Brandi Piacente - IR, The Piacente Group Onward Choi - Acting CFO William Ding - CEO

Dick Wei - Credit Suisse Alicia Yap - Barclays Eddie Leung - Merrill Lynch Martin Bao - Bank of China International Thomas Chong - Citigroup Hillman Chan - Macquarie Tian Hou - T.H. Capital

Good day and welcome to the NetEase Second Quarter 2015 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Brandi Piacente. Please go ahead.

Thank you, operator. Please note that the discussion today will contain forward-looking statements relating to future performance of the company and are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities 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 affect NetEase's business and financial results are 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 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 measures and results please see the second quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. In addition, a webcast replay of this conference call will be available on the NetEase corporate site at ir.netease.com. I will now turn the call over to Mr. Onward Choi, Acting Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi. Before I begin, please note that for the purposes of this discussion, all percentages are based on renminbi. The rapid consumption of mobile games is driving considerable growth in China’s online games industry. With our long history as an Internet innovator and some of the best R&D talent available, our strategy to expand into most [Indiscernible], while still in its early stages, is beginning to take shape and contributing to our growth objectives. Our strong second-quarter results reflect this success with growth from both our PC-clients and mobile games. In fact, we saw heavy revenue increases across all three of our business segments, both sequentially and year-over-year. Compared with the same quarter in 2014, we saw revenue increases of 64.8% from online games, 22.8% from advertising services revenues, and 123.3% from our e-mail, e-commerce and others business segments. The diligent work we have put into expanding and diversifying our mobile portfolio is becoming more evident. We now operate more than 30 mobile games across a variety of genres to appeal to a broad and growing audience, and we plan to continue to build on this success. We are delighted with our accomplishments during the second quarter. To name a few, our Fantasy Westward Journey mobile game reached a record peak concurrent user level of more than 2 million in May. This game has performed extremely well and has been ranked as the top grossing app in the iOS China app store since its launch in March of this year. As of July, it was the only mobile game in China with its own customized download page in the iOS app store. For our PC-client games, we were very pleased with the performances of some of our newest games in particular Revelation, our 3D oriental fantasy MMORPG, and our 2.5D MMORPG Demon Seals, we launched in April. Both of these games have been well received by users with positive feedback. During the second quarter, we also released expansion packs for New Westward Journey Online II and Ghost II as well as conducted further beta testing for our 3D warfare MMORPG, Hegemon-King of Western Chu. Our licensed games also fared well in the second quarter. We were very excited to be launching Blizzard Entertainment's Diablo III, Reaper of Souls in China, through the joint effort of Blizzard and NetEase, and with the incredible support of passionate Chinese players. Additionally, the April launch of the mobile phone versions of Blizzard Entertainment's Hearthstone, Heroes of Warcraft helped drive that game's number of active users to a new high. Lastly, Heroes of the Storm, Blizzard's brand-new free-to-play online team brawler, began open beta testing in late May followed by the game's official launch in early June, which had a promising performance. We continue to work closely with Blizzard to introduce exciting new content to China and are thrilled to have licensed Overwatch, Blizzard's first-ever first-person shooter game. Our pipeline of PC-client and mobile games is strong and growing. Leveraging our strong research and development program we plan to continue to introduce new games and contents throughout the year. In July, we introduced a new expansion pack for our popular game Tianxia III, and are targeting a number of new expansion packs later in the third quarter for our self-developed games, including Fantasy Westward Journey II. At the same time we are expanding our portfolio of mobile games. Last month we released several new titles that have been well received by users including Fairy Tales, The World of the Brave, a licensed cartoon-style side-scrolling mobile game. In the coming months, we plan to release more mobile games based on our acclaimed self-developed franchises, including the Westward Journey Online mobile game, The X-World, an action-packed mobile ARPG game from the Tianxia universe, and Fantasy Westward Journey, Warriors, an exciting mobile action adventure game. We continue to evaluate international market opportunities, and our expansion plans are well under way to broaden our market reach through cross-country partnerships and licensing agreements, as well as independent sales. We have already licensed several of our mobile games to the Southeast Asia market, and our pipeline is focused on building mobile games for Western audience. And the first of our mobile games for North American markets will be an adaptation for local markets of Speedy Ninja. Turning to our advertising services business, this segment continued to perform well in the second quarter, driven by overall market demand and monetization efforts for our Mobile News Applications. The top performing advertising verticals in the second quarter were the automobile, Internet services, and food and beverage sectors. Additionally, our cross-border e-commerce platform, Kaola.com, experienced rapid growth in the second quarter and continues to gain user traction. This platform is still in its early stages and we continue to broaden our capabilities by adding high-quality suppliers, increasing warehouse efficiencies, and strengthening our overall brand equity. We have built our company on innovation and understanding the market with an innate ability to evolve and adapt our technology to address market demand such as increasing mobile accessibility. This flexibility supports our strategy to provide our community with exclusive and diverse products and services that met their expanding needs. We will continue to focus on creating top quality new games for both PC-client and mobile users and expanding our loyal user base. Our goal is to achieve balanced growth across our businesses by delivering exceptional products and services to our loyal and growing community. This concludes William’s comments. I will now provide a review of our second quarter 2015 financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profit. Total sales tax for the second quarter of 2015 were RMB265.2 million or US$22.8 million compared to RMB225 million and RMB184.4 million for the preceding quarter and the second quarter of 2014 respectively. The year-over-year and quarter-over-quarter increases in sales tax were mainly due to the increase in our total revenues. Gross profit for the second quarter of 2015 was RMB2.8 billion or US$459 million, compared to RMB2.5 billion and RMB2 billion for the preceding quarter and the second quarters of 2014, respectively. The year-over-year and quarter-over-quarter increases in online games gross profit were primarily driven by revenue contributions from our mobile games including the Fantasy Westward Journey mobile game, and licensed games such as Blizzard Entertainment's Diablo III, Hearthstone, Heroes of Warcraft and Heroes of the Storm, as well as our new self-developed PC-client games such as Revelation and Demon Seals. The year-over-year increase in advertising services gross profit was primarily attributable to strong demand from the automobile, Internet services and food and beverage sectors, and the monetizations of our mobile applications, primarily our Mobile News App. The quarter-over-quarter increase in advertising services revenues and gross profit was primarily due to seasonality. The year-over-year and quarter-over-quarter decreases in e-mail, e-commerce and others gross profit were primarily due to the temporary suspensions of e-commerce services related to third-party lottery products since late February 2015, which was partially offset by increased revenue contributions from our cross-border e-commerce platform Kaola.com and e-mail services, which have lower gross profit margins. Our gross profit margin for the online games business for the second quarter of 2015 was 69.3%, compared to 73.1% and 77.6% for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter decreases in gross profit margins were mainly due to increased revenue contributions from mobile games, which have relatively lower gross profit margins, as a percentage of our total online games revenues. Gross profit margins for the advertising services business for the second quarter of 2015 was 68.2%, compared to 59.2% and 60.9% for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter increases in gross profit margins were mainly due to enhanced economies of scale driven by revenue growth. Gross profit margin for the e-mail, e-commerce and others business for the second quarter of 2015 was 4.2%, compared to 38.9% and 35.7% for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter decreases in gross profit margins were primarily attributable to the temporary suspension of e-commerce services related to third-party lottery products discussed above, as well as increased revenue contributions from Kaola.com and our e-mail services, which have relatively lower gross profit margins. Total operating expenses for the second quarter of 2015 were RMB1.4 billion or US$225 million, compared to RMB1.2 billion and RMB823.7 million for the preceding quarter and the second quarter of 2014, respectively. The year-over-year increase in operating expenses was mainly due to increased selling and marketing expenses for mobile and PC-client games, and increased staff-related research and development costs resulting from an increase in the number of employees and share-based compensation. The quarter-over-quarter increase in operating expenses was mainly due to increased promotional costs for online games, which was partially offset by decreased promotional costs for the e-mail, e-commerce and others business. We recorded a net income tax charge of RMB145.9 million or US$23.5 million for the second quarter of 2015, compared to RMB214.5 million and RMB97.9 million for the preceding quarter and the second quarter of 2014, respectively. The effective tax rate for the second quarter of 2015 was 9.2%, compared to 14.1% and 7.4% for the preceding quarter and the second quarter of 2014, respectively. The quarter-over-quarter decrease in the effective tax rate was mainly due to the company recognizing certain tax credits in the second quarter of 2015 related to annual tax filing benefits, most of which comprised extra tax deductions for research and development expenses approved by the tax authorities. We also had a net foreign exchange loss of RMB21.7 million or US$3.5 million, compared to a net foreign exchange gain of RMB22.7 million and a net foreign exchange loss of RMB20.2 million for the preceding quarter and the second quarter of 2014, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to unrealized exchange gains and losses arising from our foreign currency-denominated bank deposits and short-term loan balances as the exchange rate of the U.S. dollar against the RMB fluctuated over the periods. Our net income attributable to the company's shareholders for the second quarter of 2015 totaled RMB1.4 billion or US$229.7 million, compared to RMB1.3 billion and RMB1.2 billion for the preceding quarter and the second quarter of 2014, respectively. Non-GAAP net income attributable to the company's shareholders for the second quarter of 2015 totaled RMB1.6 billion or US$256.4 million, compared to RMB1.4 billion and RMB1.3 billion for the preceding quarter and the second quarter of 2014, respectively. Basic and diluted earnings per ADS for the second quarter of 2015 were US$1.75 and US$1.74, respectively. This compares to basic and diluted earnings per ADS of US$1.56 and US$1.55, respectively, for the preceding quarter, and US$1.48 each for the second quarter of 2014. Non-GAAP basic and diluted earnings per ADS were US$1.95 and US$1.94, respectively, for the second quarter of 2015. This compares to non-GAAP basic and diluted earnings per ADS of US$1.75 and US$1.74, respectively, in the preceding quarter, and US$1.57 each for the second quarter of 2014. As of June 30, 2015, our total cash and time deposits balance was RMB20.7 billion or US$3.3 billion, compared with RMB21.2 billion as of December 31, 2014. Cash flow generated from operating activities was RMB835.9 million or US$134.8 million for the second quarter of 2015, compared to RMB1.9 billion and RMB1.2 billion for the preceding quarter and the second quarter of 2014, respectively. As part of our efforts to return value to our shareholders we are pleased to announce that in conjunction with our quarterly dividend policy, our board of directors has approved a dividend of US$0.44 per ADS for the second quarter of 2015. We expect to pay this on September 4, 2015 to shareholders of record as of the close of business on August 28, 2015. Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

Thank you. [Operator Instructions] And our first question comes from Dick Wei with Credit Suisse.

Hi, good morning. Thank you for taking my questions. I have two questions. First one is, I wonder if William or Onward can talk a little bit more about the life cycle for the Fantasy Westward Journey mobile game user given the strong growth in revenue is mainly coming still from the old user or we are seeing a lot of the new user coming on to play the games and contribute to revenue, so that is the first question. and the second question is, we see a pretty big increase in deferred revenue, I wonder if management can give like a mix of where is the deferred revenue coming from, maybe by PC mobile or maybe from specific games as well. Thank you.

So with regard to [Dick’s] first question about life cycles of FWJ mobile, basically we do see that since we first launched the games back in early April. Till now, about four months time, the game itself has been ranked as Number One for almost 99% over the time period on the iOS China app store, which is very encouraging. And basically from the company’s perspective, we are quite satisfied with its product performance, and we are still very confident more with regards to its revenue contributions in the upcoming periods. And based on our market research that has been undertaken so far, we have received very positive user feedback from the market, and we would uphold our business philosophies to deliver the highest qualities of products and the best ever user experience to our users by rolling out or launching our mobile games. And we are also expecting that there would be some newer versions to enrich the content and features of this game, so as to ensure that the user experiences can upkeep to the highest level of all times. And in terms of the distributions of the user profile, basically around 70% of it would be coming from the new users whereas the rest of the 30% would be coming from our existing PC-client games users. And we are expecting that for both the new and old users. They would be getting very good experiences of trying out these new mobile games, and this basically finished the first part on William’s comments on the first question. And with regard to [Dick’s] questions on the deferred revenue, and basically we do see that it has increased quite a bit in the second quarter, and basically we do see that there has been good growth in terms of our mobile games initiatives, which have increased the deferred revenues, and we also see that for all our other games, there has also been a nice growth in terms of the deferred revenues.

Great. Thank you very much William and Onward.

Thank you. Our next question comes from Alicia Yap with Barclays.

Hi, good morning William, Onward and Brandi. Congratulations on the solid quarter. Thanks for taking my questions. I do have follow-up questions on the deferred revenue, so I understand that it is related to FWJ and other games, just wanted to know a little bit color how long you would recognize the rest of those revenues, is it for the following three quarters, or the maximum of 12 months, and then can you give a little bit more color on the FWJ trends since the launch in the end of March, if the gross billing ramped up like month-over-month or is it a big jump in April and then kind of steady and small growth for the month after that?

So, perhaps I would just give you – first answer to your first questions about the deferred revenue. Basically we do see that there has been a good increase in terms of the revenue coming from the mobile fronts as well as from our PC fronts, and as long as how long we are going to recognize the revenue, it still would be – depends on the consumption of those different items [Indiscernible]. But basically you would expect that this would take a very long time. And with regard to the second questions about the FWJ Mobile trend, basically so far we are still seeing then – it has been progressing well, and basically the gross billings has also been up at very high levels and we do see that [Indiscernible] since we first launched the mobile games of FWJ in the market in late March or early April, it has been accounted in the top ranking in the iOS China app store for that long, which is a very good proof to see that the game has been very popular among the users. And we are also still expecting that…

I see, and then related to that, maybe can you share with us some, is there anything you have done differently to the game design and the game play that the FWJ able to achieve such an instant success, and even because relatively short life cycle for all the mobile games so far in other like other companies or other games. What your team is doing to keep the gamers interest in the game, any color you could provide would be helpful? Thank you.

So basically the major highlight is that NetEase always put the user experience as the number one task in order to achieve and also to ensure that the users would get best ever experience from trying out our different game titles, and based on our [Indiscernible] experiences in the game development over the years, especially in the [ARPG] games and also the item based games, we do see that. We have also accumulated a very good experiences to make sure that's the development cycle has been turn on well and smooth. And the overall success of the FWJ mobile. We would say that here, we would not be only lies on the fact that we have a strong IT or just only to the fact that we have some good past experiences in terms of the self-developed games or the game operations. But more importantly, we do view that how we put attitudes towards the product itself and offering the best as a -- user experiences to our users is of the most important points.

Thank you. Our next question comes from Eddie Leung with Merrill Lynch.

Hi, good morning. Thank you for taking my questions. Two questions; the first one is about your e-commerce business, just wondering if management can share with us, did the key differentiations of your platform again is a lot of your competitors, so what could be the advantage of NetEase running this Kaola platform? And the second is a housekeeping question on balance sheet. We noticed that there is also a pretty picture in prepayment, so wondering if Onward could share some color on that. Thanks.

So, basically with regard to our differentiations from peers in doing the prosper e-commerce businesses basically our Kaola.com business is a cross-border imported goods e-commerce business model. And basically we are also focusing on our self merchandising assets to make sure that the highest qualities and the best stuff would being sourced to our targeted users or consumers in the China market. And basically this would be an e-commerce platforms and one of our linked major issue is that, we are promoting the users to complete their transactions using their mobile applications, and in the upcoming periods we would also be adding more new features to giving more refreshing feel to our users. And as always, we are putting a very high importance of building up our own brand and we are also regarded ourselves as having a very strong overseas merchandizing capabilities on that front. That differentiates ourselves from our peers. And with regard to Eddie’s second questions about the prepayments, the increase in the balance sheet basically, you can view that since they generate this year, we have been putting into our new business line which is the Kaola.com. This cross border e-commerce businesses and we are also building up our own inventories to meet the demand of the local markets. And so one of the major increase in the prepayments and other kind of assets line items will be contributed from the increased inventory that we would be up so far.

Thank you. Our next question comes from Martin Bao with Bank of China International.

Thank you for taking my question. And I have two questions regarding the mobile games. The first one is, how did that the management think about the recent trend of the new game or it’s joining to the whole online game and the mobile game market. How does the company will accommodate to demands from these new gamers such as younger generation born in 1990s and the female gamers? The second question is how – what’s the criteria behind -- how do we choose the license games and external ITs beside our own ITs to develop or to license?

So basically, with regard to our strategies in building up our new user base on the mobile game fronts, basically we are also emphasizing the importance of the new user growth coming from the people born after ‘90s or the 2000s. And one of the examples is that for our newly launched games FWJ mobile versions we have also engaged the [PF] Wars we are planning to have to sing the songs for the game titles which also done a very good reception’s desk. And with regards to choice of the different new games targeted to perhaps to the female users and the younger generations, we would also be exploring whether there would be some more mature game titles or the game stuff that is available for us to roll out and another games that we have lately tryout would be a game called [indiscernible]. And with regard to the choice of the games or the license games from the overseas markets, one of the point that we put at the highest priority just the qualities of the games and how good those games can fit into the visual and also the how good to play can be picked up by the targeted audiences. And in the – very soon we will also be rolling out another game that has been ranked as number 1 in the Korea market, which is called a Raven, and this is how we have been moving on especially in the mobile game market.

Thank you. Our next question comes from Thomas Chong with Citigroup.

Hi, good morning. Thanks for taking my questions. I have a question regarding the online advertising, the management comments above any impacts on the macro headwinds? And on the other hand, any color about the revenue contribution coming from mobile. Thanks.

So basically, Thomas with regard to your questions about how we will approach our online advertising businesses performances, we do not – will that’s the latest macro changes or some of the other methods would get a very significant impacts to our business developments.

Thanks. And the other question is about the revenue contribution coming from mobile in online advertising?

You mean, the revenue contributions of the advertisings revenue. So basically we have very comprehensive strategies in setting out our mobile strategies. And apart from mobile news applications, we also have a very extensive work on other areas like products like the Cloud Musics, our Youdao dictionary, the Cloud Notes, the EaseRead and also the [indiscernible] and as well as the our Mail Master, all of those has been progressing very well, and we do see that there has also been -- the growth has been growing and we are anticipating that we perhaps we can share more colors about the distributions of the revenue coming from the mobile fronts, versus the PCs in the future period.

Thank you. Our next question comes from Hillman Chan with Macquarie.

Hello Willi and Brandi congrats on this strong quarter. I have two questions. First one is on your cross border e-commerce, management give us more color on the growth plans for this business for example in terms of the SKUs product categories and also your logistics deployment, and how should we think about your investment on this business going forward? And I have – had a question afterwards.

So basically with regard to [Indiscernible] your first question about our growth plan on our cross-border e-commerce, the Kaola.com businesses, first of all this would be the imported goods e-commerce platform, and so basically unlike the traditional e-commerce counterparts, we would need to put those stuff in a bond warehouse or in overseas, and in all that you addressed, the warehousing issues that we would buy a warehouse to accommodate those inventories, and also rent some warehouse in overseas. And at the same time in terms of the SKU developments, we are targeting that the numbers would come up to 10,000 SKUs for this year. And by the end of this month, which is August, we would also be launching another mobile application for the Kaola.com, which would give a more refreshing look to our targeted users and one of the competitive edge of our Kaola.com businesses is that we place a very high importance of giving the good values to our users, and we believe that by doing so the models would get the recognition from the users in the broader sense.

Just to quickly follow up on that, how should we think about the marketing dollar spend to promote, for example, mobile app Kaola and also webpage and also all these investments around your – like warehousing in China or renting overseas, and if possible some color on profitability will be helpful. Thank you.

So basically with regard to our anticipations of spending on the marketing front given the fact that [Indiscernible] user base and given the fact that we are also selling quite a lot of the fast moving consumables, and we are expecting that the marketing dollars that we are spending on this front as compared with our peers in this space would be lower. And with regards to the potential investments in building up our own warehouse and stuff like that basically this would be of a more similar magnitude to what everybody would be doing in the market and basically the inputs or the investments in those areas would be quite similar.

Okay, and my second question is on your strategy on [Indiscernible] overseas games and IP to China. Recently you announced that your partnership with [Indiscernible] also Kung Fu Panda IP from [books], so when it comes to licensing all these overseas mobile games and IP, how should we look at the realization criteria, I think you touched on it previously, just wanted to see some more color on how you see this for Chinese gamers, and what are the works that you have done afterwards once you license them, for example, localization, renovation in terms of the game play and also the monetization models, and roughly how much – how long time it takes from signing the deal to launching the games in China, this is my second question. Thank you.

So basically NetEase has – we keep a very close collaborations and relationships with the different game developers on a worldwide basis, and so giving those [smooth] and close relationship with the different developers and NetEase also got very high recognition from them, and on this front this can facilitate how we are going to proceed with different licensing arrangements, and whenever we need to consider and select particular games to license, definitely we would also be engaging our own team to perform some analysis of the different game, whether the features and the game content itself can fulfill our expectations, and we would also be considering whether those games have got a potential good response or demand in the China market and these also reflect our responsible attitude towards serving our gaming community, and on the other hand, you would also appreciate that we have also been getting into the game licensing businesses for quite a couple of years since we first get hold of corporations like Blizzard Entertainment some years before. And basically we have a very happy and smooth relationship with Blizzard so far, and we also believe that we also posses the experience and the capabilities to make sure that for whatever new license game that we are going to do, the license fees or the royalties would be negotiated under very competitive terms.

Thank you. Our next question comes from Tian Hou with T.H. Capital.

Hi, William, Onward and Brandi, I have several questions, let’s go to the first one, is about your e-commerce. Regarding the e-commerce, so what's the pick rate, I think for this business you recognize revenue as [Indiscernible], so I wonder what the take rate today and what is the [ideal life] of a take rate for that business. That is the first question. The second question is related to your – the part of this business, let's say it's totally different than game business, it's not game business, game business is what you do really well – so now you are entering into a totally new business, and previously we saw [Indiscernible] entering into e-commerce and then later on somehow [Indiscernible], they don't do it anymore. So what make you such a determination to do this business, that’s the first question and then I will have follow-on?

So basically we do regard that if you look back in the past years on how we have been doing on our virtual products e-commerce businesses like the lottery product sales, we have been doing quite good and perhaps this would be comparatively much better than our peers like the [JD] and stuff like that, and basically with regard to the cross-border e-commerce businesses all the goods are located in overseas, and in the past years we do see that there has been huge numbers of people and huge amounts being spent on that front of procuring the products in overseas. The reasons behind or the rationale is that the people would believe that the products in those areas would offer much better values for the monies that they are being spent. And so we do believe that we do have a good relationship, especially with some overseas partners in this sense, and on the premise that we are also taking care about the sourcing and merchandising by ourselves, and making sure that the best values and also the highest qualities products would be sourced, we can also set up a very good competitive edge in doing this new business for ourselves.

[Operator Instructions] Ladies and gentlemen, due to time constraints, this concludes today’s question and answer session. At this time I would like to turn the conference back to management for any additional or closing remarks.

Thank you once again for joining us today. If you have any further questions, please feel free to contact Cassia Curran, NetEase's IR Manager, based in Hangzhou or the Piacente Group. Have a wonderful day.

This does conclude today’s presentation. We thank you for your participation.