Earnings Transcript for NTES - Q1 Fiscal Year 2023

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

Margaret Shi: Thank you, operator. Please note the discussion today will contain forward-looking statements relating 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 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 announcement of the filings on the website of 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 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 2023 first quarter earnings news release issued earlier today. As a reminder, this conference is being recorded. In addition, an investor presentation and a webcast replay of this conference call will be available on NetEase corporate website at ir.netease.com. Joining us today on the call from NetEase's senior management is Mr. William Ding, Chief Executive Officer; and Mr. Charles Yang, Chief Financial Officer. I will now turn the call over to Charles, who will read the prepared remarks 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. We kicked off 2023 with an impressive performance from our game portfolios that drove our total net revenues to RMB25 billion in the first quarter, up 6% year-over-year. Our net income attributable to NetEase shareholders increased 54% year-over-year to RMB6.8 billion. Revenue from our Fantasy Westward Journey Online series flagship titles once again grew steadily in the first quarter. This franchise continues to captivate Chinese audiences and enjoyed another quarter of impressive performance, thanks to a variety of immersive passive activities and engaging new expansion packs, particularly during the spring festival period. Our flagship games have remained incredibly popular with users for almost two decades now, due to the sustained in-game user connections and continuous iterations we release every few months to keep our users engaged and content. Our newer titles are also showing impressive results. Eggy Party became China's most downloaded game on iOS in the first quarter, further solidifying its leading position in the casual game arena. Eggy Party's accomplishment is a testament to NetEase content innovation and operational know-how that keep players engaged through the consistent addition of fresh and exciting content updates, new gameplay features, tournaments and crossover events. Following its successful launch, we've been taking significant steps to solidify Eggy Party's distinct game ecosystem, including upgrading our creative incentive schemes and game additives. Our users can now design more sophisticated mini games with more flexibility and versatility, making the game more engaging and self-sustaining. We've seen new generative technology as a great tool for users to create content more easily, and we will develop and offer more of these features in our game editor to encourage more people to participate in this creative process. Eggy Party is approaching its first year anniversary this weekend. With our comprehensive UGC ecosystem, our user community has been creating more than 1 million apps per week, providing players with continued fresh and enjoyable content. As a key focus of our Eggy Party operational strategy, we will be further strengthening our UGC offerings to help ensure the longevity for Eggy Party that we see in many of our other games. Following its success in China, we are testing its potential on the global stage as well. We've already soft-launched Eggy Party in Southeast Asia and we received valuable feedback. We are working to bring Eggy Party to global audiences in the near future and believe that players worldwide will enjoy the engaging gameplay and unique UGC experience that Eggy Party has to offer. Another good example of our casual games showing longevity is Identity V, our five-year old asymmetrical Battle Arena game. In the first quarter, Identity V achieved record-high net revenues, driven by a successful Crossover campaign with Bungo Stray Dogs, a famous Japanese anime series. Moving on to our game pipeline. We have a very busy summer planned ahead for this year with Justice mobile game successful launch on June the 30th and many other titles such as Badlanders and Racing Master ready for the Chinese mainland market. We are also planning for Harry Potter

Operator: Our first question will come from Alicia Yap of Citigroup. Please go ahead.

Alicia Yap: Hi, thank you. Good evening. So, thanks for taking my questions. So have management experienced any of the weakness in the NetEase scheme because of the macro consumption weakness that you're seeing? And have you seen any gamers actually scaling back on their virtual item spending? And then do you think gaming in general has been or will be affected by the macro weakness in China? And then what is management's expectation for the gaming growth in the -- for the existing title in the next few quarters? Thank you.

William Ding: So far, we've not seen any effect from the macro weakness not in game. We are very confident that we are going to be able to provide high-quality games, not just for the China market, but also for the global market. Thank you.

Margaret Shi: Next question, please.

Operator: The next question comes from Xueqing Zhang of CICC. Please go ahead.

Xueqing Zhang: Good evening, management. Thanks for taking my question and congratulations on the strong results. My question is related to Justice mobile. Can management provide an update on the recent feedback for Justice mobile? We have implemented AI technology in various aspects, such as the creation, NPC dialog and the player looks. What should we expect for future games coming out of AI innovations? Thank you.

William Ding: Let me just do the quick translation. So we just finished two -- the last rounds of testing. And so, we mentioned we expanded our testing user base across different downloads. So we're pleased to see we were able to attract users for the different game environment, not just MMO, but other games along with as well. So even with two weeks of testing period, we received some very positive and good feedbacks. And over the next month or two, we will continue adjusting and multiplying the game. So by June the 30th, and hopefully, our users should be able to see a game that they approved in the last. Thank you. So, as you've noticed that we have been applying a lots of AI technologies into the games. And I think during the testing period, users have given us very positive feedback. And previously, you were -- we were applying AI technology in games and now we are applying games onto AI. So, for the very beginning of constructing the game, we -- this game, we've been using deep learning and technology. So I think there is a lot of excitement. The users will be seeing a lot of exciting functions coming up to the game. Thank you.

Margaret Shi: Next question, please.

Operator: The next question comes from Felix Liu of UBS. Please go ahead.

Felix Liu: Thank you, management, for taking my question, and congratulations on the strong first quarter results. My question is on Eggy Party. Can management share more color on the game's trend so far in second quarter? After its strong performance in the first quarter, how does management see the domestic and user trend from rest of this year and the games monetization potential? And lastly, what is your -- more details on the overseas strategy for this game? Thank you.

William Ding: Yes. So, Eggy Party, we've seen very strong results since the launch of this game. And we are confident over the next two to three years, we are going to be able to build a sustainable family party game on top of Eggy Party with the continued innovation within the game. During this summer you -- also we're seeing a number of other exciting games coming out of NetEase game pipeline. And obviously, we also have overseas plans for Eggy Party. So overall, we have very strong conviction that NetEase will continue to deliver fun, high-quality game for our users. Thank you.

Margaret Shi: Next question, please.

Operator: The next question comes from Kenneth Fong of Credit Suisse. Please go ahead.

Kenneth Fong: Thank you, management, for taking my questions. Can you provide an update on the overseas game studio investment plan, including like R&D investment and development stage? Thank you.

William Ding: Yes. So we have about 10-plus - closer to already now in the -- in overseas markets. We will be pleased to bringing all those great talents of gaming veterans from different markets around the world. And hopefully beginning from next year or the year after, the market will see some of those block -- hit titles be produced from those studios. And we think that collaborating with those talented individuals, talented producers will be a win-win situation for NetEase. We are -- we will be very happy to be showing the two decades of operational -- our operational know-how within NetEase with those producers. Thank you.

Margaret Shi: Next question, please.

Operator: The next question comes from Lei Zhang of Bank of America Securities. Please go ahead.

Lei Zhang: Thanks management for taking my question and congrats on the strong set of results. Can management elaborate more on AI beta strategy and its impact to our game device and investments as well as related cost savings? Thank you.

William Ding: So what we have seen in the past two years is we've seen various different applications being used under the foundation model. So for us, the most important thing is choosing -- for different products, choosing the right scenarios for the application of those foundation models. We think that going forward, the R&D cost will be coming more efficient. We'll find ways to save cost. And so -- but I think that the foundation models will be pretty much similar. But the most important thing for us is choosing the right one for our products. Thank you.

Margaret Shi: Next question, please.

Operator: The next question comes from Lincoln Kong of Goldman Sachs. Please go ahead.

Lincoln Kong: So my question is about the new game competition. Will be this year approval process start to normalize? There has been a lot of new games released into the market. So, can management comment around the competition landscape of the new game market in China? Do we see sort of any of the changes in the trend for the flagship titles? And can we have some sort of thoughts around how to strengthen the ability of long-term prospects of the games such as Eggy Party or ? Thank you.

William Ding: So, yes, you're right. Over the last four to five years, we've seen a lot more new games in the market. But at the end of day, consumers only choose the one of the highest quality. So NetEase will continue to lead the market through innovation. Whether it's through gameplay innovation or application of brand-new technology, we have full confidence that we have -- we'll maintain our competitive edge in this industry. For example, MMO games, that's one of our historically strongest suites. We've seen there is actually very little competition in this upper -- in this genre against NetEase. So for example, our MMORPG mobile game, Justice mobile, will be launched on June 30th. The development team has over decades -- one decade of R&D experience. And so, I'm pretty confident in the success of that game. Similarly, in June, you will also see games with other genres being launched to the market. So, we are confident that the market will see a variety of different products coming up on NetEase that's just strong as games like Eggy Party or FWJ. Thank you.

Charles Yang: And Lincoln, just to add one more point. In addition to our continuous innovation and launching of successful new games, the NetEase strengths in the long-term operating of our legacy titles should also be emphasized here. For example, Fantasy Westward Journey mobile, one of our earliest mobile games, has a record-high growth in the first quarter. Identify V in its fifth year, again, record-high growth in the first quarter. The sustainability of these legacy titles are truly impressive, which add -- which serves as sort of the backbone cash cow to further stimulate our investment and dedication into innovation into making even better and greater new games.

Lincoln Kong: Great. Thank you. Thank you.

Margaret Shi: Thank you.

Operator: The next question next comes from Alex Poon of Morgan Stanley. Please go ahead.

Alex Poon: Thanks, management, for taking my question. My first question is related to our games gross margin, which is a seven-year high, close to 67%. Can management share the reason behind this very high margin? And my second question is related to our dividend payout ratio. Is there any possibility of increasing it this year or next year? Thank you very much.

Charles Yang: Sure. Alex, in the interest of time, let me answer your question directly in English. Firstly, on the gross profit margins of my gaming segment, I think one big driver for that is our continued growth of my scale and comes with the scale is the operating leverage. We've been introducing new games and steady growth, consistent growth over the last many years. Secondly, as we all know, we have terminated certain licensed games starting January of this year. Those games comparatively speaking of much lower margins, so the rapid mix shift is favorable to a higher margin. And thirdly, we've been making conscious effort of continuously optimizing the channel cost -- average channel cost by trying to strive a fine balance between the iOS, Android channels as well in our official channels. So putting all these continuous effort and some of these one-off revenue mix implications, that's why we achieved a record-high gross profit margin in the recent many years. Now the second question on the dividend. Right now, we are paying 30% dividend payout ratio, making NetEase actually one of the very, very few tech companies, not only in China, but globally, that we've been paying a regular dividend for the last 10 years. We use dividend payment as well as share buyback as a tool -- a combination of tools to share the growth, to share our sustained growth and return value to our shareholders. And we are committed to be that. From time-to-time, we will revisit the -- for instance, we extend our share buyback program from our originally $500 million to $1 billion, $2 billion, $3 billion. And right now, our Board has approved a master plan of $5 billion buyback. Dividend payout ratio, we've also raised from 25% to 30% a few years back. Going forward, as we continue to achieve sustained growth, from time-to-time, we will review and revisit to see what is the optimal and best way to return value to our shareholders to share the joy of a sustained growth and value creation to our long-term shareholders.

Margaret Shi: Okay. Thank you. Operator, we have time for just one more -- one last question, please.

Operator: The next question comes from Natalie Wu of Haitong International. Please go ahead.

Natalie Wu: Thanks for taking my question. My question is related with the Cloud Music. Just wondering what's the consideration behind a lower shared ratio for live streaming function on Cloud Music. And also you mentioned that you reduced the in-app exposure for certain live streaming function, just wondering is it due to certain regulators' requirements or what? And also excluding this impact, what kind of the year-on-year growth should we be seeing? And when do you expect revenue of Cloud Music to return positive growth on the current condition? Thank you.

Charles Yang: In the interest of time, let me answer this question directly in English. The revenue composition of Cloud Music mainly comes twofold. One is the online music services, which continued its steady growth trajectory year-over-year underpinned by the continuous expansion of the paying users. The social entertainment services sector has experienced year-over-year decline. And as we previously mentioned in the call, we've been turning more conscious to focus on the healthy and sustainable profitability of the business growth rather than just looking at the top-line growth. As a result of that, we've been making some conscious effort of diverting resources to what we think are broadcasting services that's more dedicated to the music fans to -- in a sustainable manner rather than some of the agencies which commands a much, much higher revenue-sharing asks. So as a result of that, you are seeing possibly decline in our revenue year-over-year, but at the same time, our gross profit margin profile has significantly improved from 12% one year ago to right now 22.4% in this quarter. We think we are on the right way to achieve a more sustainable and healthy margin profile, which as long as we are committed and disciplined in doing so, this roadmap should bring us to a cash flow breakeven and ultimately an P&L breakeven in the coming future.

Natalie Wu: Thank you.

Margaret Shi: Operator?

Operator: That does conclude the question-and-answer session. I would like to turn the conference back over to Margaret Shi for any additional closing remarks.

Margaret Shi: Thank you once again for joining us today. If you have any further questions, please feel free to contact us directly or Piacente Financial Communications. Have a great day. Thank you.

Charles Yang: Thank you.

Operator: The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.