads chart. 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 legend and dominate the court with real-time command using strategic progress and leadership skills.

Transitioning to our pipeline, alongside the exciting titles mentioned earlier such as Naraka: Bladepoint mobile game, Eggy Party and Racing Master for the international markets, Where Winds Meet, our open-world adventure RPG is counting down to its eagerly awaited 2024 launch. At Gamescom 2023 held this week, Where Winds 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 Winds Meet allows players to embark on a journey as a mysterious swordman 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 the 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 PinCool in Tokyo which is being led by Ryutaro Ichimura, a 20-year game industry veteran and long-time producer of the Dragon Quest franchise.

PinCool 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, PinCool will also venture into various forms of entertainment. Equally exciting, we’ve welcomed T-Minus Zero 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: Galaxy’s, and Star Wars: The Old Republic. T-Minus 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 RMB1.2 billion led by strong performance in our learning services and online marketing services. Our differentiated STEAM courses continues to drive year over year increase in our learning services revenue. For our go and coding courses, their renewal rates have reached close to 70%, demonstrating our user 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 while enhancing user satisfaction. For smart learning devices, we continue 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 defined 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 with interactive English RO practice which teaches students how to initiate a conversation, express themselves naturally in a native manner, and provide grammar analysis based on student’s submitted texts through scanning.

Looking ahead, our focus on technological innovation remains our driving force while we compile 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 MAU steadily climbed to 207 million for the first half of 2023, marking a 14% year-over-year increase. Despite the industry-wide slowdown, total revenues were RMB1.9 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 space. 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 [Givenchy] and renowned managing label RYCE Entertainment, which represents a number of highly acclaimed international pop star, including Jackson Wang.

Furthermore, we have also extended our collaboration with popular Korean labels, including DREAMUS, 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 (G)I-DLE achieved over RMB10 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 Xiaoice, a technology innovator in life-like interactions.

This innovative tool offers 12 natural singing invoices 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 Yanxuan. In the second quarter, our private-label brand continues to strive by strengthening its portfolio with a focus on premium quality. This coincided with a steady increase in Yanxuan’s revenues and significantly enhanced its profitability. In particular, the June 18 promotion yielded exceptional results. Our products achieved strong ranking on best-selling charts in diverse categories, including pet food, household cleaning products, and office furniture 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 showcase 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 Yanxuan. 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 re-imagine 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 RMB24 billion or $3.3 billion, representing a nearly 4% increase year-over-year. Total net revenues from our games and related value-added services were RMB18.8 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 Eggy Party.

Net revenues from our mobile games accounted for approximately 74% of our total net revenues from online games operation. Youdao’s net revenue were RMB1.2 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 RMB1.9 billion, a 11% decline compared to the same period last year. As explained, last quarter, this result 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, lower 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 RMB2.1 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 margin. 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 Yanxuan. Total operating expenses for the second quarter were RMB8.3 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 was 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 remained 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 RMB2.8 billion for the second quarter. The increase was mainly due to the mark-to-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 credit 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 RMB9 billion or $1.2 billion. Non-GAAP basic earnings per ADS for the quarter was $1.93 or $0.39 for common share. Additionally, our cash position remains strong with net cash of approximately RMB99.6 billion as of June 30 compared with RMB95.6 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 $0.105 per share or $0.525 per ADS.

Lastly, on our current $5 billion share repurchase program starting in mid-January this year, approximately 6.1 million ADS has been repurchased as of June 30th for a total cost of approximately $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.

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Q&A Session

Operator: Thank you. [Operator Instructions] Your first question comes from Alex Poon with Morgan Stanley. Please go ahead.

Alex Poon: [Foreign Language] Congratulations management and risk development team. We have got blockbuster title one after another launching this year. Can management elaborate how the Justice Mobile leverage AI to boost revenue and user engagement? And how did Justice Mobile became the first one of this kind in China to adopt AI? And can management also share some of the difficulties and expectations of this game into the future? Thank you very much.

William Ding: [Foreign Language] Thank you. I will do a quick translation. This is — the AI — we applied — AI has an effect on us in two ways. Firstly is on the — it has greatly enhanced our R&D efficiency and secondly, it enhanced our user experience. From the R&D efficiency perspective, we’ve adopted AI technology in programming, in graphic designing, and most importantly, we changed the way we think about designing games from just game plus AI to AI plus games, which means that when we — at the very beginning of designing the game, we start thinking AI, we build the whole — the world view based on AI world, which gives our users very immersive strong open-world experience. So for what we’ll be seeing, our users have been highly attracted to this game.

And then — we feel very strong stickiness and engagement of users of the game and it has — I think the enjoyment that users are getting from the game has caused voluntary stress or promotion of our game within the gamer community and will be able to attract many gamers who were traditionally non-MMO game players. And obviously how we want to add on here is that, apply AI technology into our game development is not something that can be achieved overnight. We started thinking about AI as far as back in 2016, 2017 when we saw AlphaGo and that’s when we realized AI will have a profound impact on gaming. So that’s one. So I think what the result seen today is the accumulation of all the investments and dedication we have put into AI research and AI development in games.

Thank you.

Margaret Shi: Our next question, please.

Operator: Your next question comes from Yang Bai with CICC. Please go ahead.

Yang Bai: [Foreign Language] Okay. I will translate that myself. After the success of Eggy Party, Racing Master, Justice Mobile, we noticed that the company has recently launched Dunk City Dynasty which ranks number eight on China’s iOS top-grossing chart soon after its launch. Could the management share more color on the operation strategy of this game and how should we think of the opportunity of esports games? Besides, we can also see that the company released the PV of urban open-world game of Project Mugen which seems to be another big title. Could management tell us more about this game? Thank you.

William Ding: [Foreign Language] Yes, to answer the first question on Dunk City Dynasty. So this game is actually our first attempt in sports game runway, specifically in basketball. After researching this market, we think there’s potential innovation we can do in this particular genre. So we actually, when we started to put together the team of developers and then designers, we asked all the team members — we chose all the team members who are hardcore basketball players, personally. So all of them have a passion about basketball and they want to play the best basketball game ever in the market. So yes, actually taking another few years of development and dedication optimization, we want to — we feel like we only launched the game when we feel like we’ve mastered great graphics, and a maneuver and style in that game.