Good day and welcome to the NetEase Second Quarter 2019 Earnings Conference Call. The conference is being recorded. At this time, I would like to turn the conference over to Margaret Shi, the IR Director of NetEase. Please go ahead, ma’am..

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 the safe harbor from liability as established by 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 cause NetEase’s business and financial results is included in a – 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 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 2019 second quarter financial results 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 senior management is Mr. William Ding, Chief Executive Officer; Mr. Charles Yang, Chief Financial Officer; and Mr. Hilton Hui, Co-president of NetEase Games.

I will now turn the call over to Mr. Yang, who will read the prepared remarks on behalf of Mr. Ding..

Dragon Upon the Cloud, Pokemon Quest and Bloom & Blade. Moving on to our e-commerce business. During the second quarter, we made additional progress to improve our operating efficiency. We further optimized our internal structure, enhanced our warehouse and logistics operations and upgraded our supply chain management.

For Kaola, our self-built bonded warehouse in Ningbo, began trial operation in June. This warehouse is capable of handling millions of orders every year, which we believe will help us to improve operating efficiencies even further.

During the quarter, we also signed strategic partnerships agreement with additional international brands such as L’Oreal and Maybelline, enabling our customers to more conveniently access these world-renowned beauty brands.

For Yanxuan, we continue to promote supply chain upgrade by helping manufacturers improve their design, reduce production costs and enhance efficiencies.

We are further deepening our collaborations with top-performing partners, which will allow us to renegotiate better commercial terms, implement better controls over quality and optimize product creativity.

On the products side, we are even more selective with new product offerings, enabling us to focus on and dedicate our resources to top products with the highest repurchase rate and customer satisfaction rating.

By offering customers greater value for their money, respect the product quality and pricing, we hope to further improve customer satisfaction. Turning on to our online music business. We continue to innovate and create a highly differentiated product with an unparalleled social experience on our NetEase Cloud Music app.

At the end of July, we added a new, highly popular community module known as the Cloud Village. This is a music community that fosters discussion, creation and sharing and personalized expression around music.

It is presented in a format of waterfalls containing music video blog, music micro blog and many other exciting features that allow music lovers to follow and express themselves interactively. This brand-new module changes the way that users experience music from just listening to also watching and interacting.

At this moment, we have over 800 million users on our music app, which is 50% up year-over-year. Subscriber numbers are also growing very strongly at 135% year-over-year increase. For online education, Youdao continues to deliver solid growth, and we see significant opportunities in the online learning industry.

Over the course of the last 13 years, Youdao has built a robust suite of technology-driven learning products and services. With its leading AI technology, strong content and predictive development capabilities, Youdao has steadily built a large, engaged and diverse user base, with over 100 million average total MAUs in the second quarter of 2019.

We do not take the responsibility of education lightly, and we encourage innovation within each content studio at Youdao. Our courses are regularly evaluated and their success is measured by user satisfaction ratings, which we believe is pivotal to the long-term sustainable growth of any online learning company.

Youdao most recently hosted its annual product launch conference in Beijing.

At the event, we announced five different products for children, including Youdao children’s English mobile app, Youdao mathematics online course and Youdao Chinese reading online course, all designed to improve children’s learning habits; as well as Youdao self tooling and kata, two online courses teaching coding to children between the age of 3 to 18.

Additionally, we also announced our second-generation Youdao Dictionary pen supported by more advanced optical character recognition [indiscernible] technology, allowing more accurate and effective scanning translation. In an evolving Internet market, content is king, and NetEase is best known for our content creation capabilities.

This rings true across our different business segments. We continue to emphasize product enhancement, craftsmanship and innovation; and better user experiences to thrill our ever-growing user community of different segments.

Through our industry knowledge, deep IP, diversification strategy within our core competencies and our international growth initiatives, we believe we can continue to bring relevant, exciting new products and services to NetEase players, fans and users around the world.

As we continue to grow and evolve, we are always very appreciative of the long-term support from our shareholders. With that in mind, our Board of Directors have approved a dividend payout ratio of 30% this quarter. We are delighted to be returning value to our investors, as our business continues to boast healthy and growing profits.

This concludes William’s comments. I will now provide a very brief overview of our second quarter 2019 financial results. Given the limited time on the call, I will be presenting some abbreviated financial highlights. We encourage you to read through our press release issued earlier today for further details.

For the second quarter, our total net revenue were CNY 18.8 billion or USD 2.7 billion, representing approximately 15% increase year-over-year. Net revenues from online game services were CNY 11.4 billion, down 4% quarter-over-quarter but up 14% year-over-year.

The sequential decrease was due to the second quarter typically being a slower quarter seasonally. The year-over-year increase was primarily driven by increased revenue contribution from flagship titles such as FWJ and new games such as Justice and LifeAfter.

Mobile games accounted for approximately 72% of net revenue from our online games in the second quarter. Net revenue from e-commerce were CNY 5.2 billion, and net revenues from advertising services were CNY 582 million.

Net revenues from our innovative businesses and others were CNY 1.5 billion, up 18% quarter-over-quarter and 23% year-over-year both due to increased contribution from Cloud Music, CC live streaming and Youdao. Our overall gross margin was 43.3% in the second quarter compared with 44.1% in the preceding quarter and 44.5% for the prior year’s period.

Gross margin for our online game services for the second quarter was 63.1%. By and large, our gross margin for games is generally stable, fluctuating quarter-to-quarter within a narrow bandwidth based on the revenue mix of mobile, PC, self-developed and licensed games. For e-commerce, our gross margin was 10.9% in the second quarter.

We achieved a positive gross margin for our innovative businesses and others business of 1.4% in second quarter versus losses of 13.1% and 7.3% in the prior quarter and second quarter of last year, respectively.

The significant improvements came from increased revenue contribution from some of our business lines within this segment, as mentioned a moment ago, as well as better cost controls. For the second quarter, total operating expenses were CNY 4.6 billion.

Our selling and marketing expenses as a percentage of net revenue were 9.4% in the second quarter, largely stable from the previous quarter. We continue to see operating leverage as we benefit from economies of scale and improve operational efficiency.

E-commerce-related shipping and handling expenses included in selling and marketing expenses as a percentage of e-commerce revenue were 7.4% in the second quarter, significantly improved from 8.4% in the previous quarter.

R&D expenses were maintained at around $2 billion level, reflecting our commitment to investing in content creation and product development, which is what defines us as a technology company. Operating income for the second quarter of 2019 increased by 2% quarter-over-quarter and 50% year-over-year to CNY 3.5 billion.

The effective tax rate for the second quarter was 18%. The lower effective tax rate in the second quarter was mainly due to reduced losses from certain subsidiaries as well as certain tax credits being recognized for certain subsidiaries of the company during the quarter.

Non-GAAP net income attributable to our shareholders for the second quarter totaled CNY 4 billion or USD 531 million, representing an increase of 21% quarter-over-quarter and 34% year-over-year. Our non-GAAP diluted earnings per ADS were CNY 28.06 or USD 4.09 for the second quarter of 2019. Our cash position remains strong.

As of June 30, 2019, our total cash and cash equivalents, current and non-current time deposits and short-term investments balance totaled CNY 55.6 billion compared with CNY 50.1 billion as of year-end last year.

For the second quarter, we are pleased to report that our Board has approved a dividend of USD 1.04 per ADS, representing a 30% dividend payout ratio. As we mentioned earlier in William’s remarks, we are thankful for the long-term support from our shareholders, and we are always looking for ways to return value to our shareholders.

As a result, this quarter’s higher dividend payout ratio reflects this commitment as we continue to boast healthy and growing profits. Thank you for everyone’s attention. We would like now to open the call to your questions. Operator, please go to Q&A..

[Operator Instructions] We will take our first question from Hillman Chan from Citi..

I have a question regarding the overseas expansion strategy for our games. So as we noticed, we recently launched a new game studio in Montreal and acquired stake in Behaviour Interactive.

And our games are doing well in Japan and some overseas market, so going forward in the future, could management share more on the strategies? In particular, what are the key focus markets by geography, the target game genres and steps you will take to achieve the overseas growth either from organic growth or M&A? And also, some of the – updates on the latest partnership synergy with this overseas studio will be helpful..

[Foreign Language].

[Foreign Language].

Okay. Thank you, Hillman. I will provide a brief translation of William’s comments, for everyone’s benefit.

So as you can see that we’ve been very active and open-minded for deeper collaboration with global premium game studios, it’s because for ourselves, NetEase, we have been cultivating in game content development R&D with almost two decades of expertise and experiences. So we are very, very open minded.

And we will continue to explore deeper collaboration with peers, the best-in-class studios globally. In terms of the overseas expansion strategy, William has summarized from a few different aspects. First is about our games launched NetEase Games into global stage. Currently, we have achieved certain milestones in Japan.

And we are hopeful and we are working hard to make also our popular content, popular games into a popular hit into mainstream Western market in North America and Europe.

In terms of collaboration with global peers, we’ve always been focusing on joint R&D development as a priority because that is our know-how, and that is where we see a lot of supplementary capabilities that we can provide to each other.

The goal is to jointly develop by leveraging each other’s competitive strengths to develop premium content for global gamers. As to the genres, there’s no fixed, rigid framework. We are very open minded to be more explorative in nature because, as everyone can witness, in the most recent years, game genre has been evolving very fast.

And we are very glad that NetEase is always a pioneer in the forefront of keeping innovation in terms of gameplays and genre..

We will take from – our next question from Alex Poon from Morgan Stanley..

I have a question regarding with the music business. It’s very glad to see the new module Cloud Village launch recently. Can you also talk about in the second half how your monetization strategy will change? And I also have seen some news regarding the timetable of profitability.

Can you also share with us, how are you going to control the costs and achieve that profitability? [Foreign Language].

[Foreign Language].

Okay, Alex. So for everyone’s benefits, let me quickly translate William’s remarks. So we are glad to see that you’ve noticed in our most recent version update of Cloud Music there is a prominent music community feature called Cloud Village. So everyone – a true music lover is now official villager of our app.

As we’ve mentioned previously, a key focus of Cloud Music is to dedicate our platform and our user outreach to promote independent musicians and independent music here in China. And with these community features, I think this is more productive in us achieving this mission.

In terms of your question on monetization, by and large, I think it can be categorized into, one, being the user subscription, which we’re now seeing a very robust growth in both the overall users as well as subscriber growth more than 135% year-over-year.

Second is from advertising, which again come – grows hand-in-hand as we’re growing our user base and popularity amongst users. The third is broadcasting, which is not only in the format of video live streaming but also audio broadcasting.

Fourth, now with the establishment of a community feature, we will also be more innovative and exploring a – deeper monetization opportunities around these community interactive features.

In terms of your question on profitability, we’ve never officially commented on any timetable, but rest assured we feel very, very confident about the growth upside of China’s online music industry as a whole.

And NetEase, as you can now witness for the past few records, we are very disciplined in controlling costs at a reasonable level; as well as be focusing on the return on the various investments, whether it’s selling, marketing or R&D, into our different business segments. So profitability is ultimately our target..

We will take our next question from Natalie Wu from CICC..

I actually have two here. First one is regarding the Cloud Music as well. You just mentioned about the Internet Cloud Village module. Actually, I tried this, that module, and it’s very innovative and interesting.

Just wondering, can management share with us some further operating metrics regarding the user engagement recently for the Cloud Music? I just want to get a sense of how that new function has improved the user engagement, say, the daily active user or the daily time spent, as well some things relating with that. And secondly, about the Marvel IP.

Just wondering, how should we anticipate the use of Marvel IP? Will there be some new brand – some brand-new games or genres launching under these IPs or just new update with these new features embedded in our existing games? [Foreign Language].

Thank you, Natalie. I will answer your first question, on operating metrics, and then William will further comment on the Marvel IP. Well, as you know, we’ve only launched this new updated version almost – I think it’s 29th of July, towards the very end of July, so it’s about 10 days.

So there’s really not a lot of operating metrics that I can specifically share, but we’ve seen very, very encouraging signs of strong growth in both DAU and MAU since we launched the most updated version.

And these data is exactly why we are confident that our innovation in bringing in this new interactive community feature will eventually be very well rewarded, because it is not only a way of changing people’s habit of experiencing music, but hand in hand, as this new feature is now not only encouraging users to listen but also to watch and interactive – interacting with other music lovers, it also creates possible opportunities for us to explore monetization potential.

And I’ll leave the second question to William. [Foreign Language].

[Foreign Language].

For the Marvel IP. Natalie, it’s a big area for – a deep route of collaboration is that we will, by – we will leverage Marvel’s global popularity of the IPs to develop games. And it’s not only one. It’s actually several games across different genres that we have different schedule and timetable to collaboratively develop with Marvel.

And the partnership also goes beyond games. For all those details, it will be gradually announced as we further progress along this long-term strategic partnership..

We will take our next question from Thomas Chong from Jefferies..

Congratulations on solid cost control for this quarter. And my questions is mainly focusing on the costs side. I think, for the GP margin, the innovation and others achieved the first positive gross profit in the past 12 months.

Can we basically assume that our cost control is very solid and we should expect innovation and others to maintain GP margin to be positive going forward? As well as for e-commerce, do we need to stay stable GP margin for e-commerce in 2019? And my second part of the question is about the OpEx.

Can management comments about the headcounts that we have in Q2 versus Q1? And how should we think about 2019? In particular, for R&D expenses, is there any reason why we see a sequential decline? Should we expect the trend to go – to be continued in the following quarters? [Foreign Language].

R&D, yes, we are a technology company, so R&D is an engine for our continued sustainable growth for the longer term. I do not see any reason why we should scale back or cut down R&D costs significantly. Quarter-to-quarter, small fluctuations that can – it’s difficult to explain. Sometimes, it’s – relates to some one-off event.

Sometimes, it’s the provisions and all that, but I think a general trend is that we are going to dedicate a considerable amount of our net revenue into R&D. But again like I’ve commented earlier on, whatever format of investment, whether it’s R&D and – or selling, marketing, we focus internally on the return on these investments.

In terms of margin, the reason why we have grouped some business segments into innovative businesses and others is exactly because they are in a relatively early stage. So as they continue to grow their top line, their user base and – the economies of scale will help us to improve their margin trajectory.

It is too early to predict whether all those relatively young business segments will then, starting from this quarter, always have positive GP margin, but I do not see any indication of margin materially decline.

So going forward, as long as my music business, my Youdao, are growing healthily – and I think, earlier on, Natalie also – I think Alex also asked that question. Profitability, making positive profits and then returning value to our shareholders always remains as a priority to NetEase..

We will take our next question from Bill Liu, Goldman Sachs..

I have a follow-up question on costs, mainly about the sales and marketing line. I noticed that, for this quarter, it’s almost flattish quarter-on-quarter but a reduction from a year-on-year perspective.

So I wonder for the sales and marketing expense, so how should we think for this line for the rest of the year given that for – on one side, we have a deceleration in e-commerce growth and, on the other hand, the new – the number of new products has been rather limited comparing to previous expectations?.

Thanks, Bill. I’ll again take that question since it’s relates mostly to financials. For selling and marketing, majority of the selling and marketing is allocated to games. And as you mentioned and relatively speaking, there’s fewer new games that has been launched in the first half of this year.

That explains why the selling and marketing on games is a relatively lower amount comparing to periods where we have major titles that we needs to promote.

Now on e-commerce, as I mentioned for now at least two, three quarters, it’s always a balanced approach between how fast we wants to grow the top line as well as the profit profile of my e-commerce segment.

And I think, coming into 2019, we are more disciplined in keeping that balance in a sense that we will not – it’s just never our philosophy that we are to pursue a faster top line growth at the expense of a bigger loss. So that is not our intention and it’s never in our corporate DNA.

So these two factors accounts for mostly why in the first half, for the past two quarters, selling and marketing expense has been maintained at a very cautious and disciplined level. Well, that does not mean that we face resource constraint. In the second half, if there are new games that’s ready for marketing and promotion, we will do so.

And if there are opportunities for us to see a re-acceleration of my e-commerce or other business segments top line growth, we will not hesitate to spend marketing dollars, but whatever marketing dollars we spend, it will be a very calculated investment focusing on returns and focusing on the results of my marketing dollar expenditure..

We will take our next question from Eddie Leung, Bank of America Merrill Lynch..

I have two quick questions. The first one is about e-sports. It seems like there is a – plans to invest in a stadium in Shanghai. So wondering how will that affect our capital expenditure going forward.

And then secondly, just any update on game regulation, anything related to the young users time restriction? Anything on along that line would be helpful. [Foreign Language].

[Foreign Language].

[Foreign Language].

Okay. So Eddie, I will translate the first question. You – I think you noticed the recent news we made at ChinaJoy. Yes, we are going to invest in Shanghai on e-sports related. And Shanghai is very supportive of e-sports and overall new economy as a whole.

As you may notice, that – our team dragons, which most recently won a championship in the Overwatch League, is a team that is based in Shanghai. And we’ve also had plan to invest – it’s not solely just for e-sports stadium, but it’s an e-sports and as well as R&D center that is more tilted towards developing e-sports-relevant game content.

So that’s a longer-term strategic plan. And in terms of CapEx, because it’s going to be spend across next three, five years or even longer, so – from a financial statement, from a cash flow perspective, these are well within our resource capability and control. It is not going to impact our financial results materially at all. [Foreign Language].

[Foreign Language].

And on your second question, game regulations, we don’t have any further update on how the regulation is progressing..

We will take our next question from Jialong Shi from Nomura..

I have two questions. First question is about your dividend payout. And as Charles mentioned in the prepared remark, you revised your dividend payout from a fixed 25% to the range of 20% to 30% going forward. So I still – I just wonder the rationale to make this change.

Is it fair to think, going forward, you will be able to pay higher than previous 25% in dividends since your earnings outlook is getting better? And my second question is about Fantasy Westward Journey 3D. And this game will – based on the game’s website, this game will start a new round of testing today.

So can you give us some colors on its revenue potential based on the performance during the past rounds of testing? And is there any potential cannibalization risk between the upcoming FWJ 3D and your existing 2D FWJ game? And finally, how long do you expect this latest round – how long this latest round of testing may last and when you expect to monetize this new game.

[Foreign Language].

[Foreign Language].

[Foreign Language].

Okay. So to just translate, for everyone’s benefits. For FWJ 3D, yes, we started – we will start closed beta testing on Android today.

As to the official launch and monetization time line, that will be subject to, first of all, obviously the approval when we can get the license; secondly, also based on the testing results of these closed beta testing rounds.

On your concerns on internal cannibalization, as this FWJ 3D and the current FWJ PC version and the FWJ mobile version, they are targeting different user appeals, so see – we see very, very little concern, if any at all, in terms of user internal cannibalization.

We are very, very confident and positive about the future outlook of FWJ 3D upon its official launch.

For your first part of the question, on the dividend payout ratio, let me comment saying that NetEase is in fact one of the very, very few technology companies globally that has been consistently paying dividends, returning dividends to our shareholders on a quarterly basis.

Every quarter, the exact dividend payout ratio is obviously subject to the Board approval. So now the Board has authorized the management, instead of a fixed 25% point, to a 20% to 30% range. And that’s not means that we are bound by this range.

So every quarter, the exact dividend payout ratio will be dependent on the financial and operational performance of the company and ultimately subject to the Board’s reapproval.

So that’s – it does not indicate that in the future we will always be paying 30%, but we are still pleased that, this quarter, we are paying more because we are confident about our sustainable profitability profile down the road. For the future quarters, it all depends on how the macro economy and our outlook of the company’s performance change..

Thank you. This conclude today question-and-answer session. Margaret, at this time, I will turn the conference back to you for any additional or closing remarks..

Thank you again for joining us today. If you have any further questions, please feel free to contact us or TPG investor relations. Have a great day..

This conclude today conference. Thank you for your participation..