Good day, and welcome to the NetEase 2023 Second 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..

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 second quarter earnings news release issued earlier today. Please note that certain financial information regarding Cloud Music we'll be discussing on this call have been prepared in accordance with IFRS.

For additional information, please refer to Cloud Music's interim report for the first half of 2023. 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's corporate website at ir.netease.com.

Joining us today on the call from NetEase senior management is Mr. William Ding, Chief Executive Officer; and Mr. Charles Yang, Chief Financial Officer. We will now turn the call over to Charles, who will read the prepared remark on behalf of William..

The Old Republic. T-Minus Zero Entertainment is developing an online multiplayer-focused third-person action game that takes place within a Sci-Fi universe. Now let's move on to Youdao.

The company's net revenues resumed its robust growth trajectory following the pandemic's impact earlier this year, registering a 26% year-over-year increase to reach RMB1.2 billion led by strong performance in our learning services and online marketing services.

Our differentiated STEAM courses continues to drive year over year increase in our learning services revenue. For our go and coding courses, their renewal rates have reached close to 70%, demonstrating our user satisfaction with our course content.

Online marketing services for Youdao achieved record revenues in the second quarter, nearly doubling comparing to the same period of last year. This achievement can be attributed to the utilization of our proprietary algorithm which has substantially elevated advertising precision and efficiency.

Notably, it operates at a nearly 90% accuracy rate in intelligently targeting tagging KOLs and reduce the time required to produce advertising materials by 80% all while enhancing user satisfaction. For smart learning devices, we continue to invest in innovative technology and rolled out new products.

We were excited to launch Youdao Dictionary Pen X6 Pro model in August, our first Dictionary Pen powered by our proprietary Ziyue large language model, which is the first large language model defined specifically for the education sector in China.

X6 Pro offers highly personalized tutoring functions for students of varying ages and levels of learning progress For instance, the platform introduces a digital human language coach named Echo.

Echo engages users with interactive English RO practice which teaches students how to initiate a conversation, express themselves naturally in a native manner, and provide grammar analysis based on student's submitted texts through scanning.

Looking ahead, our focus on technological innovation remains our driving force while we compile long-term success across our business lines. Turning to NetEase Cloud Music. In the second quarter, Cloud Music continues to enrich its music-centric ecosystem and optimized the user experience resulting in a thriving music community.

Total online music MAU steadily climbed to 207 million for the first half of 2023, marking a 14% year-over-year increase. Despite the industry-wide slowdown, total revenues were RMB1.9 billion, remaining stable compared to last quarter.

This can be attributed to a combination of strong growth in online music services driven by revenues from subscription-based memberships and declining social entertainment services as we shift towards more sustainable development. Regarding margins, we are making remarkable progress.

Our gross margin continues to improve in the second quarter reaching 27% versus 13% for the same period of last year. Cloud Music also achieved positive operating profit for the first time under IFRS in the first half of 2023. We continuously enrich our music library to offer a comprehensive music selection for our diverse audience space.

In addition to the partnerships we established earlier this year with [Being Music] and CoMix Wave Films.

We were happy to announce our collaboration with the country's top pop singer Chris Lee, leading brand [Givenchy] and renowned managing label RYCE Entertainment, which represents a number of highly acclaimed international pop star, including Jackson Wang.

Furthermore, we have also extended our collaboration with popular Korean labels, including DREAMUS, SLL, and JTBC. Our collaboration efforts with copyright holders have also proven to be successful in terms of digital album sales.

Notably, the digital album, I Feel by the leading Korean girl group (G)I-DLE achieved over RMB10 million in gross sales and 430,000 copies sold after its release in May. We continue to empower and support independent artists. By the end of June, we were serving a growing community of more than 640,000 registered independent artists.

In addition to our support programs for nurturing music talent, we actively harness cutting-edge technology to provide tools that aid in music creation. During the second quarter, we introduced Cloud Music X Studio, a voice synthesis software developed in collaboration with Xiaoice, a technology innovator in life-like interactions.

This innovative tool offers 12 natural singing invoices covering a variety of singing styles and provides musicians with resources in music creation. Moving forward, we will continue to foster our music-centric ecosystem, further grow our community, and drive healthy long-term monetization and margin expansion for NetEase Cloud Music.

Now moving on to Yanxuan. In the second quarter, our private-label brand continues to strive by strengthening its portfolio with a focus on premium quality. This coincided with a steady increase in Yanxuan's revenues and significantly enhanced its profitability. In particular, the June 18 promotion yielded exceptional results.

Our products achieved strong ranking on best-selling charts in diverse categories, including pet food, household cleaning products, and office furniture across leading e-commerce platforms. In Q2, we also introduced a campaign that highlights the production Journey of some of our popular products.

Using short films, we showcase how much detailed attention goes into the making of some of these products which was heavily validated by our user community. Looking ahead, we will persist in our dedication to explore and introduce to consumer great well-crafted products under the Yanxuan.

In summary, innovation through content production continues to be the cornerstone of NetEase and will be what propels our future growth. Superior content, products and services come from fresh ideas.

This concept forms the heart of our company, where we will always strive for excellence, manifest through hard work and persistence to inspire the industries we serve from games to music to education to retail. We work to re-imagine what is possible, creating value for our global community, our employees, and our stakeholders.

This concludes William's comments. I will now provide a brief review of our 2023 second-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 more details.

Total net revenue for the second quarter were RMB24 billion or $3.3 billion, representing a nearly 4% increase year-over-year. Total net revenues from our games and related value-added services were RMB18.8 billion, up nearly 4% year-over-year.

The growth was primarily driven by increased revenue contribution from mobile games, including our strong legacy titles such as Fantasy Westward Journey series and our newer games such as Eggy Party. Net revenues from our mobile games accounted for approximately 74% of our total net revenues from online games operation.

Youdao's net revenue were RMB1.2 billion, a year-over-year increase of 26% primarily due to increased revenue contribution from learning services and online marketing services. Net revenues from Cloud Music were RMB1.9 billion, a 11% decline compared to the same period last year.

As explained, last quarter, this result reflected declining revenue of social entertainment services as we adjusted our focus to improve profitability in a sustainable manner, we introduced multiple measures to enhance the listening experience of more dedicated music fans, lower the revenue-sharing ratio to broadcasters and agencies as well as reinforced risk controls and additional live-streaming function optimization.

Net revenues for innovative businesses and others were RMB2.1 billion, up 10% year-over-year with a balanced approach to top-line growth and margin expansion. Our total gross profit margin continues to grow, reaching close to 60% in the second quarter compared with 56% in the second quarter of last year.

Looking at our second-quarter margin in more detail. Gross profit margin was 67.4% for our games and related value-added services sector compared with 64.9% in the same period of last year. The growth was primarily driven by the termination of certain licensed games with comparatively lower gross margin.

Our gross profit margin for Youdao was 47% compared with 42.8% in the same period of last year. The increase mainly resulted from increased revenue contribution from its learning services and online marketing services, which carry higher margins.

GP margin for Cloud Music continues to improve in the second quarter, climbing to 27% versus 13% in the same period one year ago. The quarter-over-quarter and year-over-year increase in Cloud Music's gross profit, primarily resulted from the growth of membership services and continuous cost optimization initiatives.

For our innovative businesses and others, gross profit margin was 29.5% compared with 25.8% in the second quarter of 2022. The increase was primarily the result of margin improvement in Yanxuan. Total operating expenses for the second quarter were RMB8.3 billion or 35% of our total net revenues.

Taking a closer look at our expense component, our selling and marketing expenses as a percentage of total net revenues was 13.6% in the second quarter and remained relatively stable year-over-year. Our R&D expenses as a percentage of total net revenue also remained stable year-over-year at 16.3% in the second quarter.

As an innovative content and technology-driven company, our commitment to investing in content creation and product development is ongoing. We are also seeing leverage in our R&D investments in the longer term. Our other income was RMB2.8 billion for the second quarter.

The increase was mainly due to the mark-to-market value appreciation of certain publicly traded securities in our investment portfolio during the quarter, as well as higher unrealized net FX exchange gains. As per applicable accounting standards, we are required to reflect these fair-value changes.

Effective tax rate was 8% for the second quarter of 2023. The lower effective tax rate for the second quarter was mainly due to tax benefits recognized in this quarter.

As a reminder, the effective tax rate is presented on an accrual basis and the tax credit differ for each of our entities at different time periods depending on applicable policies and our operations. Our non-GAAP net income attributable to our shareholders for the second quarter totaled RMB9 billion or $1.2 billion.

Non-GAAP basic earnings per ADS for the quarter was $1.93 or $0.39 for common share. Additionally, our cash position remains strong with net cash of approximately RMB99.6 billion as of June 30 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 have approved a dividend of $0.105 per share or $0.525 per ADS.

Lastly, on our current $5 billion share repurchase program starting in mid-January this year, approximately 6.1 million ADS has been repurchased as of June 30th for a total cost of approximately $536 million. Thank you for your attention. We would like now to open the call to your questions. Operator, let's move on to the Q&A..

Thank you. [Operator Instructions] Your first question comes from Alex Poon with Morgan Stanley. Please go ahead..

[Foreign Language] Congratulations management and risk development team. We have got blockbuster title one after another launching this year.

Can management elaborate how the Justice Mobile leverage AI to boost revenue and user engagement? And how did Justice Mobile became the first one of this kind in China to adopt AI? And can management also share some of the difficulties and expectations of this game into the future? Thank you very much..

[Foreign Language] Thank you. I will do a quick translation. This is -- the AI -- we applied -- AI has an effect on us in two ways. Firstly is on the -- it has greatly enhanced our R&D efficiency and secondly, it enhanced our user experience.

From the R&D efficiency perspective, we've adopted AI technology in programming, in graphic designing, and most importantly, we changed the way we think about designing games from just game plus AI to AI plus games, which means that when we -- at the very beginning of designing the game, we start thinking AI, we build the whole -- the world view based on AI world, which gives our users very immersive strong open-world experience.

So for what we'll be seeing, our users have been highly attracted to this game.

And then -- we feel very strong stickiness and engagement of users of the game and it has -- I think the enjoyment that users are getting from the game has caused voluntary stress or promotion of our game within the gamer community and will be able to attract many gamers who were traditionally non-MMO game players.

And obviously how we want to add on here is that, apply AI technology into our game development is not something that can be achieved overnight. We started thinking about AI as far as back in 2016, 2017 when we saw AlphaGo and that's when we realized AI will have a profound impact on gaming. So that's one.

So I think what the result seen today is the accumulation of all the investments and dedication we have put into AI research and AI development in games. Thank you..

Our next question, please..

Your next question comes from Yang Bai with CICC. Please go ahead..

[Foreign Language] Okay. I will translate that myself. After the success of Eggy Party, Racing Master, Justice Mobile, we noticed that the company has recently launched Dunk City Dynasty which ranks number eight on China's iOS top-grossing chart soon after its launch.

Could the management share more color on the operation strategy of this game and how should we think of the opportunity of esports games? Besides, we can also see that the company released the PV of urban open-world game of Project Mugen which seems to be another big title. Could management tell us more about this game? Thank you..

[Foreign Language] Yes, to answer the first question on Dunk City Dynasty. So this game is actually our first attempt in sports game runway, specifically in basketball. After researching this market, we think there's potential innovation we can do in this particular genre.

So we actually, when we started to put together the team of developers and then designers, we asked all the team members -- we chose all the team members who are hardcore basketball players, personally. So all of them have a passion about basketball and they want to play the best basketball game ever in the market.

So yes, actually taking another few years of development and dedication optimization, we want to -- we feel like we only launched the game when we feel like we've mastered great graphics, and a maneuver and style in that game.

So going forward, we hope to continue to expand the user base for this game and hopefully become the dominant player in this category. Thank you. And -- so the second question is on Internet. So this is actually our attempt on innovation in the anime-style game genre. So ACG game.

This is our attempt to bringing the open-world experience and AI technology into the ACG genre. And so, this is our attempt to further solidify our development capabilities in AI and also give our ACG game lovers a true experience of open-world city lifestyle game experience.

And hopefully, we'll be able to do -- will be able to introduce the game to our gamers in a not too far future. Thank you..

Thank you. Next, please..

Your next question comes from Ritchie Sun with HSBC. Please go ahead..

Bladepoint to a free-to-play game? And how's the reception in terms of in-game item sales and user base? And how would this change the game performance trajectory going forward? Thank you..

[Foreign Language] Okay. So when office returned this game to a free -- to free, we were able to bring in more users. So after this transition, we actually saw a great improvement in terms of both our active users and also our revenues. So we think that was the right decision to make. Thank you..

Thank you. Next question, please..

Your next question comes from Felix Liu with UBS. Please go ahead..

[Foreign Language] Let me translate myself. On the domestic pipeline, congratulations on the [Badlanders] win on Where Winds Meet. We look forward to more color on the game in Gamescom.

Can management share more color on the status -- R&D status of the game? What are the potential launch time that we're looking at? And what is the game's differentiated marketing positioning comparable with Justice Mobile given both seems to be open-world and martial arts-based RPG game? Thank you..

[Foreign Language] So Where Winds Meet is actually a very important game for us. It actually has a very different worldview to our Justice. So when we develop -- when we were developing Where Winds Meet, we are actually learning about different things with open world experience and hopefully, we'll be able to launch it by the second half next year..

Second quarter..

Second quarter next year. So for NetEase, we believe we have a lot of experience in open-world games. So -- and then we -- every game we launch, we try to bring our users to a different user experience. Thank you..

The next question comes from Lincoln Kong with Goldman Sachs. Please go ahead..

[Foreign Language] So thank you management for taking my question. My question is about the new game title offer a NetEase. So in the past 12 months, we have seen a very successful launch of Eggy Party, Racing Master, and also recently the Dunk City Dynasty. Those are relatively less exposed game from NetEase in the past.

So how should we conclude and understand the success experience -- learning from these games? And after the breakthrough for all these different type, what company's R&D development or operational strategy have any change or priorities in the future, especially for those leisure party, car racing or even like a shooting type of games..

[Foreign Language] So as the -- as the Internet company, as a content provider, we keep our innovations really at heart and we continue to invest very heavily in R&D. So the success you've seen in the past 12 months are some positive results from the past effort with fully in R&D and in developing game.

But these are successive, but there have been failures too, but we will continue to work hard, never give up, and we want to bring our game users continues great game content through our innovation and dedication analogy. Thank you..

Your next question comes from Kenneth Fong with Credit Suisse. Please go ahead..

[Foreign Language] Thank you for taking my question and congrats for the very strong set of results. I have a question about the gross profit margin. What's the game business and overall business gross profit margin outlook for second half and 2024 as we see strong performance of self-developed titles and continuous channel optimization? Thank you..

Okay. Thank you, Kenneth. It's Charles. In the interest of time, let me answer this question directly in English. As you have rightfully put, NetEase prioritizes our R&D resources and attention to self-developed proprietary games, which would yield, relatively speaking, much higher margin vis-a-vis licensed games.

In the first half of this year, we continue to enhance our game services-related GP margins largely because the termination of certain licensed games as well as very strong performance of our self-developed legacy games such as FWJ, WWJ, as well as new games such as Eggy Party.

In the second half, as you can already tell, that we launched multiple new exciting very, very strong-performing games in June. So the trajectory of more self-developed games contributing to higher margins is somewhat sustainable..

Thank you, Kenneth. Next question, please..

Thank you..

Next question comes from Natalie Wu with Haitong International. Please go ahead..

[Foreign Language] Thanks for taking my question. My question is related with the games overseas expansion plan.

Just want to get an update both in short term and the long term, which market and regions will be the focus for your game expansion? And wondering if you can give us an update of your overseas expansion plan and target, both in short term and long term. And Charles, you've mentioned that Naraka's transition and other party in your prepared remarks.

So just wondering if your -- if NetEase get any expiration on license lessons or learns from these kind of recent initiatives. And lastly, just one housekeeping, what's the overseas wrapping contribution for game in last quarter? Thank You..

[Foreign Language] So in terms of geographical focus, both North America and Europe, Japan and Korea. So in terms of -- and the markets are very different in the sense that in the China market, mobile game is a mainstream and console game second place. Whereas in overseas market, console and PC games are still the mainstream.

And thirdly, in terms of genres a lot of the games that's popular -- a lot of genres are popular in China probably do not apply for overseas market. So what are the genres that will attract overseas audiences is a topic that we are studying.

I was -- we have spent a lot of time evaluating and I'm sure that very soon, we'll be able to introduce to the world the right genre, the right answer. Thank you..

And, Natalie, for your second part of the question. Overseas games revenue, well, since the strong performance of Eggy Party from Q4, the year-end of last year, the overseas revenue percentage has slightly declined to a single-digit from previously around 10-ish.

So -- but again the primary reason of that percentage mix to change is mainly due to the strong performance of certain of our new games launched mostly in domestic market.

Now with Justice Mobile and Racing Master's strong debut launch in June, we would expect my domestic games -- particularly domestic mobile games in the second half to continue to grow -- outgrow fast -- at a faster rate than my overseas game revenue..

Thank you..

Thank you..

Your next question comes from -.

Thank you, operator. No, I think this -- that's what the time we got for today. I think that's all the questions -- all the time we've got for today, so maybe this concludes the question-and-answer session. So thank you once again for joining us today.

If any further questions, please feel free to contact us directly or Piacente Financial Communications. Thank you. Have a good day..

Thank you. The conference has ended. You may now disconnect your line. Thank you..