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Edited Transcript of NTES earnings conference call or presentation 16-Nov-17 1:00am GMT

Beijing Nov 16, 2017 (Thomson StreetEvents) -- Edited Transcript of NetEase Inc earnings conference call or presentation Thursday, November 16, 2017 at 1:00:00am GMT

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Corporate Participants

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The Piacente Group, Inc. - Founder and President

* Lei Ding

NetEase, Inc. - Founder, CEO and Director

NetEase, Inc. - CFO

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* Han Joon Kim

Citigroup Inc, Research Division - Research Analyst

* Jialong Shi

Nomura Securities Co. Ltd., Research Division - Head of China Internet and Media Research and VP

* Marcus Yang

Macquarie Research - Research Analyst

* Sef Chin

T.H. Capital, LLC - Founder, CEO, & Senior Analyst

* Yue Wu

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Operator [1]

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Good day, everyone, and welcome to the NetEase Third Quarter 2017 Earnings Conference. Today's call is being recorded. At this time, I'd like to turn the conference over to Brandi Piacente. Please go ahead, ma'am.

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Brandi Piacente, The Piacente Group, Inc. - Founder and President [2]

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Thank you, Tamari. 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 cause (sic) [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. The company does not undertake any obligation to update this 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 the reconciliation of GAAP to non-GAAP financial results, please see the 2017 third quarter financial results news release issued earlier today.

As a reminder, this conference is being recorded. In addition, an investor presentation and a webcast 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 is Mr. William Ding, Chief Executive Officer; Mr. Charles Yang, Chief Financial Officer; and Mr. [Hilton Huang], Co-President of NetEase, Inc.

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

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Zhaoxuan Yang, NetEase, Inc. - CFO [3]

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Thank you, Brandi, 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 renminbi. With that said, I'm pleased to deliver opening remarks on William's behalf.

Since establishing NetEase in 1997, our focus has been on innovation, high-quality content and community. 20 years later, we are pleased to be implementing these same values as we develop and operate some of China's most popular mobile and PC-client games as well as some of the country's most prominent advertising, communication and e-commerce services. The cornerstones of our future success are based on these principles, along with our ability to continue to broaden and diversify our portfolio of online products and services, enhance our brand equity and expand our global footprint.

During the third quarter, we did exactly that. We advanced each of our core business segments year-over-year, growing our quarterly net revenues by nearly 36%. Our growth was spearheaded by our online game services sector and, in particular, our mobile games, which accounted for approximately 68% of this segment net revenues, led by our self-developed mobile games, including Onmyoji, New Ghost, Land of Glory, Invincible and Demon Seals. The popularity of several of our legacy games continues to grow, and our PC-client games, Fantasy Westward Journey Online, and mobile game, Invincible, achieved another record quarterly revenues during the third quarter.

In addition to our legacy titles, players are also responding enthusiastically to our newer hit games such as Onmyoji. Although Onmyoji's performance in China slowed down in the third quarter, this popular title regained traction when we introduced new content and gameplay, supported by promotional activities through media, literature and merchandise collaborations. To further expand the success of the Onmyoji brand and to captivate players, we are developing a battle arena game based on the Onmyoji IP. The initial testing for this game is progressing well and on track with our expectations.

In line with our expansion strategy to bring exciting titles overseas, Onmyoji's international presence remains strong. After being introduced in Japan and Southeast Asia, Onmyoji was also successfully launched in Korea, followed by promising user feedback during closed beta testing in the U.S. and Canada.

We also strengthened our portfolio in the third quarter by introducing a number of new expansion packs that extends life cycles of our games as well as launched new mobile titles. The highly anticipated release of Minecraft in China went exceptionally well as we introduced the game for PC JAVA and iOS in the third quarter and Android shortly thereafter in October. On its first day of release, Minecraft was ranked the #1 downloaded mobile game on both the iPhone and iPad. Minecraft has received considerable accolades in China, and by the end of October, the game had accumulated nearly 30 million registered users. Early monetization efforts for Minecraft are underway, with server rental and partial content monetization for the PC JAVA version, which began in mid-September. We have also initiated monetization testing for high-pixel server, and we plan to [commerce] a small-scale monetization for the mobile version in early 2018.

Our renowned portfolio of games continues to delight Chinese players. In addition to Minecraft, we also introduced Index, a Japanese-themed RPG, to millions of gamers and fans during the third quarter. We are focused on growing our portfolio with a number of new exciting games in our pipeline that broaden and diversify our offering in a variety of genres. We have a rich pipeline that leverages our top resources in R&D and talented pool of developers and optimal strategy to license and operate marquee games. In the coming quarters, we are looking forward to bringing new titles across different genres to gamers, including MMORPG such as Chu Liu Xiang; and Tribes and Empires: Storm of Prophecy; Japanese-themed RPG, Forever 7; and card game, HAN-GYAKU-SEI Million Arthur; as well as a battle arena game based on Onmyoji IP; and our 3D PC-client game, Conqueror's Blade.

In addition to our domestic offerings, we are bringing our vision to audiences across the globe markets where mobile games are growing at a steady pace. International expansion allows us to grow our brand worldwide and introduce our games to audiences around the world, eager for the thrilling, high-quality game experience that NetEase players love. Games like Onmyoji and Crusaders of Light are performing very well overseas, and Crusaders of Light has now been recognized as one of the top-grossing games in more than 20 different countries since its launch.

Now turning to our other business segment. Leveraging our technology advantage, premium brand and larger user base, we continue to strengthen our market position with NetEase Media. During the third quarter, we grew our advertising services net revenue by approximately 12% year-over-year, with automobile, real estate and Internet services as our top-performing verticals. Our pan-entertainment marketing program is supporting a growing number of high-profile projects, and we are also seeing the increase in demand for performance-based advertising to support our growth in an otherwise mature market.

Investment in both original and third-party, high-quality content, customized smart push technology, video content and innovative marketing solutions amid the evolving advertising climate support our ability to remain one of the most sought after advertising platforms in China.

Our email, e-commerce and other business also continued to grow in the third quarter, with net revenues increased by nearly 80% year-over-year, primarily due to increased revenue contribution from our e-commerce businesses such as Kaola and Yanxuan. These e-commerce platforms are prospering the net revenues from Kaola and Yanxuan of RMB 2.7 billion, accounting for approximately 71% of the segment's net revenues. Each of our business lines is an integral to our growing brand.

As we continue to amass one of China's preeminent game portfolios, we are simultaneously focused on advancing our Internet service offerings to support our healthy business platform. We will continue to invest in the growth of each of these business segments. Together, they strengthen not only the NetEase brand but our commitment to our investors and user community.

This concludes William's comments. I will now provide a review of our third quarter 2017 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 detail.

Our gross profit for the third quarter of 2017 was RMB 5.9 billion or USD 893.9 million compared to RMB 6.7 billion and RMB 5.3 billion for the preceding quarter and the third quarter of 2016, respectively. Our gross profit grew year-over-year for our online games segment in the third quarter. However, as mobile games become an increasing revenue contributor, gross margin for our online games business decreased slightly. For the third quarter of 2017, gross profit margin for our online games was 62.5% compared to 63.1% and 65.0% for the preceding quarter and the third quarter of 2016, respectively.

Gross profit margin for our advertising services business increased year-over-year and quarter-over-quarter in the third quarter of 2017, with gross margin of 68.0% compared to 67.6% and 65.3% for the preceding quarter and the third quarter of 2016, respectively.

Gross profit decreased year-over-year for our email, e-commerce and others businesses for the third quarter of 2017, with gross margin of 11.9% compared to 11.3% and 33.5% for the preceding quarter and the third quarter of 2016, respectively. This is mainly a result of the change in product mix, with Kaola and Yanxuan representing increasingly significant revenue contribution.

Total operating expenses for the third quarter of 2017 were CNY 3.4 billion or USD 510.7 million compared to CNY 3.3 billion and CNY 2.5 billion for the preceding quarter and the third quarter of 2016, respectively.

For the third quarter of 2017, we recorded a net income tax charge of CNY 225.5 million or USD 33.9 million compared to CNY 703.5 million and CNY 427.2 million for the preceding quarter and the third quarter of 2016, respectively.

The effective tax rate for the third quarter of 2017 was 8.1% compared to 19.0% and 13.3% for the preceding quarter and the third quarter of 2016, respectively. The changes in the effective tax rate were mainly due to the recognition of tax credits related to Key Software Enterprises for certain subsidiaries in the current quarter and the third quarter of 2016.

Our net income attributable to shareholders for the third quarter of 2017 totaled CNY 2.5 billion or USD 379.9 million compared to CNY 3.0 billion and CNY 2.7 billion for the preceding quarter and the third quarter of 2016, respectively.

Non-GAAP net income attributable to our shareholders for the third quarter of 2017 totaled CNY 3.0 billion or USD 454.6 million compared to CNY 3.5 billion and CNY 3.0 billion for the preceding quarter and the third quarter of 2016, respectively.

For the third quarter of 2017, our basic and diluted earnings per ADS were USD 2.88 and USD 2.86, respectively. This compares to basic and diluted earnings per EPS -- ADS of USD 3.39 and USD 3.37, respectively, for the preceding quarter, and USD 3.14 and USD 3.12, respectively, for the third quarter of 2016.

Our non-GAAP basic and diluted earnings per ADS for the third quarter of 2017 were USD 3.45 and USD 3.43, respectively. This compares to USD 3.96 and USD 3.94, respectively, in the preceding quarter and USD 3.46 and USD 3.43, respectively, for the third quarter of 2016.

Our cash position remains strong. As of September 30, 2017, our total cash and cash equivalent, current and noncurrent time deposits and short-term investment balance totaled CNY 40.7 billion or USD 6.1 billion. This compares with CNY 36.9 billion as of December 31, 2016.

Our cash flow generated from operating activity was CNY 1.7 billion or USD 248.8 million for the third quarter of 2017 compared with CNY 2.3 billion and CNY 3.7 billion for the preceding quarter and the third quarter of 2016, respectively.

Returning value to our shareholders remains a top priority. For the third quarter of 2017, we plan to pay a dividend of USD 0.72 per ADS in accordance with our 25% dividend distribution policy.

Under our current share repurchase program, we repurchased approximately 1.1 million ADS for approximately USD 306.1 million as of November 14, 2017, the last day of this program. To continue this activity, our board has approved a new 12-month share repurchase program beginning on November 16, 2017, for up to USD 1.0 billion.

Thank you for your attention. We would like now to open the call to your questions. Operator, please go ahead.

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Operator [1]

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(Operator Instructions) We'll move first to Hillman Chan with Citigroup.

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This is Hillman on behalf of Alicia. My first question is regarding the monetization strategy and potential for Wilderness (foreign language) and also Minecraft piece for both PC JAVA and mobile. And regarding (foreign language) Wilderness, how do we see the competition from several games of similar genre in the market? What's defining (foreign language) And I have another follow-up question.

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [4]

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Okay. So let me translate the response from William. Firstly, to address the competition. Wilderness is a sandbox battle arena game, and currently, it's in the internal testing stage. So we will continue to optimize this game and to inject innovations and bring this exciting new game to our global audience. In terms of monetization, for Minecraft, this is a sandbox platform, so essentially, you can think of this as a marketplace. We encourage developers to come to this marketplace, this platform, to come up with exciting, innovative modes and users willing to pay for these modes to get enhanced user experience on Minecraft platform. For Wilderness, as you know, this is a FPS game, and this is also based on a sandbox concept. And you should take full confidence in NetEase's almost 2 decades of experience in developing games, bringing innovations. We have full confidence on this game, and we think of this quite many opportunities in terms of monetization in this game without compromising the user experience of this fair battle arena game. So for -- at this stage, we are not really rushing out for any of the monetization initiatives for these games.

Operator [5]

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And next, we'll move to Natalie Wu with CICC.

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Yue Wu, China International Capital Corporation Limited, Research Division - Analyst [6]

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I actually have 3 questions. The first one is regarding your deferred revenue. As we noticed, that your total deferred revenue this quarter increased to 2.7 sequentially. So what are the drivers behind the sequential increase? My second question is about your international expansion. Can management please show your current progress and future plans for the overseas expansion? What are the revenue contributions from overseas market at current stage? And how should we expect this contribution going forward? My third question is regarding your Cloud Music business. Can management please elaborate more about your current strategy for this business, especially that the competition of music copyright are getting fierce for more media players? Can management please share your thoughts for current competition landscape? Any comments would be helpful.

Zhaoxuan Yang, NetEase, Inc. - CFO [7]

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So, Natalie, let me answer your first 2 questions, financials, and then I will translate the third question to William and the management. On deferred revenue, this [causes] deferred revenue has been stabilized. This is largely because of our game growth and performance has been stabilized in the recent quarter. And as you know, deferred revenue, we never changed any accounting policy for the revenue deferral. So the numbers reflects the stability of the performance of the games. For your second question on international expansion, as you know, we are continuing with this initiative. Overseas revenue this quarter accounted for approximately 2.4% of the total revenue, which has been quite stable comparing to the preceding quarter and the significant improvement comparing to prior year. For your third question, I will translate for the management. (foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [9]

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So our -- as you know, our Cloud Music is quite unique in terms of our competitive landscape. Our smart push technology is best-in-class. But beyond that, we've also been quite focused on original music. There are millions of independent musicians in China that creates very exciting music, and Cloud Music, this platform is dedicated to be the priority choice of the platform to help these independent musicians to broadcast and distribute their music to a broader audience of music lovers.

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Operator [10]

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Next, we'll move to Jialong Shi with Nomura Securities.

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Jialong Shi, Nomura Securities Co. Ltd., Research Division - Head of China Internet and Media Research and VP [11]

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(foreign language) I will translate my questions. My first question is about the e-commerce services. I was quite impressed by the strong growth of NetEase e-commerce service in the past quarters as NetEase e-commerce revenue -- e-commerce business has reached such a big scale. I just wonder if NetEase may consider partnering with any strategic -- external strategic investors. And if yes, what types of investors NetEase likes to work with? My second question is about a recent media report. NetEase -- based on the report, NetEase recently viewed one of the Chinese game lab broadcasting platforms for live streaming NetEase online games. I just wonder, what's the rationale for NetEase to take this action? And how does NetEase think of its relationship with this external like game lab broadcasting platforms?

Zhaoxuan Yang, NetEase, Inc. - CFO [12]

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(foreign language) Okay. Well, for our -- first question, for our e-commerce, as you know, e-commerce remains one of our pivotal focus of broadening our Internet products and services. We remain open-minded. We welcome all strategic partnerships, particularly on the business level. At the appropriate time, we will also consider bringing in external strategic shareholders. For now, I think our top priority is to continue a buildup, Kaola and Yanxuan brand equity, amongst the users by focusing on the user experience and by bringing in a new e-commerce concept to the Chinese users. The second question, I will defer to the management. (foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [14]

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So to your second question, Jialong, this incident was actually referring to 3 years ago in 2014 when that platform was broadcasting Fantasy Westward Journey. During the broadcasting, they have inserted advertisement that direct the users, the audiences to a suboptimal-quality web game. We think that is not appropriate. We have been following -- we've been following written communications with the platform and -- because we did not get the reasonable response within the reasonable time frame, so we have initiated this litigation process. But overall, in terms of our relationship to all the live streaming platforms, we remain very open-minded. We, in fact, welcome all these partnerships and broadcasters to come experience our NetEase games. We have a lot of exciting games, Minecraft, Overwatch, Heartstone as well as our own self-developed games. All of these are very suitable contents for game live streaming. But, of course, we will require reasonable and rational restrictions not to do things inappropriate and jeopardize the user experience when other platforms are broadcasting our games.

Operator [15]

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And we'll move next to Chi Tsang with HSBC.

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Ningchuan Wang, HSBC, Research Division - Associate [16]

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This is Wayne Wang speaking on behalf of Chi. So I have a question regarding to the monetization of Wilderness. So as management has mentioned that we will come up with some interesting idea about monetization. So I have noticed that. So there were some -- recently, some in-game advertisements in Wilderness, for example, like the JD advertisements on the plane. Will that be the majority main monetization approach going forward? And will that be included in the advertising services segments of our online game segment? And also as (inaudible) says, in this quarter, so in Kaola's margin, things should have slightly (inaudible) recover. So what's our long-term expectation about Kaola? I mean, the email segment margin Q-on-Q slightly improved. So how should we think about the long term? Is it (inaudible) about the second margin or maybe the e-commerce margin going forward?

Zhaoxuan Yang, NetEase, Inc. - CFO [17]

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(foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [19]

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So let me first translate for William's comment. So first of all, for Wilderness or, more broadly, for these survival category games, because this is a new genre, and we will take a holistic approach to -- in terms of monetization, just like this high-quality game has surprised users, just give us some patience and confidence. We -- as you know, we will have a very comprehensive approach to monetize this game in due course. And at this stage, do not worry too much, and we are not overly rushed out in terms of this monetization effort. To your second question on the margins, overall, we are happy see that email, e-commerce and other segments, the margin has now been stabilized. I think going forward, we remain the margin will be stabilized at this level as we further grow our e-commerce and other business units within this segment. Over the longer term, we think the skill factor will start to kick in, but that obviously would also require some time.

Operator [20]

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Let's move to Tian Hou with T.H. Capital.

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Tianxiao Hou, T.H. Capital, LLC - Founder, CEO, & Senior Analyst [21]

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So okay. William, [Dennis] and Brandi. I have a question not really related to your game. I do believe you guys have a strong capability of come out with a surprising, good content. The question is really related to what is really the buzzword, AI, big data. And at NetEase, you have a lot of -- lots of data, emails and dictionaries and games and commerce and news. And I haven't heard a word from you about the big data, about AI. I wonder how NetEase actually benefits or using such kind of a property to benefit your own content creation. That's my question, William.

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Zhaoxuan Yang, NetEase, Inc. - CFO [22]

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Okay. Let me translate for the management. (foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [24]

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So to answer your question, AI, we also agree and recognize its importance, of AI, towards the future success. However, we are also a little bit concerned that in media, in particular, AI, big data, these buzzwords have been overly exaggerated. To NetEase, we invest significantly into AI, big data and all these new trend of technologies. But ultimately, we believe these technologies are best reflected out of the product, the user experience of the product. To give some concrete example, for instance, our Youdao Dictionary, we have been adopting the AI technology into this product, and it can now utilize this app for audio -- verbal translation as well as translating the contents when you take a photo, for instance. In this regard, we think we are very advanced. And another example is in our Cloud Music, for instance. We've also been embedding AI technology into our daily push. So this is our belief. We think instead of overexaggerating AI as a mysterious science, our approach is that we take these very modern technology, embed them into the products and the users eventually will feel the difference, but they don't necessarily need to recognize the codes, the science behind it. What they get is the product experience they ultimately have, and it represents an elevated and enhanced user experience.

Operator [25]

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Next, we'll move to Han Joon Kim with Deutsche Bank.

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Han Joon Kim, Deutsche Bank AG, Research Division - VP and Research Analyst [26]

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I have 2. One is on Wilderness versus Terminator 2. I think they're similar games, but why do you think we're seeing better kind of responses from 1 over the other, apart from the IP? If you could just give us some qualitative color on that, that would be great. And then the second one is on Minecraft KPI. If you can just give us a little bit more DAU or time spent or any other metrics apart from registration, that will be helpful.

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Zhaoxuan Yang, NetEase, Inc. - CFO [27]

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Okay. Let me translate for the management. (foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [29]

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So to answer your first question, Wilderness and Terminator 2, yes, broadly speaking, they fall into the same genre, the same category, but there are very subtle differences in terms of user experience. On the technology perspective, both games are self-developed. And we utilize 2 different self-proprietary engines for these games, and they bring different -- subtle, but they bring different experience catering to different user demands. So in terms of the data we see, the user profiles of playing these 2 games are actually quite different. (foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [31]

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For Minecraft, as you all know, this is at a relatively early stage, and we are starting early monetization effort in recent months as well as in early 2018. So at this stage, other than the accumulated users, we don't plan to disclose any other additional KPIs. But again, to reiterate, we have full confidence in this game in the longer run.

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Operator [32]

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And next, we'll move to Fan Lu with Goldman Sachs.

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Sef Chin, Goldman Sachs Group Inc., Research Division - Equity Research Analyst [33]

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This is Sef asking on behalf of Fan. I have 2 questions. The first question is on e-commerce. So given the rising revenue contribution, perhaps when could we expect maybe a separate disclosure of the segment on a quarterly basis? And the second question is on whether management could shed some color on the game performance of Blizzard. (foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [34]

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Okay. So for the first question, let me answer you. We are actively exploring the possibility of separating out our e-commerce. We're actively discussing that amongst our auditors, council, et cetera, and we hope to materialize that as early as next quarter. For the second question, I'll -- let me defer to the management. (foreign language)

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [36]

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Okay. So with respect to Blizzard, they are a very close business partner with us. A couple of key titles that we license from Blizzard are performing well in China, and we expect to further deepen our strategic relationship with Blizzard. With StarCraft II, we are in the efforts to make it a free-to-play mode. So overall, because of this close partnership with Blizzard, we are actually keeping a very active dialogue to collectively bring the best product experience and user experience to the Chinese gamers.

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Operator [37]

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We'll move to Marcus Yang with Macquarie.

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Marcus Yang, Macquarie Research - Research Analyst [38]

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I've got 2 questions. First of all, regarding the survival (inaudible) games. Can you share the rationale behind the popularity of this genre, mainly in your view? Which, I guess, one of them could be the social community element. And do you think that factor will continue for the upcoming potential new hit genres? Or anything that you can share, I mean, regarding the key element for the next potential genres? And my second question is regarding -- how's the regulation issues being fixed here? And -- regarding the survival game genre. And also from your perspective, is this a winner take all genre or market? And that is my question. (foreign language)

Lei Ding, NetEase, Inc. - Founder, CEO and Director [39]

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(foreign language)

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Zhaoxuan Yang, NetEase, Inc. - CFO [40]

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Okay. So first of all, I would like to correct a concept. This genre, we don't agree to call this genre as a survival type of game. We -- for -- to us, this broadly falls into a sandbox category. And 1 important element of the sandbox category is that you enjoy the total freedom. Every time you enter into the game, you have the total freedom to experience the game with endless possibilities. This is the same for Minecraft, for instance, and same for our Wilderness and Terminator 2. We don't encourage anyone to view this game as, so to speak, a survival type of game. So that's something we would like to elaborate here.

Operator [41]

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And due to time constraints, there are no further questions. I'll turn the call back over to management for any closing or additional remarks.

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Brandi Piacente, The Piacente Group, Inc. - Founder and President [42]

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Thank you, once again, for joining us today. If you have any further questions, please contact Juliet Yang, NetEase's Senior IR Manager based in Huangzhou, at ir@service.netease.com or TPG Investor Relations. Thank you.

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Operator [43]

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And everyone, that does conclude our conference call for today. Thank you all for your participation. You may now disconnect.


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