Brandi Piacente - IR Charles Yang - CFO William Ding - CEO & Director

Hillman Chan - Citigroup Natalie Wu - China International Capital Corporation Jialong Shi - Nomura Securities Wayne Wang - HSBC Tian Hou - T.H. Capital Han Joon Kim - Deutsche Bank Sef Chin - Goldman Sachs Marcus Yang - Macquarie Research

Good day, everyone and welcome to the NetEase Third Quarter 2017 Earnings 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.

Thank you, Tamari. Please note, that 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 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. 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 Senior Management is William Ding, Chief Executive Officer; Mr. Charles Yang, Chief Financial Officer; and Mr. [Hilton Huang], Co-President of NetEase Inc. I'll now turn the call over to Mr. Yang, who will read the prepared remarks on behalf of Mr. Ding.

Thank you Brandi, and thank you everyone for participating in today's call. Before we begin, I'd like to remind everyone that all percentages are based on Renminbi. With that said, I'm 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 the 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 eCommerce 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 and enhance our brand equity and expand our global footprint. During the third quarter, we did exactly that. We advanced each of our 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 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 arcade games such as Onmyoji, although Onmyoji's performance in China slowed down in the third quarter with popular title regained traction when we introduced new content and game play supported by promotional activities through media, literature and merchandize 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 casting 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 remained strong. After being introduced to Japan and Southeast Asia, Onmyoji was also successfully launched in Korea, followed by promising user feedback during closed beta testing in the U.S. 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 on the way with further rentals and partial content monetization for the PC JAVA version, which began in mid-September. We have also initiated monetization testing for high pixel server and we plan to converse 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 RPG 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 to rich pipeline that leverages our top resources in R&D and talented pool of developers and the 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 Chu Liu Xiang and Tribes and Empires; Storm of Prophecy, Japanese-themed RPG Forever 7 and card game HAN-GYAKU-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, 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 and Crusaders of light has been recognized as one of the top-grossing 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 grow our advertising services net revenue by approximately 12% year-over-year with automobile, real estate and Internet services as our top performing verticals. Our pan-entertainment marketing program is supporting a growing number of high profile projects and we also seeing the increase in demand for performance-based advertising to support our growth in otherwise mature market. Investment in both our regional and third party high-quality content, customized smart push technology, video content and innovative marketing solutions, amid evolving advertising climate support our ability to remain one of the most sought-after advertising platforms in China. Our email, eCommerce and other business also continues to grow in the third bottom with net revenues increased by nearly 80% year-over-year, primarily due to increased revenue contribution from our eCommerce businesses such as Kaola and Yanxuan. These eCommerce platforms are prospering the net revenues from Kaola and Yanxuan of RMB2.7 million accounting for approximately 71% of the segment's net revenues. Each of our business line 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 or 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 games 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 65.0% for the preceding quarter and the third quarter of 2016 respectively. Gross profit and margin for our advertising services business increased year-over-year and quarter-over-quarter in the third quarter of 2017 with growth margin of 68.0% 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, eCommerce and others 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 represented 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 2017 was 8.1% compared to 19.0% and 13.3% for the preceding quarter and the third quarter of 2016 respectively. The changes in 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 on 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 on 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 was 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 per 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 30, 2017, our total cash and cash equivalents, current and noncurrent time deposit and short-term investment balance totaled RMB40.7 billion or US$6.1 billion. This compares with RMB36.9 billion as of December 31, 2016. 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 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 months 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 your questions. Operator, please go ahead.

Thank you. [Operator instructions] We'll revert to Hillman Chan with Citigroup.

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. And also, Minecraft each for both PC JAVA and mobile. And regarding Wilderness how do we see the competition from several games of similar genre in the market? And I have another follow-up question. [Foreign Language]

Okay. So, let me translate the response from William. Firstly, to address the competition, Wilderness is a sandbox battle arena game and currently in a stage. So, we will continue to optimize this game and to inject innovation and bring the exciting new game to our global audience. In terms of monetization, for Minecraft, this is sandbox platform. So 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 mode and users willing to pay for this most to get constant user experience of Minecraft platform. So, Wilderness, as you know, this is a FPS game and this is also based on sandbox concept and you should take full confidence in NetEase almost two decades of experience in developing games, bringing innovations. We have full confidence on 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 arena game. So, at this stage, we are not really rushing out for any of the monetization initiatives for these games.

And next we'll move to Natalie Wu with CICC.

Good morning, management. Thanks for taking my question. I actually have three questions. The first one is regarding your deferred revenue. As we notice that your total deferred revenue this quarter increased to RMB2.7 billion sequentially. So, what are the drivers behind the sequential increase? My second question is about your international expansion. You mentioned your current progress and future plans for the oversea expansion. What are the revenue contributions from overseas markets across stage and how should we expect this contribution going forward? My third question is regarding your current music business. Can management please elaborate more about your current strategy for this business, especially that the competition over music copyright are getting fierce among major players? Can management please share your thoughts for current competition landscape? And comments would be helpful, thanks.

So, Natalie, let me answer your first two questions financials and then I'll translate the third question to William and the management. On deferred revenue, this causes deferred revenue as being stabilized. This is largely because of our game grossing performance has been stabilized in the recent quarter. And as you know, deferred revenue we never changed any accounting policy for the revenue deferral. So, the numbers reflects 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. [Foreign Language] Okay. So, our cloud music is quite unique in terms of the 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 creates 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.

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

[Foreign Language] I'll translate my questions. My first question is about the eCommerce services. I was quite impressed by the strong growth of NetEase's eCommerce service in the past quarters and as NetEase's eCommerce revenue, eCommerce business has reached such a big scale, I just wonder if NetEase may consider partnering with any strategy -- external strategy investors and if yes, what types of investors NetEase might like to work with? My second question is about a recent media report, NetEase, based on the report, NetEase recently received one of the live broadcasting one of the attorneys gain live broadcasting platform for live streaming NetEase's online games. I just wonder what the rationale for NetEase is to take this action and how tough NetEase you think of its relationship with these external game live broadcasting platforms?

Yes. Okay. We'll for our first question for our eCommerce, as you know, eCommerce remains one of our pivotal focus of broadening our Internet products and services. We remain open-minded. We will welcome all strategic partnerships, particularly on the business level and at appropriate time, we will also consider bringing in external strategic shareholders. For now, I think our top priority is to continue build up Kaola and Yanxuan brand equity amongst the uses by focusing on the user experience and by bringing in a new eCommerce concept to the Chinese user. The second question I will defer to the management. So, to your second question Jialong, this incident, I was actually referring to three years ago in 2014 when that platform was broadcasting Fantasy Westward Journey. During the broadcasting, they've inserted advertisement that direct to users, the audiences to a sub-optimal quality web game. We think that is not appropriate. We have been following -- we've been following recent communications with the platform and 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 the live streaming platforms, we remain very open-minded. We in fact welcome all these partnerships and broadcasters to come experiences our NetEase games. We have a lot of exciting games; Minecraft, Overwatch, Heroes of the Storm, as well as our own self-developed games. All of these are very suitable contents 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.

And we'll move next to Chi Zhang with HSBC.

Hi management. Thank you. This is Ningchuan Wang speaking on behalf Chi. So, I have a question regarding to the monetization of Wilderness. So as management has mentioned that we will come up with some interesting idea about monetization. So, I have noted that, so there were some recently some in game advertisements in Wilderness, for example like the JDs of advertisements on the plane. Will that be the majority of the main monetization approach and going forward and will that be included in the Advertising Services segment or Online Games segment? And also in this quarter, so in Kaola margin, since you have slightly recover, so what's your long-term expectation about Kaola -- the email segments margin get to slightly improve? So how do you think about the long-term invitation about the second margin or maybe the eCommerce margin going forward. Thank you very much.

So, let me first translate for William's comment. So first of all, for Wilderness, more broadly for these survival category games, because this is a new genre and we will take a holistic approach to in terms of monetization just like this high quality game has 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 and 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're happy to see that email, ecommerce and other segment, the margin has now been stabilized. I think going forward, the margin will be stabilized at this level and we further grow our eCommerce and other business units within this segment. Over the longer term, we think the skill factor will start to kick in, but that obviously will also require some time.

Let's move to Tian Hou with T.H. Capital. Please go ahead. We're not able to hear you.

Hello. Brilliant. 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 surprising good content. The question is really related to what really the best, I dictate and at NetEase you have a lot of data emails and dictionaries and games and commerce and news. And I haven’t heard a word from you about the big data. I wonder how NetEase actually benefits or using such kind of a property and to benefit your own content creation, that's my question William.

Okay. Let me translate for the management. So, to answer your question, we also agree and recognize its importance of AI towards the future success. However, we are also a little bit concerned that in media in particular, AI, Bid Data, these passwords has been overly exaggerated. To NetEase, we invest significantly into AI, Big Data and all these new trend of technology, 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 dictionary, we have been adopting the AI technology into the product and it can now utilize this app for audio verbal translation as well as translating the contents when you take a photo for instance. In this regard, we think we're very advanced. And another example using our cloud music for instance, we're also being embedding AI technology into our daily push. So, this is our belief. We think instead of over exaggerating AI as a mysterious science, our approach is that we take these very modern technology, invest them into the products and the users eventually will feel the difference, but 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.

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

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

Okay. Let me translate for the management. Okay. So, to answer your first question, Wilderness and Terminator II, broadly speaking they fall into the same genre, the same category that there are very subtle differences in terms of user experience. On the technology perspective both games are our self-developed and we utilize two different self-proprietary engines for these games and they bring different subtle, but they bring different experience catering to different user demand. So, in terms of the data we see, the user profiles of playing these two games actually quite different. For Minecraft, as you all know, this is at a relatively early stage and we are starting early monetization asset in recent months as well as in early 2018. So, at this stage, other than the accumulated users, we don't plan to disclose any other additional KPIs. But again, to reiterate, we have full confidence in this game in the longer run.

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

Hi management, this is Sef Chin on behalf of Fan. Thank you for taking my questions. I've two questions. The first question is on eCommerce. So, 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 whether management could share some color on the game performance of Blizzard?

Okay. So, for the first question, let me answer you. We are actively exploring the possibility of separating out our eCommerce. We're actively discussing that amongst our auditors, counsel, etcetera and we hope -- we hope to materialize that as early as next quarter. For the second question, let me defer to the management. Okay. So, with respect to Blizzard, they are a very close business partner with us and a couple of key titles that we licensed from Blizzard are performing well in China and we expect to further deepen our strategic relationship with Blizzard. For StarCraft II, we're in the effort to make it free to play mode. So overall because of this close partnership with Blizzard we actually keeping a very active dialogue to collectively bring the best product experience and user experience to the Chinese gamers.

And we'll go to Marcus Yang with Macquarie.

Thanks for taking my question. I had two questions. First of all regarding survival games, can you share the rationale behind the popularity of this general being in your view, which I guess one of them could be the social community element? And do you think that sector will continue for the upcoming potential new hit channels or anything that you can share regarding the key element for the next potential channels? And my second question is regarding house regulation of issues being fixed here and regarding the survival game general and also from your perspective is this old channel or market and that is my question.

Okay. So first of all, we would like to correct the concept. This genre, we don't agree to call this genre as a survival type of game. To us, this broadly causing to a sandbox category and one important element of the sandbox category that we enjoy the total freedom. Every time you enter 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.

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

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

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