Good day and welcome to the NetEase Third Quarter 2020 Earnings Conference Call. Today’s conference is being recorded. And I would now like to turn the conference over to Margaret Shi. 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 the U.S. Private Securities Litigation Reform Act.

Such statements are not guarantees of future performance and are subject to certain risks and uncertainties, assumptions and other factors. Some of these risks are beyond the company’s control and could cause actual results to differ materially from those mentioned in today’s press release and this discussion.

A general discussion of the risk factors that could affect NetEase’s business and financial results 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 in the filings on our website [indiscernible] Exchange.

The company does not undertake any obligation to update these 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 2020 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 will be available on the NetEase corporate website at ir.netease.com. Joining us today on the call from NetEase’s senior management team 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..

Rise to War, Nightmare Breaker, Ghost World Chronicle, Diablo Immortal and Pokémon Quest. Revelation is one of our flagship MMORPGs which we have been operating for more than five years on PC. We have just closed the final round of beta testing of its mobile version and user feedback was very encouraging.

Carrying on the legacy of the PC game, Revelation mobile game brings players to our big world of discovery and adventure. They can travel across vast fields, through deep oceans, and up to the sky. We are expecting to bring this highly anticipated game to the users before Chinese New Year.

As for our education business, Youdao had another strong quarter with total net revenues up 159% to RMB 896 million. Gross billings from Youdao’s online classes accelerated at 228% year-over-year to RMB 955 million supported by our large-scale marketing and branding initiatives.

Gross billings growth in our K-12 segment reached a record high of RMB 676 million, up 369% year-over-year, and K-12 paid enrollment expanding to around 499,000 in this quarter. Youdao further strengthened its servicing capabilities as well.

To better serve the new enrollments during the summer, we continued strengthening our top quality instructor team by recruiting those of the highest caliber and we increased the number of teaching assistants by over 600 to around 3400 now.

We are constantly looking to upgrade our content offerings with the best-in-class technology and teaching materials to make learning more efficient for our students. This effectively improved the conversion and retention rates for certain classes during the third quarter.

Net revenue of Youdao’s learning devices also grew significantly by 289% year-over-year to RMB 163 million attributable largely to the huge market popularity of our Dictionary Pen second series. We continue to lead the intelligent learning device market with our active technology advancements.

In September, we launched our brand-new product named Super Dictionary, an electronic dictionary device that supports translating text and photos and all the other functions from Youdao Dictionary without the distraction of smartphones.

We are highly committed to online education space and we believe this is the right time to be acquiring students and taking advantage of the sector’s rapid growth. We are confident that Youdao will continue to grow in a robust and sustainable manner. Turning to music, NetEase Cloud Music is growing rapidly.

We saw notable increases in the number of paying users supported by our continued efforts to create an innovative user experience and the recent successful collaboration with Ali Baba and their customer royalty Baba VIP program. Paying ratio has also notably improved.

In terms of music content, we continue to partner with worldwide music labels and top artists to provide our users with access to the fullest music content possible. In the third quarter, we secured more direct partnership with leading record labels such as UMG and BMG gaining us access to even larger music catalogues.

Concurrently, we continue to emphasize on our original music library by strengthening our supporters and investment in independent musicians with dedicated teams of professional songwriters, composers, producers as well as other resources such as AI technology and marketing solutions.

We have various incubation initiatives in place to help young and aspiring musicians to create better music and to be appreciated by the users. NetEase Cloud Music is now home to more than 200,000 independent musicians, where they will always find help and resources they need and an avenue to connect with millions of music lovers.

For Yanxuan, we saw encouraging year-over-year net revenue growth in the third quarter as well as continued improvement in operating efficiencies. Our strategic focus for Yanxuan is clear.

By creating compelling merchandise, popular products and enhancing brand recognition among users, Yanxuan is now making steady progress, establishing itself as a leading new consumer brand in China.

Some of our most popular products include cat food, bluetooth earphones and ergonomic chairs, each of these for example has become the bestsellers of their respective categories for online sales in China.

Additionally, as we continue to improve our operating efficiencies for Yanxuan, we further enhanced our pro membership benefits, giving our loyal customers value they truly appreciate. This has resulted in rapid growth in pro membership user base.

We have also taken strict measures to manage all stages of products from early product development, to post marketing tracking of product performances, effectively lowering the production and logistics costs.

In summary, our consistent focus on creating innovative and high quality content is what propels our leading role within these market verticals and what makes us even more confident as we further expand in each of our key business segments.

We will fulfill our commitment to users and shareholders as always, with a strong sense of purpose and solid rationale focusing on the return on investment. We are confident that we can continue to provide our user community with excellent products and services that support solid long-term returns for our investors. This concludes William’s remarks..

I will now provide a very brief overview of our 2020, 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 RMB 18.7 billion or US$ 2.7 billion, representing 27% increase year-over-year. Net revenues from online games were RMB 13.9 billion up 20% year-over-year, primarily driven by the increased net revenues of from FWJ H5, Life-After, Knives Out and Sky.

Mobile games accounted for approximately 73% of net revenues from our online games in the third quarter.

Net revenues from Youdao increased by 169% year-over-year in the third quarter, reaching a record high of RMB 896 million, primarily due to the increased net revenues from online classes with a rapid increase in the K-12 paid students enrollment and increased sales of intelligent learning devices.

Net revenues from innovative businesses and others were RMB 3.9 billion for the third quarter, up 42% year-over-year, mainly due to increased contribution from NetEase Cloud Music business. Our total gross profit margin was 53% in the quarter, with a breakdown as follows. GP margin for our online game services for the third quarter was 63.6%.

As a reminder, this number is generally stable with some narrow fluctuations based on the revenue mix of PC and mobile as well as self developed and licensed games. GP margin for Youdao for the third quarter was 45.9%, comparing to 25.8% a year ago.

The year-over-year increase was primarily attributable to a significant increase in net revenues, improved economies of scale, and further optimization on our faculty compensation structure. This marks our fourth quarter of consecutive improvement on a sequential basis.

GP margin for innovative businesses and others was 16.8% compared to 15.2% for the third quarter of last year. The increase was due to improved GP margin of NetEase Cloud Music driven by its strong revenue growth. As a reminder, the GP margin of innovative businesses and others line would fluctuate mainly due to the revenue mix of this line.

For the third quarter, total operating expenses were RMB 7 billion. Our selling and marketing expenses as a percentage of net revenue were 18.5% compared with 12.8% in the prior quarter. The quarter-over-quarter increase was mainly due to increased marketing related to Youdao.

Excluding Youdao, our selling and marketing expense as a percentage of net revenues were 12.9% comparing with 10.7% in the prior quarter, mainly due to increased spending on certain games promotions during the quarter. Our R&D expenses were RMB 2.8 billion as we remain committed to investing in innovative content creation and product development.

That's what defines us as a technology company. As a percentage of net revenues, R&D expenses were 14.9% this quarter, compared with 13.2% in the prior quarter, mainly due to R&D headcount increase. Our R&D expenses are mainly related to online games.

Other income was RMB 266 million for the third quarter, which included net investment income of RMB 1.3 billion and net foreign exchange loss of RMB 1.6 billion due to the U.S. dollars exchange rate depreciation against RMB.

This compares with other income of RMB 915 million in the same period last year, which included investment income of RMB 395 million, and a net foreign exchange gain of RMB 121 million. Effective tax rate was 10.9% for this quarter, compared with 18.6% in the prior quarter.

The effective tax rate is lower this quarter, as certain of our subsidies received and recognized certain tax credits in this quarter. Non-GAAP net income from continuing operations attributable to our shareholders for the third quarter of 2020 was RMB 3.7 billion or US$ 540 million.

Our non-GAAP diluted earnings per ADS from continuing operations were RMB 5.35 or US$ 0.79 for the third quarter. Our cash position remained strong.

As of September end our total cash and cash equivalents, current and non-current time deposits, and short-term investment balance, totaled RMB 103 billion compared with RMB 74 billion as of the year end last year.

In accordance with our dividend policy, we are pleased to report that our Board of Directors has approved a dividend of US$ 0.195 per ADS or US$ 0.039 per share. As a reminder, we changed our ADS ratio on October 1 from one ADS for every 25 ordinary shares to one ADS for every five ordinary shares.

And finally, under our current share repurchase program for up to 2 billion as of September quarter end, approximately 15.3 million ADS has been repurchased under this program for a total cost of US$ 1.1 billion. Thank you very much for your attention. We would like now to open the call to your questions. Operator, let's go to the Q&A..

[Operator Instructions] We will now take our first question from Alex Poon, Morgan Stanley. Please go ahead. The line is open..

[Foreign Language] Translating my question, my question is regarding overseas game strategy. In the last eight, nine to 10 months during COVID, we have seen very successful expansion, overseas expansion of Chinese mobile games in overseas market even for Chinese RPG games. So NetEase has a lot of strong and top legacy RPG IPs.

Can you share with us what's your strategy in terms of geographical focus, genre, and your product investment and lastly, about the competition landscape? Thank you very much..

[Foreign Language].

I will provide a brief translation of William's remarks. So Alex, first of all, we are very dedicated in focusing on the overseas strategy for NetEase. Right now, in Japan, we have achieved a small step.

Beyond Japan, we think major markets what NetEase is eyeing for in terms of game lineups, there will be games that are being developed specifically for global launch, games such as Harry Potter as well as certain games in the SLG genre. There's also another more casual game, UNO, which has been also performing quite well in the overseas market.

Going forward, we are very confident about our NetEase developed games competitiveness when Chinese games are going overseas because quality and the sophistication of these games are what we think we have a competitive edge vis-à-vis the peers. Thanks.

Operator next question please?.

Thank you. We will now take our next question from Elsie Cheng from GS. Please go ahead. The line is open..

[Foreign Language].

[Foreign Language].

Okay. I will briefly translate the question and then also the translation of William's remarks.

So, the question is asking what is in the next three to five years, what is the NetEase’s game development strategy? How -- what is our view of this industry, both in China and globally? William's response is that, first of all, we think this is a very good sector. Game entertainment is a very good sector.

If you read the recent news of how well received that PS5 and Xbox were by the global consumers, as well as for instance, throughout the COVID-19 situation entertainment, new format of game interactions are all being encouraged. It's been, it's a demand, a strong demand from the consumer side.

So, we think this is really a good sector with a very promising future upside. Now focusing back to NetEase, we have a track record of almost two decades, dedicating ourselves in game development and game operations. We are willing to invest more and more into the future, into R&D, into marketing.

And we are not only complacent about Japan, but we are also eyeing for mainstream Western market, Western market, European market. So all-in-all, we are very confident that by combining our experience, track record, willingness to invest and also our suaveness into directing the genres of future game development.

We're very confident that our high-quality game product can be well received by both the domestic China market as well as more geographies in the international market..

Thanks..

Operator, let's go to the next question please?.

Thank you. [Operator Instructions] We will now take our next question from Alicia Yap from Citi Group. Please go ahead. The line is open..

Hi, thank you. [Foreign Language] So, my question is related to the online music.

So how does management envision the future landscape of online music industry in China? Will there be just two major players or do you foresee more players will come into the market, and is there a market share target that NetEase Cloud Music hopes to achieve in the future? Thank you..

[Foreign Language].

Okay, I will provide a brief translation of William's remarks. So first of all, we have launched NetEase Cloud Music since more than seven years ago and over the last seven years, as we all can see, the consumer habit has dramatically changed to streaming music, streaming consumption rather than buying a CD or downloading mp3.

We, right now, there are two players. Obviously, we are very confident and ambitious that into the future, we will have a leading market share.

The way for us to position ourselves as on one side, we do want to emphasize on original and organic music, and bring them to the end users to be better appreciated and accessed by the music listeners and at the very same time, provide resources to support and nurture China's independent musicians in supplying more and more high quality music content building a healthy cycle organically.

Obviously, there might be more challenges coming into this sector, but we are confident that as long as we commit to the purpose and mission, we should be able to achieve a leading market share in this very promising online music sector in China..

Thank you, Charles. Thank you, William..

Operator, next question please? Thank you, Alicia..

We will now take our next question from Kenneth Fong from Credit Suisse. Please go ahead. Your line is open..

[Foreign Language] We noticed that some recent game launch like Genshin Impact have been launching through like BiliBili and TapTap have been to avoid the high revenue sharing of Android channel.

With the success of this launch as well as the Cloud gaming platforms, does it means that the power of negotiation power is gradually shifting towards us as a major game developer? How should we think about the margin upside over the medium term and also any room for this channel fee to gradually decline over time? Thank you..

[Foreign Language].

I will provide a brief translation of William's remarks. So Kenneth, so first of all, we remain very optimistic on how the future trend is shifting. Right now, as we all know, China is arguably the most expensive channel fee country in the world, especially for Android channel fee, whereby the global standard is the same as Apple iOS app Store 30%.

In China, the norm is 50% Android channel fee. So we also encourage players such as Yanxuan and others, including ourselves to try to explore other non-conventional ways of distributing high quality content to the end users.

Last night, I think we all saw the news that Apple has announced that they are going to reduce the channel fee to 10% for small developers, in an effort to encourage the better upside and economics for the developers. We do think, probably Google Play and others will also follows suit.

Let's wait and see, but broadly speaking, as a trending wise, a shift towards content providers is probably a more and more clear and visible trend that we can all observe globally and that should also come to China..

[Foreign Language].

Thank you. We will now take our next question from Binnie Wong, HSBC. Please go ahead..

[Foreign Language] My question is mainly on the sales and marketing expense. We actually see that even excluding Youdao, NetEase itself also increased in terms of the sales and marketing as a percentage of revenue.

Is it because of some of the overseas launches? And then into -- going forward into the future quarters, as we are launching some of the bigger things we had in the pipeline, shall we expect that other further changes or any structural changes in our marketing strategies that we should be aware of too? Thank you so much and congrats on a very strong quarter again..

Thank you, Binnie. I will answer this selling and marketing expense question directly from my end. Well, I think for Youdao, they posted the earnings call just now ahead of this call.

The explanation was fairly sufficient that we are very, very confident that this is the right time and we are in a ready state to continue to invest more aggressively in acquiring users. We will be rewarded by the ROI given how prudent we are, although we are investing more into selling and marketing in Youdao, but the unit economics works.

So this, we are not shy of investing more into expanding our market share, and the user scale as robust as possible. Excluding Youdao for this quarter, our selling and marketing as a percentage of net revenues again, excluding Youdao, stays at around 12.9% slightly below 30%. This is still a very healthy level comparing to many of the industry peers.

Our NetEase approach towards selling and marketing is always very straightforward. It is always ROI driven. We have a very, very high standard of the required rate of return internally.

So when we invest, by the way, the excluding Youdao, the substantially, substantial amounts of the selling and marketing are game related, now game related either for the existing titles for the maintenance, old tax that we spend to maintain the longevity and the efficiency of the gross billing, as well as new games such as the FWJ H5 and new genres of the games that we are going to launch down the road.

So all-in-all, I do not think when we tap into international market, when we go into a new genre, that's a determining factor for us to spend irrationally.

Regardless of which market, which genre or which specific new game that we are going to launch, I think we always do a very prudent math behind it before we deploy the selling and marketing resources. So it's just a matter of timing gaps.

Sometimes we will be launching, we will be spending up front in the same quarter, but the gross billion of these sales and marketing expenses will be reflected into the gross billions, which might be only recognized in the subsequent quarters into recognized revenue..

Thank you, Charles, very clear. Thank you..

Thank you, Binnie..

Thank you. We will now take our next question from Natalie Wu, Haitong International. Please go ahead. Your line is open..

[Foreign Language] Okay, I will translate myself. So thanks for taking my question and congratulations for a very solid quarter. So my question is regarding the increased sales and marketing, just wondering how much of that is related to Cloud Music.

And regarding a margin if we exclude the impact of [indiscernible] deal last year, and also Youdao expanded loss, actually the margin jumped 4% year-over-year.

So just wondering how much of that is related to expanding scale of low margin music business or if you have some investments on the other business units? And also speaking of Cloud Music, how should we think of the revenue model compensation of music business as well as the margin profile going forward? Thank you..

Okay, thank you, Natalie. It's a finance related question, so I'll answer directly from my end. For this quarter, total selling and marketing expenses was RMB 3.4 billion. Roughly speaking, RMB 1.15 billion is Youdao, the remaining about RMB 2.3 billion are selling and marketing excluding Youdao.

Out of that RMB 2.3 billion super majority of that is game related. So music Yanxuan media and others comparing to games that's just represents a small fraction. So it is not really about us investing irrationally into some lower return segments in a big amount. You've also pointed out the declining trend of the operating margin overall.

I think obviously, mathematically, a big reason of that is what I just explained to Binnie’s question. There's a timing gap right, for instance, for both Youdao and games, in particular. The expenses are recognized in this quarter. However, gross billions are not entirely recognized into revenue into the same quarter.

Beyond that, there's also another factor is in the game revenue mix. For instance, the PC and mobile game ratio stays relatively stable.

However, within the mobile games, we are also pioneering with some different genres of the games, for instance FWJ H5, which is a more casual mobile game, so even though it is the same broad category of a mobile game, but if you were to look at a more casual game, vis-à-vis a hardcore MMORPG, mobile game, they would demonstrate different margin profiles.

I think that's another small factor explaining why you are observing a downward trend of the operating margin. That in fact reminds us of many years ago, when we decided to transition from the PC game into mobile games, a revenue mix change, resulting in certain margin profile changes.

I do think that's, again, it's the mathematics right, whether you want a bigger pie, whether NetEase is bold enough and confident enough to tap into more genres of the games, they might be demonstrating some different margin profiles, versus our most familiar MMORPGs, but we do think it is the right move for us to be more diversified in terms of genre offering.

So Natalie, hopefully it answers your question..

Yes, very clear, but what about the longer term margins of your music business?.

For music, so you hide your second question into your first question. For music, yes so I have to admit that it is still a loss making business for now, even at the GP margin level, because we all know that the music content licensing fee, it is still at a irrationally high level.

Because our music monetization is growing very well, the economies of scale is helping us to improve the margins. So in a sense, it is still negative GP margin, negative operating margin, but the negative margin is being narrowing down. Going into the future, we do think the macro trend is in favor of us.

On one side the music, record labels, music licensing fees are more rationalized, especially following the non-exclusive licensing arrangement into the medium to longer run. At the same time, we are also emphasizing a lot more on organic and original music from independent musicians.

With all that, I think it is something to expect that very soon, in two to three years time, the overall China's online music segments should be a very profitable segment..

Got it very clear. Thank you, Charles..

Thank you..

Thank you. We will now take our next question from Thomas Chong from Jefferies. Please go ahead. Your line is open..

[Foreign Language] Thanks management for taking my questions, and congratulations on a strong set of results. My question is about the NetEase Cloud Music. Just now we just touched upon the strong revenue growth momentum.

But if we go into the revenue mix, can you talk about the growth momentum in terms of the paying subscribers, as well as the live streaming revenue, and how we should think about the revenue mix over time as well as the opportunities on new business models? Thank you..

Okay, thank you Thomas. I'll answer your question directly in the interest of time. I think this probably would be the last question on this earnings call. So first of all, subscription revenue has been trending up very well.

We have seen a notable increase this quarter, both in terms of the paying user base, as well as the paying ratio, as mentioned in the scripts earlier on. In fact, when we compare that to our peers who have publicly disclosed their paying ratios, I think our paying ratio is slightly better. But for the entire industry, this is still a single digit.

It’s a very low paying ratio. There's plenty of upside room for China's online music industry to improve, substantially improve the paying ratio, that the first comment. Live streaming is a very fast growing, monetization vertical format is Cloud Music, well partly also because we also grow from a relatively much smaller base.

So right now live streaming is already becoming a very sizable and significant major revenue contributor of my overall NetEase Cloud Music revenue. At the same time, we are also very, very actively ramping up other formats of monetization such as advertising for instance. New business model it is always a time [indiscernible].

I think that, I've been saying this for multiple quarters already, that's the exciting part of China's online music industry. Because try not to fix your imagination by what Apple Music or Spotify has been doing in a different geography.

I think for China's online music industry as a whole, we will be, together with the other players in the sector, we will be experimenting and pioneering some interesting and new format event monetization that is probably not yet available in the Western world.

And on that, we can give one thing on the direction, we do think that music is not, at least NetEase Cloud Music is not just a platform to play songs. It is an avenue for social interaction.

So social interaction, social media, this is a direction that we are focusing a lot on exploring potentially new business models and potentially new monetization models..

Thank you, Charles. Congratulations on a strong set of results..

Thank you, Thomas..

Thank you. Ladies and gentlemen, that will conclude today's Q&A session. I will now turn the call back to your host..

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

Thank you. Ladies and gentlemen, that will conclude today's call and you may now all disconnect..