NetEase, Inc. (NASDAQ:NTES) Q3 2023 Earnings Call Transcript

NetEase, Inc. (NASDAQ:NTES) Q3 2023 Earnings Call Transcript November 16, 2023

NetEase, Inc. beats earnings expectations. Reported EPS is $13.3, expectations were $1.65.

Operator: Good day, and welcome to the NetEase 2023 Third 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 third 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 the NetEase corporate website at ir.netease.com. Joining us today on a call from NetEase 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 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. The third quarter was another period marked by outstanding results. Our beloved legacy titles and new hit games are strengthening our reach throughout the gaming world. Our total net revenues were RMB27.3 billion for the third quarter up nearly 12% year-over-year and our net income attributable to shareholders rose to RMB7.8 billion increasing by 17% year-over-year. Our time-honored flagship franchises have maintained robust popularity. Notably, we brought players updates for the Fantasy Westward Journey Saga in the third quarter with a brand-new storyline and captivating activities which once again breathed new life into the saga and drove year-over-year revenue growth for more than 20-year old epic title.

In addition to our well-established games, we are actively expanding our portfolio by consistently launching and cultivating long-lasting franchises across more genres. We have strengthened our leadership in MMOs by pushing the boundaries of industry standards. We have also expanded our presence in broader game categories and demographics with innovative content, gameplay, and monetization models. We can see this in during popularity of the games that we have introduced in recent years such as Eggy Party, Naraka: Bladepoint. Furthermore, our recently launched titles including Justice Mobile Game, Racing Master, and Dunk City Dynasty have quickly climbed to the top of the iOS growth in charts after its release. Looking at our newest hit titles Justice Mobile game launched just in June impressively surpassed 50 million registered users in October establishing itself as one of the largest MMOs in NetEase company history in terms of user base size.

Notably a significant portion of its player community comprises Generation Z players who were previously unfamiliar with the MMO genre becoming a gateway of MMO games for the younger generation in China as a trendsetter in the MMO industry. NetEase has once again brought key innovations to the genre with the launch of Justice Mobile Game and reshaped the MMO landscape. It offers players a vast array of high-quality content for free revamping the conventional paying model for MMOs. The shift to a more balanced spending approach gives players more freedom to enjoy the game’s rich features and gameplay with optional purchases focused on avatars cosmetics and accessories. This model was very well received by the game’s player base solidifying its stability.

In late October, we introduced Justice Mobile Games’ first seasonal update, which significantly enhanced player engagement with captivating storylines, new gameplay, and additional professional role options. It swiftly propels Justice Mobile game to the number two position on China’s iOS growth chart shortly after its release. The innovative seasonal mechanism we’ve introduced to the MMO genre gives all players a fresh start with a focus on fair and balanced gameplay. It also reduces the gap between experienced and new players ensuring that everyone can enjoy and engage in this game. In addition to the success of this new blockbuster MMO title, we also achieved success across other game genres in the third quarter. Our new racing simulation game Racing Master consistently ranked amongst the top three most downloaded and highest grossing games on the iOS chart in China following each new game update, proving its broad appeal to racing enthusiasts.

Notably, as China’s very first AAA standard racing simulated mobile game, Racing Master has introduced an authentic racing experience into China’s mainstream gaming sphere, with the plan for Racing Master’s global market expansion, we will soon commence overseas testing to bring this exciting racing simulation experience to players worldwide. We also achieved a significant milestone with our foray into sports games, a historically less popular category in China. We’ve broken new ground with Dunk City Dynasty, a street basketball game that provides various modes to deliver a casual basketball gameplay experience. Dunk City Dynasty quickly rose to the number two position on the iOS growth in China just a few weeks after its release. Following our latest seasonal updates with the introduction of new basketball superstars to the Team Rooster like James Harden, the game rose to the number one position on the iOS grossing chart in China.

The innovative gameplay and balanced gaming experience we’ve infused in Dunk City Dynasty are important differentiators for our game. By integrating players authorized by the MBPA [ph] with street basketball, we provide players with higher gameplay freedom along with expanded cosmetic options. The game also includes a fair card for fair play, meaning increased player spending doesn’t dictate who wins. This facilitates more inclusive gameplay and even more potential for the game’s long-term success. Player enthusiasm for Racing Master and Dunk City Dynasty underscores the significant demand in China for top tier games in the casual game genre. Along with our rich R&D capabilities, we are leveraging the inroads we’ve already made across a broad spectrum of genre verticals to fill these gaps in a market with new hit games that players love.

Games we’ve introduced in recent years continue to resonate with players demonstrating enduring popularity and long-term operating potential. Eggy Party for example continues to achieve remarkable milestones. In August, Eggy Party set new records by mapping over 100 million UGC maps and attracting 100 million MAUs. We have been committed to fostering and nurturing our UGC ecosystem, which is a cornerstone of Eggy Party’s success. We enhanced our self-developed editor in the third quarter by introducing more advanced and interactive functions. We also added collaborative map crafting functionality that lets users create with friends online on the shared canvas. To help foster even more creativity, we have introduced tutoring systems and a range of incentives to reward and motivate creators through various activities.

Building on the game’s notoriety in domestic markets, we are actively pursuing global expansion plan for Eggy Party. In the third quarter, we launched Eggy Party in Southeast Asia, where it consistently secured dominating positions on Google Play download chart for multiple weeks, particularly in Indonesia and Thailand. These early overseas releases also gave us valuable feedback and insights that guide our assets as we optimize the game for a global audience. We are also proud to announce that, Naraka: Bladepoint recently reached a remarkable milestone of 40 million users. Following the transition to a Free to Play mode in July, we also introduced new heroes to the game in the third quarter igniting greater player enthusiasm and attracting a massive influx of additional users to the game.

To bolster our robust portfolio of games, we have a number of new games under development. As we get closer to some of these introductions, we are particularly excited about Where Winds Meet, our new AAA martial arts themed action-adventure game. Where Winds Meet infuses an immersive open-world experience with an exciting historical backdrop that’s relatively untouched in Chinese gaming. This interactive sandbox-style adventure features an extensive map, a diverse array of weaponry, and captivating martial arts techniques, players have the flexibility to explore this interactive world, both individually and in groups. With two gameplay options, players can freely roam in the Asian-Chinese landscape in single-player mode enjoying a highly personalized combat experience.

In multi-player mode, players can work closely with friends to complete tasks engaging in exciting and heartwarming social interactions, we will soon launch the second round of testing, where players will be able to see more of the game with a longer playtime. Early feedback fuels our excitement as we get closer to officially launching this brand-new open-world experience, to our players in 2024. As a developer of China’s first ACG hit title, Amioji [ph] NetEase has made ongoing investments in the animation genre accumulating valuable industry expertise, and we hope to impress ACG community once again. The promotion video release of our upcoming ACG title under development set in the metropolitan-themed open world genre, Project Mugen has garnered significant attention from players both domestically and internationally.

We are committed to infusing new vitality into the ACG arena join upon our renowned innovation capabilities and experienced in the realms of animated games. Beyond these titles, we also have a number of other games in the making including Mission Zero, Once Human, [indiscernible], and Naraka: Bladepoint mobile game. On the global stage, our game development is progressing smoothly in Japan, North America, and Europe. This month we are excited to welcome Fantastic Pixel Castle as our newest additions to the NetEase family. Fantastic Pixel Castle is led by Greg Street who is well-known for his contribution to massively successful games around the world including World of Warcraft and League of Legends. Greg and his experienced founding teams are currently developing a top-tier MMO game code named Ghost to provide players with a fresh and immersive fantasy MMO experience.

We are thrilled to collaborate with so many talented industry producers leveraging their creativity in synergy with our deep research and operational capabilities. Together, we aim to deliver even more captivating games to players worldwide. Now let’s move on to Youdao. In the third quarter, Youdao achieved record-high revenue of RMB1.5 billion growing 10% year-over-year, driven by the growth in learning services and online marketing. Additionally, as part of our continued efforts to improve profitability, our operating loss for Youdao narrowed by a significant 74% year-over-year to RMB58 million. A solid growth in our learning services was due to our consistent ability to launch unique and high-quality courses. Notably in the third quarter, our coding courses introduced a specialized program aimed at preparing students for the CSP Informatics competition, one of the most popular competitive programming events in China.

Our program features all-encompassing services that include learning, context practice, and an evaluation system. The evaluation system is supported by our in-house developed scoring model allowing students to estimate their scores and assess their probability of progressing into the next round of the contest. Youdao’s online marketing services have consistently grown at an impressive rate of approximately 100% for the second consecutive quarter. This underscores our expertise in proprietary algorithms and the effectiveness of our customized solutions that are precisely crafted for diverse industry sectors. Revenues from our smart devices declined in the third quarter as we strategically optimized our channel mix by reducing sales through less the cost-effective channels.

Although this may have a temporary impact on Youdao’s revenue, we believe it will lay a solid foundation for sustained long-term growth and enhance Youdao’s profitability potential over the long run. Our focus on technological innovation remains our driving force. In addition to Youdao’s tech-boosted performance, we upgraded AI Box on Youdao translation product in the third quarter, which enables more accurate and natural translation across various types of documents. With the support of our machine-generated functions, third quarter revenue from subscription fees for translation increased by over 160% year-over-year. Furthermore, following the August introduction of our digital human language coach Hi Echo through Youdao Dictionary Pen X6 Pro, we expanded our reach to a broader user base through an independent app in October attracting over 100,000 user registrations within just a month.

We will continue to iterate Hi Echo with a new update coming soon. Looking forward, we will look to drive more technological innovation and introduce more products that genuinely meet our users’ needs by harnessing our expertise in machine learning technology. Next turning on to NetEase Cloud Music. In the third quarter of 2023, Cloud Music continues to navigate quality development across our core music-centric ecosystem while further extending the robust monetization momentum in the core online music sphere and improving overall profitability. Total online music MAUs remained largely steady staying above RMB200 million in the Q3, total revenues for the quarter were RMB2 billion on par with late last quarter. Growth in our music-centric memberships accelerated demonstrating our ability to introduce premium offerings including expensive content and innovative features.

Additionally, our social entertainment services started to stabilize on a monthly basis during the latter part of third quarter following our strategic positioning refinements in live streaming which resulted in short-term setbacks with solid monetization momentum in the core online music businesses and continued cost structure optimization, Cloud Music maintained steady margin improvement for the period. We are constantly expanding our music library to provide a comprehensive selection of music for our diverse audience base. During the third quarter, we broadened our extensive music collection by adding songs from popular Chinese pop artists like Karen Mok, ZHENG Jun, and ZHANG Jie. In addition, we were delighted to release albums by pop stars including JAM, KeyNG, and Shen Yichen [ph].

As part of our ongoing commitment to enriching our music-centered ecosystem, we remain dedicated to empowering and assisting independent artists. As of the end of September, we proudly serve a thriving community of over 660,000 registered independent artists showing strong growth of 16% compared with the same period last year. We have also broadened our support for emerging music talent. Our new programs are tailored to regional routes and distinctive styles in different areas, including programs like Localized Sound and Project Sound Season Five to honor and promote more diverse artists. At the same time, we hosted offline music festivals such as 65PARK Camp Music Festival, providing more exposure for our independent musicians. In addition to broadening our content selections, we continued our product innovation initiatives, aiming to elevate users’ music listening experience and foster our music-centric community.

We have recently officially launched the Private DJ feature incorporating music recommendations with an intelligent and personalized music introduction and explanatory experience. This feature allows users to record old-fashioned radio DJ, while enjoying a more personalized music accompaniment, as part of their listening experience. Building on our iconic comments section, our Comments Square has emerged as a vibrant gathering place for users to express and find connections with one another. Moving on to Yanxuan, in the third quarter, our private-label consumer brand launched more popular products through diversified channels. We saw robust sales growth in selected categories like pet supplies and home cleaning products and sellers like ergonomic chairs, bathroom fragrances, and cat food, consistently outperformed competitors across various platforms.

Our strategic efforts including efficient warehouse and distribution management and personalized packaging have also proven successful. Thanks to the innovative marketing campaign, our Down Jacket series, which is highly acclaimed for its exceptional quality at affordable price, gained immense popularity during this year’s Double Eleven online shopping event, driving the collection to hit top positions on multiple bestselling charts on several e-commerce platforms. In summary, innovation is at the core of all of our businesses, driving our growth and our competitive edge. We believe that great content, product, and services, stem from new and creative ideas. This principle lies at the heart of NetEase, whether it is games, Cloud Music, Youdao or Yanxuan, we consistently strive to reach new heights.

In doing so, we help to drive the industries we serve forward, while delivering value to our growing global community, our partners, our team members, and our stakeholders. This concludes William’s comments. I will now provide a brief review of our 2023 third 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 further details. Total net revenues for the third quarter were RMB27.3 billion or US$3.7 billion, representing an increase of approximately 12% year-over-year. Total net revenues from our games and value-added services were RMB21.8 billion, up 16% year-over-year. The growth was primarily due to increased revenue contribution from newly launched games such as Justice Mobile Game, Racing Master, and Eggy Party.

Net revenues from our mobile games accounted for nearly 78% of our total net revenues from online games operations. Youdao’s net revenues were RMB1.5 billion, a year-over-year increase of nearly 10%, primarily due to increased revenue contribution from learning services and online marketing services. Net revenues from Cloud Music were RMB2 billion, a 16% decline compared to the same period last year. As we explained earlier, this result reflects declining revenue of social entertainment services as we adjust our focus to improve profitability in a sustainable manner. Net revenues for innovative businesses and others were relatively flat in the third quarter at RMB2 billion. Our total gross profit margin continues to grow exceeding 62% in the third quarter, compared with 56% in the third quarter of 2022.

Looking at our third quarter margin in more details, gross profit margin was 69% for our games and related value-added services compared with 65% in the same period of last year. The increases were primarily attributable to changes in the revenue mix of the NetEase self-developed and co-developed and license gains. GP margin for Youdao was 55.9% compared with 54.2% in the same period of last year. The increase mainly resulted from increased revenue contribution from its learning services and online marketing services segment. Gross profit margin for cloud music improved in the third quarter reaching 27.2% versus 14.2% in the same period a year ago. The margin improvement primarily resulted from increased revenues, scale from membership subscription, and continued improvement to our cost management measures.

For innovative businesses and others, gross profit margin was 27.3% compared with 25.5% in the third quarter of last year. The increase was primarily the result of margin improvement in Yanxuan and some of our innovative businesses. Total operating expenses for the third quarter were RMB9.4 billion or 35% of our total net revenues. Taking a closer look at our expense composition, our selling and marketing expenses as a percentage of total net revenues were 13% in the third quarter compared with 15.4% for the same period of last year. This reflects our ongoing efforts to consistently enhancing marketing efficiency. Our R&D expenses as a percentage of total net revenues also remained stable quarter over quarter at 16%. As always, we are committed to ongoing investments in content creation and product development.

We are also seeing leverage in our R&D investments longer term. Our G&A expenses as a percentage of total net revenues was 5.5%. The slight increase from the previous quarter was primarily due to certain one-off items. Our other income was RMB1.5 billion for the third quarter of 2023 versus RMB2.8 billion in previous quarter. The decrease was mainly due to the exchange rate of the U.S. Dollar against the RMB is fluctuating over the period. As per applicable accounting standards, we are required to reflect these fair value changes. The effective tax rate was 14.2% for the third quarter. As a reminder the effective tax rate is presented on an accrual basis and the tax credits differ for each of our entities at different time periods depending on applicable policies and our operations.

Our non-GAAP net income from continuing operations attributable to our shareholders for the third quarter totaled RMB8.6 billion or US$1.2 billion. Non-GAAP basic earnings from continuing operations per ADS for the quarter was US$1.84 or US$0.37 per share. Additionally, our cash position remains robust with net cash of approximately RMB104.4 billion as of September end 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 has approved a dividend of US$0.0990 per share or US$0.4950 per ADS. Lastly, under our current US$5 billion share repurchase program starting in mid-January this year, we had repurchased approximately 7 million ADS as of September 30, 2023, for a total cost of approximately US$588 million.

Thank you for your attention. We would like now to open the call to your questions.

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Q&A Session

Operator: [Operator Instructions]. Our first question comes from Ritchie Sun with HSBC. Please go ahead.

Ritchie Sun: [Foreign Language]. I will translate these questions myself. Thank you, management, for taking my questions. I have a question about the competitive landscape for Party games. Does management think it’s a winner takes all market or can you have two players? And we noticed that Eggy Party has strong user base and UGC content already, given that there are more potential competition from other platforms, what would NetEase further do to sustain the leadership? Thank you.

William Ding: [Foreign Language]. Just a translation for William. So, we think it’s absolutely normal to have a competition. So, from that perspective, we will continue to drive innovation and provide good services to our users, and that’s how we lead the market. So, we have full confidence in keep placing our users in the Party game genre. Thank you. Next question, please.

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

Yang Bai: [Foreign Language]. My question is about the flagship games. Could management share more details with us about how do the flagship game such as [indiscernible] and Racing Master game? Thank you.

William Ding: [Foreign Language]. So, I want to say, that the most important thing for a game is innovation and continue to provide high-quality content for our users and it is important for us to focus on the long-term longevity of our games and never make any short-term decisions. So, based on our 20 years of operational experience, we think that a long-term goal is key. Thank you. Next question, please.

Operator: Our next question comes from Felix Liu with UBS. Please go ahead.

Felix Liu: [Foreign Language]. Let me translate myself. Thank you, management, for taking my question, and congratulations on the strong third quarter results. My question is on the pipeline. In among the three your games already have done how including Studio, Where Winds Meet, and Project Zero? How’s the R&D progress for these games? And when do you think these games can come to market? And for the other games that are still waiting for Banhao, such as Naraka Mobile and Project Mugen. Does management have any color on their R&D progress? Thank you.

William Ding: [Foreign Language]. Thank you. Just a quick translate for William. Yes, so for each of our games, it’s always after very careful adjustments, moderation before we are ready to release them to the market. And so, games such as studio, we are still, we’re in the final stage of preparation and hopefully we’ll get them released to the market no later than the second quarter of next year. Thank you. Next question, please.

Operator: Our next question comes from Thomas Chong with Jefferies. Please go ahead.

Thomas Chong : [Foreign Language]. Thanks, management for taking my questions. My question is about overseas strategies. Given that we have demonstrate very good sets of result in the domestic market with a very solid pipeline. How should we think about our overseas expansion in the coming years as well as our investment strategies? Thank you.

William Ding: [Foreign Language]. So, on the global market, we will continue our strategy of high-quality focused direction, and we’ll continue to look for partners who share the same mentality, share the same passion for games as we do and continue to invest in good teams to produce and create great content for users all around the globe. Thank you. Next question, please.

Operator: Our next question comes from Lincoln Kong with Goldman Sachs. Please go ahead.

Lincoln Kong: [Foreign Language]. So, thank you, Mitchell, for taking my questions. So, we have seen this year our successful title from Eggy Party and Justice Mobile, which is a bit different from traditional legacy games, have a very big user base and DAU. So, when we think about the future upcoming launching games, especially for next year where Weemings and Xiaodao [ph], should we expect some of the similar type of features and anything we can sort of copy from past success? When should we expect the next success of Justice Mobile?

William Ding: [Foreign Language]. Thank you. Let me do the translation. So, the large DAU games is definitely a very important direction for us. We’ll continue to find the key takeaways from the games that have succeeded in order for us to produce more games of this type. But at the same time, it’s also very important to create high-quality games of a particular niche category to meet the different requirements and preference of different type of users. For example, this year, we launched a basketball game, racing car games. So, these are good examples of top-performing games of each of their respective categories. So, within that ease, we have lot games who teams who specialize in large DAU games and our teams that focus on particular niche. So that we have various different teams with NetEase and we encourage them to show do to apply their unique edges and unique experience. Thank you. Next question, please.

Operator: Our next question comes from Ritchie Sun with HSBC. Please go ahead.

Ritchie Sun: [Foreign Language]. So, the Dunk City Dynasty has quite successful despite launching without Android App Store. Although it could have higher channel costs, Android can also bringing more users potentially, which can sustain the game longevity. So how does management assess the ROI of not using Android store? And what type of titles would absorb a single launch strategy in the future? Thank you.