May 21, 2007
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Executives
Brandi Piacente - The Piacente Group Michael Tong - Co-Chief Operating Officer Onward Choi - Acting Chief Financial Officer William Ding - Chief Executive Officer
Analysts
Richard Ji - Morgan Stanley Wallace Cheung - Credit Suisse Lin Shi - Lehman Brothers Dick Wei - J.P. Morgan Jason Brueschke - Citigroup Tony Gikas - Piper Jaffray Evan Wilson - Pacific Crest Securities Ming Zhao - Susquehanna Financial Group James Mitchell - Goldman Sachs Tian Hou - C.E.Unterberg
Operator
Good day, ladies and gentlemen. Thank you for standing by.
Welcome to the NetEase.com first quarter 2007 financial results conference call. For opening remarks and introductions, I would like to turn the call over to Ms.
Brandi Piacente. Please go ahead, Madam.
Brandi Piacente
Thank you, Operator. Please note that 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, 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.
The company does not undertake any obligation to update this forward-looking information except as required by law. As a reminder, this conference is being recorded.
In addition, a webcast replay of this conference call will be available on the NetEase corporate website at corp.netease.com. I will now turn the conference call over to Michael Tong, Co-Chief Operating Officer, who will read the prepared remarks on behalf of Mr.
William Ding, Chief Executive Officer of NetEase.
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Michael Tong
Thank you for joining us today. Before I begin the operational review, I would like to acknowledge Denny Lee for his more than five years of service to NetEase.
Denny Lee, CFO and Director, has submitted his resignation effective June 30, 2007, for personal reasons. He will remain a member of the Board of Directors of our company.
We wish to thank Denny for his contributions and dedication during a period of substantial growth and development. We look forward to continuing our relationship with Denny through the Board of Directors and we wish him all the best in his future pursuits.
Onward Choi, our Financial Controller since 2005, has been named Acting Chief Financial Officer. With a background at Ernst & Young and KPMG, Onward is well prepared to take on his new leadership role.
Onward will deliver the first quarter financial review today and participate in the question-and-answer session at the conclusion of our prepared remarks. Now, turning to our first quarter operations, total revenues for the first quarter were $71.8 million, up from $69.2 million for the fourth quarter of 2006 and an increase from $66.1 million for the first quarter of 2006.
Online game revenues were $62.4 million for the first quarter, up from $57.9 million for the fourth quarter of 2006 and up from $56.2 million for the first quarter of 2006. Fantasy Westward Journey reported another record for peak concurrent user numbers of approximately 1.5 million, up from the 1.3 million we reported last quarter.
This continued strength in user growth was driven in part by major weekend events that we staged during the quarter, along with strong usage as a result of Chinese Valentine’s Day holiday. This followed an expansion pack that was released in the beginning of the first quarter.
The game grew by 11% in revenue in the first quarter over the fourth quarter in 2006, and we believe the strong PCU numbers and revenue growth are indicators of the game’s ongoing popularity and long lifecycle. We continue to have positive expectations for Fantasy Westward Journey and we are investing in the development of an expansion pack to be launched in the second half of this year.
Westward Journey III, which is the upgraded version of Westward Journey Online II, entered internal closed beta as of last Sunday and is scheduled to enter open beta testing in the second half of 2007. The upgraded version consists of 100% new graphics and several new game play features.
We preserve each gamer’s user data. We are confident in our ability to migrate the existing players to the upgraded version because the hardware requirements, playing levels and other features of Westward Journey II will remain the same.
Additionally, we have developed an aggressive marketing program in order to attract new users, as well as migrating the existing users from Westward Journey Online II. With Tianxia II, we are obviously disappointed with our findings during the unlimited beta testing in March.
It is not that the hardware requirements are too sophisticated, but that the game design and player functionality needs to be more conducive to beginner play as well as event competitions. We decided to extend our open beta testing until we are satisfied.
Our R&D team is hard at work focusing on two key objectives: first, enhancing group play and player advancing features; and second, reducing game complexity for beginners. During this extended development phase, we are reallocating investment to R&D and away from marketing and we will continue to open beta test until our redesign or redevelopment work is completed and we are satisfied with it.
Turning to our advertising services segment, revenues from advertising services were $7.3 million for the first quarter of 2007, a decrease from $9.2 million for the fourth quarter of 2006 and $7.7 million for the first quarter of 2006. The advertising income as compared to our peers has been lower than our expectations, due to the decrease of advertising spending in industries such as e-commerce.
However, revenue growth in other industries has been satisfying, such as automobiles, FMCG, and the healthcare industry. Overall, the portal traffic has been healthy in the first quarter as a result of improved content, such as news, sports, the finance channels and other products, including our blog and e-mail services.
We believe that building traffic will help us to continue to grow our advertising business. Our development of the in-house search engine has been progressing well and we are planning to officially launch it during the second half of 2007, simultaneously with a major marketing campaign.
With that, I would like to turn the call over to Onward Choi for his review of our financial results. Onward.
Onward Choi
Thank you, Michael. I will now provide an overview of our financial highlights using numbers and percentages based on U.S.
dollars. In order not to repeat what has just been explained by Michael on the revenue side, I will focus on explaining margins and expense fluctuations along with net profits.
First quarter gross profit was $55.7 million, compared to $58.5 million in the preceding quarter, and $52.5 million for the same period in 2006. The quarter-over-quarter decrease in gross profit was primarily due to a one-time business tax refund of $4.5 million recorded in the fourth quarter of 2006.
The year-over-year increase in gross profit was mainly due to higher online game services revenue in the first quarter of 2007. The company’s overall gross margin was 80.6% for the first quarter compared to 82.4% for the preceding quarter and 82.7% for the same period last year.
Gross margin for the online game business was for the first quarter of 2007 was 89.6% compared to 90.3% and 90.4% for the fourth and first quarter of 2006 respectively. The quarter-over-quarter decrease was primarily due to the above mentioned tax refund.
The year-over-year decrease was primarily due to higher stock related costs as a result of an increase in headcount and increased server custody fees and depreciation charges for enhancing our online game development and ongoing business capacity requirements. Gross margin for the advertising business for the first quarter of 2007 was 35.7% compared to 50.5% and 51.2% for the fourth and first quarters of 2006 respectively.
The quarter-over-quarter decline in gross margin was primarily due to the seasonal decline in demand for advertising services while costs remained relatively stable in the first quarter of 2007. The year-over-year decline in gross margin was due to lower advertising services revenue as a result of increased competition, increased production costs for content enhancement, and high server custody fees and depreciation charges to support our online advertising business capacity requirements.
Gross loss margin for wireless value added services and others for the first quarter of 2007 was 36.1%, compared to gross loss margin of 18.9% and 12.0% for the fourth and the first quarters of 2006, respectively. The quarter-over-quarter and the year-over-year decline in gross margin was mainly due to higher server depreciation costs and server custody fees to support our expanding free email and photo storage capacities offered to our registered email account-holders.
Total operating expenses for the first quarter of 2007 were $15.2 million compared to $15.9 million and $14.2 million for the fourth and first quarters of 2006, respectively. The quarter-over-quarter decrease was due to a reversal of provision for doubtful debts of approximately $1 million as a result of the collection of outstanding accounts receivables with respect to the advertising business during the first quarter of 2007, compared to an increase in provision for doubtful debts of $0.6 million made during the fourth quarter of 2006.
This was partially offset by an overall increase in selling and marketing costs of $0.8 million. The increase in selling and marketing costs was mainly in relation to the marketing of Tianxia II during the first quarter of 2007.
The year-over-year increase was mainly due to an increase in research and development expenses associated with increased staffing for the enhancement of existing products and for the development of new products. Net profit for the first quarter of 2007 totaled $39 million, compared to $41 million and $36.6 million for the fourth and first quarters of 2006 respectively.
Our basic and diluted earnings per ADS were $0.31 and $0.29 for the first quarter of 2007, respectively. This compared to basic and diluted earnings per ADS of $0.32 and $0.30 and $0.28 and $0.26 for the fourth and first quarters of 2006 respectively.
As of March 31, 2007, our total cash and time deposit balance was $520.6 million, an increase from $504.6 million at December 31, 2006. Cash flow generated from operating activities was approximately $35.9 million compared to $68.1 million and $51.4 million for the fourth and first quarters of 2006 respectively.
With regard to our share repurchase program, on March 13th our Board authorized a share repurchase program of up to $100 million of the company's outstanding ADS for a period not to exceed three months. As of March 31, 2007, we had effected transactions in the open market purchasing approximately 1.1 million ADS for an aggregate purchase consideration of approximately $20.8 million, including transaction costs.
With respect to the separate share repurchase program of up to $100 million authorized by the Board on August 28, 2006, the company had repurchased approximately 3.6 million of its issued and outstanding ADS for an aggregate purchase consideration of $60.1 million, including transaction costs, as of the end date of the share repurchase program on February 27, 2007. Thank you for your attention and we will now be happy to take your questions.
Operator, please go ahead.
Operator
(Operator Instructions) First we’ll hear from Richard Ji of Morgan Stanley.
Richard Ji - Morgan Stanley
Good morning. I have two questions.
The first, obviously starting with your Westward Journey III. Could you just help us understand a little better how you will ensure the stability of the user base during the migration process?
Michael Tong
The stability of the users -- well, basically first of all we have to explain that Westward Journey III, as we have mentioned in the conference calls now, that the game play will be the standard game play in Westward Journey II will also be in Westward Journey III. Also, at the same time the user date, which is the most important, in Westward Journey II will also be migrated to Westward Journey III.
So all those experience points that players have played in Westward Journey II, all these things will all be migrated into Westward Journey III. This is very important for the users.
But Westward Journey III, we also look at it as a fairly new game. For example, all the graphics will be 100% new, as compared to Westward Journey II.
The reason for that is especially because there are new game designs, new game play that we are designing with these new graphics that can be implemented in this new game. Because in Westward Journey II, the engine has been old and a lot of things that we want to implement just cannot be implemented.
But with the new engine, new graphics, we can do a lot more and be able to retain the existing users and at the same time try to attract new users as well.
Richard Ji - Morgan Stanley
In terms of technical complexity, the new game will not increase the hardware requirements?
Michael Tong
Basically, no. The game will continue to be a turn-based game and the hardware requirement will continue to be very low.
It is going to be a 2.5D game. It is not going to be a 3D game, so it should be totally fine.
Richard Ji - Morgan Stanley
Okay, good and my second question is regarding your online search and portal strategy. Obviously we know you have heavy traffic on your leading portal.
I’m particularly interested in how you are going to monetize your portal traffic. Will it be more focused on your online brand advertising strategy?
Also, can you also help us to understand a little better about the commercialization of your paid search? Thank you.
Michael Tong
Sure, of course. Let me talk about the portal first and then I will ask William to talk about the search.
For the portal, I think the good news for us is that we have the content channels have been doing pretty well for the last quarter or two. We have been seeing very strong growth, just looking at the content channels.
For example, the news, the finance, entertainment, sports and so on. That is I think as a result that the market continued seeing the improved content and then we are really able to market it right now.
That’s also resulted in better advertising revenue in those products. At the same time, our growth in the e-mails and the blogs has been doing well, although I have to explain that the advertising for those products, we are working on this to see how we can better monetize e-mails and blogs.
For example, blogs, basically the advertising budgets that we have been doing have been very, very low and so has the industry as well, but we believe there are ways that we can monetize it better. So I think on the portal, overall it is doing fine but I will let William.
William Ding
The main point is that from the current NetEase portal, we have a lot of traffic in both the e-mails, blogs and content. All of this traffic, after we launch our search in the third quarter, we will try to guide all of these users to try our new search engines.
With the technology that we have built, we believe that this search engine will become their first choice for search engine for all our NetEase users.
Richard Ji - Morgan Stanley
Thank you.
Operator
(Operator Instructions) Next we’ll hear from Wallace Cheung of Credit Suisse.
Wallace Cheung - Credit Suisse
Good morning. My two questions actually, firstly on Tianxia II, can you explain a little more on the reasons why you have the delayed launch?
Also, how is the launch schedule? What kind of features are you going to include?
Secondly is on the advertising revenue side. Can you explain why it seems the revenue is actually behind the peers’ performance in the first quarter?
Thank you.
Michael Tong
Sure. Let me answer the question first.
For Tianxia II, I think one of the biggest disappointments for us is that the game play that we have designed has been very focused on the advanced level. What has been really disappointing for us is that a lot of the users in the games, basically they are not able to achieve those levels because before, they really enjoyed the fun part of the game and they left in the beginner’s level.
It also reflects that we have not done a good job in introducing these users to the advanced levels. We continue to believe there are a lot of really hardcore fans of the game, as we can see from different surveys and also from our bulletin boards and so on.
So right now what we are doing is -- let me explain more on the reasons first. It is not because of the hardware requirements which somebody has been talking about.
The hardware requirements we believe we have streamlined it and it should not be a problem for the gamers. It is really because of the game play itself, which we have done -- we haven’t been doing very well in that.
What we are doing right now is that we are having a redevelopment for the game. We are going to redevelop the beginner levels.
It is already in the press release that we have introduced new members to the teams and we want to bring in more new ideas in how to induce beginner users. So that is for Tianxia II.
And then, for the advertising revenue, as we also mentioned in the script basically what happened is that the industry such as the e-commerce industry, which we use to heavily rely on, has not been doing very well during this quarter. I think that’s really it.
The traffic of our products, the portals, the e-mails and so on has been doing well and so is the growth of the advertising and in other industries has also been doing well. There is another reason.
Another reason is that the current search revenue has also been dropping and that is simply because we have now focused our energy more into our in-house developed search rather than the current partnership with Google right now. So there are two reasons; one is the search advertising revenue and the second is the e-commerce industry.
Wallace Cheung - Credit Suisse
Will NetEase develop its own 3D game engine that can improve Tianxia or the games we can play? Thank you.
Michael Tong
No, it has no relationship with the engine. It is really the, as we have mentioned, the game play -- that we have made a mistake in that area.
It is not really related to the engine.
Wallace Cheung - Credit Suisse
Thank you.
Operator
We’ll take our next question from Lin Shi with Lehman Brothers.
Lin Shi - Lehman Brothers
Good morning. Thank you for taking my questions.
The first question is regarding Westward Journey II. Just now as you mentioned, it sounds like they actually delivered growth in revenue by about 15%, so it might imply there has been a decline in Westward Journey II.
I just wonder, before the Westward Journey III, can bring in additional revenues, whether there is any sense about Westward Journey II?
Michael Tong
Well, just simply put, for Westward Journey II, the growth of revenue on first quarter versus the fourth quarter is a decrease of 5%, and the growth of Fantasy Westward Journey for the same quarter comparison is a growth of 11.8%, actually. So those are the facts.
It is true that Westward Journey II experienced a decrease in this quarter but I think you’ve been following us for a long time, that Westward Journey II has been up and down. We have seen quarters that it has decreased for 5% or so and then the next quarter, all of a sudden grow by 2% or so.
So I will say in general, it is a flat game right now. What we are seeing in Westward Journey III is because the game is quite completely new -- I mean, the graphics are completely new while the game is an extension of Westward Journey II, we believe that the game will be able to attract new users as well as retain old users.
We don’t know how many new users we can attract but we do look at it as -- I mean, we don’t look at it, at least from the marketing point of view, that we are looking at it as a new game. So that’s for Westward Journey III.
Did I answer your question?
Lin Shi - Lehman Brothers
So you don’t send any expansion packs before the launch of Westward Journey III?
Michael Tong
No, because the internal beta, the internal closed beta for Westward Journey III has already started and we are looking at the open beta by the second half of this year.
Lin Shi - Lehman Brothers
Understood. My second question is regarding the search business.
I’m not sure whether I’m looking at the right page. I’m looking at your dotcom -- I noticed that you featured the blog search and [channel] search.
My question is basically, there are some search engines available in the market and as a latecomer, what will be your strategy in terms of user experience or focus on functionality of your search engine to gain user traffic?
William Ding
Lin Shi - Lehman Brothers
Okay, no problem. My last question is regarding the minority interest.
I noticed there’s no minority interest as compared with last quarter. What’s the reason?
Michael Tong
Let me translate what William just said first, and then I will ask Onward to explain on the minority interest. Basically, our search engine is still in kind of open beta mode right now.
It is true that you can go into the domain name and try it out but a lot of the new functionality and the uniqueness of the search engine we haven’t released yet. It is very competitive information right now but once we release, please do take a look at it and you will know the difference and the uniqueness of the product.
On the minority interest --
Onward Choi
Basically, regarding the minority interest, why there is no figure in this quarter is mainly because the share of loss of the minority interest has already been absorbed by the capital contributions by the minority in the previous quarters. So the whole sum has been used up and so there is no further minority interest being reflected in this quarter.
Michael Tong
I guess we have to take the next question.
Lin Shi - Lehman Brothers
Thank you.
Operator
We’ll move on to Dick Wei with J.P. Morgan.
Dick Wei - J.P. Morgan
Good morning. Thanks for taking my questions.
I have two questions. The first question is about your games development plan.
Can you talk some more about your current R&D team size? I understand also you have a number of studios open around the country.
Can you also talk about the game pipeline and the launch date? Thanks.
Michael Tong
Okay. We have around 1,000 game developers right now all over the country, including studios in Guangzhou, Hangzhou, Shanghai and also in Chengdu.
For the games pipeline, I think we have mentioned in the previous conference calls we have games for MMORPGs, advanced casual games, and also some other casual games. That includes of course -- for the timeline, let’s pick Westward Journey III as kind of things after Westward Journey III.
We have Fly For Fun. We have MMORPG games.
We have some advanced casual games as well. We are looking at the end of 2007 or into 2008 but it is too early to say right now what those games are exactly and the exact timeline for those games.
Dick Wei - J.P. Morgan
Is it possible to roughly separate the number of R&D staff in Westward Journey II, Fantasy and Tianxia? How many are working on future games?
Michael Tong
We do not really look at our team this way because we have been pooling our resources together. So for example, our graphic artists or the programmers, so to date or this week, they may be working on Westward Journey II but next week they might be working on another project.
So it is really difficult for me to divide it the way you think about it.
Dick Wei - J.P. Morgan
Okay. My last question is can you talk some more about the longer term strategic plan for NetEase, like a couple years down the road?
Is it maybe games or what other strategic progress the company has longer term?
Michael Tong
Can you be more specific?
Dick Wei - J.P. Morgan
I think just beyond the current in-house development games, I think you guys are trying to put more focus on search and also on the advertising. I just wanted to see which are incorporated more of the growth driver, or more of the stronger focus that the company has.
Michael Tong
I think just to put it into three different areas, one continues to be the game. It could be in-house developed games.
It could also be licensed games, that we have mentioned our interest or active participation in licensing games in the last quarter conference call. On the advertising side, it is really based -- I mean, on the branded advertising side, it is really built on the portal, including the traffic generated from the content channels development, the blogs, the e-mails, which are applications on the Internet that also generate traffic.
The third really is on the search, where we are going to launch in the second half of this year, which we believe is a new area for us. We have a lot of confidence in but be reminded that we frankly do not see material commercialization of the search, at least in ’07.
Dick Wei - J.P. Morgan
Thanks a lot.
Operator
Our next question comes from Jason Brueschke of Citigroup.
Jason Brueschke - Citigroup
Thank you. Good morning, gentlemen.
May I start by conveying my best wishes to Denny on his future endeavors. I’ve enjoyed working with him over the last three years.
Let me give you three quick questions. First of all, could you -- this is a follow-up to an earlier question -- could you maybe give us some sense of the timeline that you guys expect to fix the problems with Tianxia?
Is it a six month fix? Is it a three month fix?
Is it a nine month fix? Based upon what you know and the teams that you’ve hired, what do you think that will be?
Michael Tong
Okay, and the next question?
Jason Brueschke - Citigroup
Okay, the next question is on advertising. Given your demographics, you compete pretty heavily head-to-head with Tencent.
In April, they announced a $5 million to $8 million advertising campaign to enhance the brand of their Q2 portal. I was wondering, in light of your indications that you guys are willing to spend more going forward on sales and marketing, would you plan to do something similar to enhance a lot of the new content in channels that you have so that the advertisers out there are aware of it and can help accelerate your advertising?
My final question is with respect to Fantasy. I was wondering if you could help us understand how much of the strength in Q1 was due to the expansion pack plus the marketing efforts that you did and promotion, and how much of it was due to the Valentine’s Day holiday and things that won’t necessarily repeat in Q2?
Thanks.
Michael Tong
Sure. I think for Tianxia, I am sorry we cannot give you a very specific timeline but all I can say is it is in the range of what you have mentioned, but obviously that is not very specific.
On the next question on the advertising, I think the market definitely has generally seen that our content has really improved a lot and we are really experiencing a lot of growth in the content area. I think we -- in some way we are not really competing with Tencent in a way because Tencent continued to rely a lot on their advertising revenue on the IMs, which we have -- I mean, our Popo is much smaller compared to Tencent’s, but on the other hand our content has been built and is much stronger than that.
The portal, the dot.com itself has been much stronger than that of Tencent’s in terms of the content, quality and so on. So I would not say that we are really competing head to head right now.
We are fully confident that our advertising revenue will continue to grow, although there are some problems as mentioned, as I explained just now. On the Fantasy Westward Journey, I think it is really hard to separate between the Valentine’s Day or the expansion pack or the marketing, but I will say that the Valentine’s Day is the day that we experienced the new PCU of 1.5 million.
We saw a lot of new users coming in that day but it is really difficult to say what the percentage or the contribution, to divide or to separate between this and the expansion pack or the marketing.
Jason Brueschke - Citigroup
Okay, great. You may have mentioned this, but could you give us the ACUs for Fantasy and Westward Journey II please?
Michael Tong
Sure. The ACU figures for the first quarter is around 117,000 for Westward Journey II, and the ACU number for Fantasy Westward Journey is around 510,000.
Jason Brueschke - Citigroup
Thanks, guys.
Operator
Our next question comes from Tony Gikas of Piper Jaffray.
Tony Gikas - Piper Jaffray
Good morning and thank you for taking my call. A couple of questions; any update regarding licensing opportunities?
You talked about that on the last call. You mentioned it again today.
Is that something that we should expect to see later this year or is that more of a 2008 catalyst? The second question, could you just give us a little update on industry growth trends and do you expect to return to industry growth levels in 2008?
If so, when would you expect that revenues would start to accelerate? And then I have a couple of follow-ups.
Michael Tong
Yes, of course. I think all I can say is that for the licensing business, that we are active in looking at licensing opportunities right now but I’m sorry, there’s nothing we can comment more because there’s no -- we don’t have any deals that we can disclose or publicly announce right now.
But definitely we are having very active participation in the market right now versus a year ago or so. On the industry growth, I think we are still looking at -- can I assume that you are talking about the game market?
Tony Gikas - Piper Jaffray
Yes.
Michael Tong
I think we are still looking at, that the industry is looking at 30% plus growth in ’07 and ’08 per year. I think -- can we get back to industry growth?
Yes, definitely but I think it really depends on when we have the new products coming out. I think Westward Journey III is an interesting product that can help us to attract new users.
We continue to believe and have a lot of confidence in Tianxia II when it is redeveloped, but obviously all of this takes time. So will it be a mid-07 event?
I don’t think so, but is it something in ’08 or so? I think it is possible.
Tony Gikas - Piper Jaffray
In terms of licensing opportunities, are there a number of attractive properties out there that you are seeing or are they relatively limited at this point?
Michael Tong
There are numerous opportunities out there, from different countries. It could be from Korea, Japan or in the United States.
It is clear in the markets that there continues to be good opportunities in licensing as well, and as we have mentioned we are actively participating in those.
Tony Gikas - Piper Jaffray
Okay, and you gave us where the share repurchase was at the end of the quarter. Could you update us on where you are with the share repurchase as of today?
Michael Tong
We cannot mention until today, but we can repeat what is up to the end of the first quarter.
Onward Choi
Yes, basically this is just as we have mentioned earlier in the call today, that for the share repurchase program, that the Board authorized on March 13th $100 million share repurchase. As of March 31, 2007, we have already purchased about 1.1 million ADS with an aggregate purchase consideration of about $20.8 million, whereas our other share repurchase program of $100 million has been authorized on August 28, 2006.
We have repurchased about 3.6 million ADS with an aggregate purchase consideration of $60.1 million.
Tony Gikas - Piper Jaffray
Okay, and any visibility or maybe help in terms of modeling advertising revenues next year as those opportunities should start to improve?
Michael Tong
As we mentioned, we continue to see the advertising business as a very good, healthy business going forward. But I don’t know in what way I can help you to model it.
I’m sorry. I guess we need to take some other calls.
Quite a few other people are still lining up.
Tony Gikas - Piper Jaffray
Thank you.
Michael Tong
Okay. We’ll talk later.
Thanks.
Operator
Next we’ll hear from Evan Wilson with Pacific Crest.
Evan Wilson - Pacific Crest Securities
Good morning. Two questions; first, as it relates to the sales and marketing expenses, you indicated an increase both for the proprietary search engine as well as increased spending on multiplayer games going forward.
I was hoping you could help us quantify exactly what type of increase that would be and how it would relate to the model. Second, on the gross margin in the advertising business, how exactly should we look at that business going forward?
Is this a new run-rate or do you plan a near-term rebound in sales or maybe cost cuts, one of those? Could you help us with your strategy there in exactly how to look at the gross margin?
Thanks.
Michael Tong
I think the way we can help you to look at the sales and marketing for the going forward project, for example, for this quarter we have explained that the launch of Tianxia we are looking at around $0.8 million. I think you can look at it this way, that our next marketing program, for example for Westward Journey III, it could be a bit more aggressive.
We look at it in this kind of range, okay? And then for the gross margin of advertising revenue, it really simply is the content itself -- I mean the costs is really a fixed cost.
It is mainly the people cost and the content purchase cost and those are really fixed costs. But the revenue does fluctuates from quarter to quarter.
The first quarter is usually seasonally our lowest quarter, so I really expect this gross margin experienced in the first quarter to be a very low one and we believe that we will see improvements in the second and third quarter, where seasonally those are good quarters. We don’t expect this to be a continued run-rate for the gross margin for our advertising revenue.
Evan Wilson - Pacific Crest Securities
Thanks very much.
Operator
Our next question comes from Ming Zhao with SIG.
Ming Zhao - Susquehanna Financial Group
Thank you. Good morning.
Two questions; first question on the search. I want to ask you, you are developing your in-house search engine.
Does that mean your partnership with Google will end some time in the second half of this year? Also, relating to the search, how much of the search traffic on NetEase search engine is from the portal content channels and how much is directly from people going directly to that so.163.com?
William Ding
The answer to the first question is correct. When we have our own search engine to be released, then we will terminate the contract or the current partnership with Google.
Secondly, right now we have not marketed our search engine at all in our 163.com, and it is really irrelevant to look at traffic patterns or so in the website right now.
Ming Zhao - Susquehanna Financial Group
Thank you.
Michael Tong
Thank you. I think we can take two more questions.
Operator
We’ll move on then to James Mitchell with Goldman Sachs.
James Mitchell - Goldman Sachs
Thank you for taking my question. It is on a really -- Westward Journey II, and I’m currently paying the RMB20 a month to play Westward Journey II, and then as soon as Westward Journey III is available, I instantly switch to Westward Journey III to enjoy the open beta of Westward Journey III as soon as I can.
Does that mean that there will be a one or two month period in which you previously collected money from me paying for Westward Journey II but you wouldn’t collect money from me in the open beta for Westward Journey III, or is that not correct?
Michael Tong
We do not have exact plans right now on this but the simple answer is that the open beta of Westward Journey III will be taken in steps, where we will -- taken in stages where we will expand it slowly. Also, basically the answer to your question is no, because for Westward Journey II players right now, if they want to migrate their user data to Westward Journey III, then we will ask them to migrate when Westward Journey III basically becomes commercialized.
That is really how simple this is. Of course, if they want to become a new player in Westward Journey III, then you are right.
Then they become an open beta user, but then they will have a problem in migrating their experience points and so on. But I can comfort you on this; that a lot of the users will want to take their experience points and so on to migrate to Westward Journey III and at the same time, we will make sure that Westward Journey III open beta will be taken in stages where we will have the distribution and the coverage, make sure before we actually commercialize it.
James Mitchell - Goldman Sachs
Okay, that puts my mind at rest. And then just to confirm, I think in the past, I’ve been under the impression that the first quarter was seasonally a strong quarter for game revenue because of the holidays, and the second quarter was seasonally a little bit slower because of the examinations.
Is that still true, do you think?
Michael Tong
Yes, seasonally the first quarter is always pretty good, actually, but then the same quarter, we still have the national holiday, although combined with the exams, and then we have the summer holidays in the third quarter.
James Mitchell - Goldman Sachs
Thank you very much.
Michael Tong
Thank you.
Operator
We’ll take our final question from Tian Hou with Unterberg.
Tian Hou - C.E.Unterberg
Thank you for taking my questions. My question is regarding the operating model for the new games coming to market.
Are you still going to use pay-to-play or are you going to change the model to free-to-play?
Michael Tong
We are open. Basically, we will have games that will continue to be fee-based and we will have games that could be item-paid.
Tian Hou - C.E.Unterberg
So for the new game, like Westward Journey III, is that going to be pay-to-play?
Michael Tong
We haven’t decided, but basically it will be a pay-to-play game, a subscription-based game, but then we will have other games that we will be addressing the markets of free-to-play or item-based games.
Tian Hou - C.E.Unterberg
The last question would be on R&D. R&D dollars in Q1 was an increased amount from Q4.
Going forward, do you think that R&D dollars to go up dollar wise? Is it going to be higher than Q1 or in a similar range?
Michael Tong
I think it would be a bit too early to comment on the future trends of the R&D, but I think we can still give out our R&D balance at the current level. I think that concludes the Q&A session.
Brandi Piacente
Okay, everyone, thanks again for joining us. Please feel free to contact us if you have any questions.
Operator
Again, ladies and gentlemen, we do thank you for your participation. That does conclude today’s conference.
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