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Form 20-F
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 20-F

 

 

(Mark One)

¨ REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR 12(g) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

 

¨ SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report

For the transition period from              to             

Commission file number: 000-30666

 

 

NETEASE.COM, INC.

(Exact name of Registrant as specified in its charter)

 

 

N/A

(Translation of Registrant’s name into English)

Cayman Islands

(Jurisdiction of incorporation or organization)

26/F, SP Tower D

Tsinghua Science Park Building 8

No. 1 Zhongguancun East Road, Haidian District

Beijing 100084, People’s Republic of China

(Address of principal executive offices)

 

 

Onward Choi

26/F, SP Tower D

Tsinghua Science Park Building 8

No. 1 Zhongguancun East Road, Haidian District

Beijing 100084, People’s Republic of China

Phone (86 10) 8255-8163

Facsimile (86 10) 8261-7072

(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)

 

 

Securities registered or to be registered pursuant to Section 12(b) of the Act.

NONE

Securities registered or to be registered pursuant to Section 12(g) of the Act.

Name of each exchange and Title of each class on which registered:

American Depositary Shares, each representing 25 ordinary shares, par value US$0.0001 per share, NASDAQ Global Select Market

(Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.

NONE

(Title of Class)

 

 

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report: 3,206,468,735 ordinary shares, par value US$0.0001 per share.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or (15)(d) of the Securities Exchange Act of 1934.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (s232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  x   Accelerated Filer  ¨    Non-Accelerated Filer  ¨

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

U.S. GAAP  x   International Financial Reporting Standards as issued by the International Accounting Standards Board  ¨   Other  ¨

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow:    Item 17  ¨    Item 18  ¨

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

(APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.     Yes  ¨    No  ¨

 

 

 


Table of Contents

TABLE OF CONTENTS

 

INTRODUCTION    1
PART I    2

Item 1.

  Identity of Directors, Senior Management and Advisers    2

Item 2.

  Offer Statistics and Expected Timetable    2

Item 3.

  Key Information    2

Item 4.

  Information on the Company    30

Item 4A.

  Unresolved Staff Comments    53

Item 5.

  Operating and Financial Review and Prospects    53

Item 6.

  Directors, Senior Management and Employees    84

Item 7.

  Major Shareholder and Related Party Transactions    95

Item 8.

  Financial Information    101

Item 9.

  The Offer and Listing    101

Item 10.

  Additional Information    102

Item 11.

  Quantitative and Qualitative Disclosures About Market Risk    118

Item 12.

  Description of Securities Other than Equity Securities    118
PART II    118

Item 13.

  Defaults, Dividend Arrearages and Delinquencies    118

Item 14.

  Material Modifications to the Rights of Security Holders and Use of Proceeds    118

Item 15.

  Controls and Procedures    119

Item 16.

  Reserved    119

Item 16A.

  Audit Committee Financial Expert    119

Item 16B.

  Code of Ethics    120

Item 16C.

  Principal Accountant Fees and Services    120

Item 16D.

  Exemptions from the Listing Standards for Audit Committees    121

Item 16E.

  Purchases of Equity Securities by the Issuer and Affiliated Purchasers    122

Item 16F.

  Change in Registrants’ Certifying Accountants    122

Item 16G.

  Corporate Governance    122
PART III    123

Item 17.

  Financial Statements    123

Item 18.

  Financial Statements    123

Item 19.

  Exhibits    123


Table of Contents

INTRODUCTION

This annual report on Form 20-F includes our audited consolidated financial statements as of December 31, 2007 and 2008 and for the years ended December 31, 2006, 2007 and 2008.

Forward-Looking Information

This annual report on Form 20-F contains statements of a forward-looking nature. These statements are made under the “safe harbor” provisions of the U.S. Private Securities Litigation Reform Act of 1995. You can identify these forward-looking statements by terminology such as “will,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates” and similar statements. The accuracy of these statements may be impacted by a number of business risks and uncertainties that could cause actual results to differ materially from those projected or anticipated, including risks related to:

 

   

the risk that the online game market will not continue to grow or that we will not be able to maintain our leading position in that market, which could occur if, for example, our new online games do not become as popular as management anticipates;

 

   

the risk that we will not be successful in our product diversification efforts, including our focus on item- and fee-based games and entry into strategic licensing arrangements;

 

   

the risk of changes in Chinese government regulation of the online game market that limit future growth of our revenue or causes revenue to decline;

 

   

the risk that we may not be able to continuously develop new and creative online services or that we will not be able to set, or follow in a timely manner, trends in the market;

 

   

the risk that the Internet advertising market in China will not continue to grow and will remain subject to intense competition;

 

   

the risk that we will not be able to control our expenses in future periods;

 

   

the impact of any future public health problem in China, including avian influenza or severe acute respiratory syndrome, or SARS, or Influenza A (H1N1), or H1N1;

 

   

governmental uncertainties (including possible changes in the effective tax rates applicable to NetEase and its subsidiaries and affiliates), general competition and price pressures in the marketplace;

 

   

the risk that fluctuations in the value of the Renminbi with respect to other currencies could adversely affect our business and financial results;

 

   

the risk that current or future appointees to management are not effective in their respective positions; and

 

   

other risks outlined in our filings with the Securities and Exchange Commission.

We do not undertake any obligation to update this forward-looking information, except as required under applicable law.

 

1


Table of Contents

PART I

 

Item 1. Identity of Directors, Senior Management and Advisers

Not Applicable.

 

Item 2. Offer Statistics and Expected Timetable

Not Applicable.

 

Item 3. Key Information

 

A. Selected Financial Data

The following table presents the selected consolidated financial information for our business. You should read the following information in conjunction with Item 5 “Operating and Financial Review and Prospects” below. The following data for the years ended December 31, 2006, 2007 and 2008 and as of December 31, 2007 and 2008 have been derived from our audited consolidated financial statements for those years, which were prepared in accordance with generally accepted accounting principles in the United States, or U.S. GAAP, and should be read in conjunction with those statements, which are included in this annual report beginning on page F-1. The following data for the years ended December 31, 2004 and 2005 and as of December 31, 2004, 2005 and 2006 has also been derived from our audited consolidated financial statements for those years, which were prepared in accordance with U.S. GAAP and are not included in this annual report.

 

     For the Year Ended December 31,  
     2004     2005     2006     2007     2008     2008  
     RMB     RMB     RMB     RMB     RMB     US$ (Note 1)  
     (except per ordinary share and per ADS data)  

Statement of Operations Data:

            

Revenues:

            

Online game services

   628,936,223      1,379,475,803      1,856,062,971      1,932,634,947      2,498,518,103      366,217,384   

Advertising services

   171,054,305      241,200,444      285,772,653      305,057,556      405,887,007      59,492,416   

Wireless value-added services and others

   158,310,317      73,742,136      75,406,121      68,018,461      71,718,938      10,512,120   
                                    

Total revenues

   958,300,845      1,694,418,383      2,217,241,745      2,305,710,964      2,976,124,048      436,221,920   

Business tax (expense)/benefit

   (54,703,018   (82,054,902   (52,882,275   (92,424,200   108,460,101      15,897,413   
                                    

Net revenues

   903,597,827      1,612,363,481      2,164,359,470      2,213,286,764      3,084,584,149      452,119,333   
                                    

Cost of revenues:

            

Online game services

   (74,629,515   (137,301,493   (178,676,915   (187,411,229   (268,574,306   (39,365,966

Advertising services

   (54,056,435   (78,589,395   (125,183,293   (143,676,057   (208,907,875   (30,620,429

Wireless value-added services and others

   (55,117,445   (59,346,085   (77,437,973   (84,365,760   (82,123,181   (12,037,110
                                    

Total cost of revenues

   (183,803,395   (275,236,973   (381,298,181   (415,453,046   (559,605,362   (82,023,505
                                    

Gross profit

   719,794,432      1,337,126,508      1,783,061,289      1,797,833,718      2,524,978,787      370,095,828   

Operating expenses:

            

Selling and marketing expenses

   (152,842,334   (152,192,422   (170,142,691   (235,318,304   (221,551,138   (32,473,600

General and administrative expenses

   (101,631,070   (117,942,605   (179,879,602   (176,178,740   (181,841,322   (26,653,180

Research and development expenses

   (34,362,806   (90,170,092   (153,162,158   (180,734,713   (207,023,649   (30,344,250

Insurance claims settlement for the now-settled class action litigation

   16,553,200      —        —        —        —        —     
                                    

Total operating expenses

   (272,283,010   (360,305,119   (503,184,451   (592,231,757   (610,416,109   (89,471,030
                                    

Operating profit

   447,511,422      976,821,389      1,279,876,838      1,205,601,961      1,914,562,678      280,624,798   

Other income (expenses):

            

Investment income

   3,522,169      1,301,975      340,721      474,446      1,517,890      222,483   

Interest income

   22,333,511      58,070,148      94,364,852      112,599,994      144,805,368      21,224,678   

 

2


Table of Contents
     For the Year Ended December 31,  
     2004     2005     2006     2007     2008     2008  
     RMB     RMB     RMB     RMB     RMB     US$ (Note 1)  
     (except per ordinary share and per ADS data)  

Interest expenses

   (3,877,129   (344,859                    

Exchange loss

   —        (8,360,834   (958,435   (50,891,094   (167,101,510   (24,492,709

Other, net

   507,428      (540,628   1,239,105      (1,084,240   3,551,919      520,617   
                                    

Profit before tax

   469,997,401      1,026,947,191      1,374,863,081      1,266,701,067      1,897,336,345      278,099,867   

Income tax expense

   (28,576,719   (94,957,022   (132,485,543   (2,689,309   (300,673,321   (44,070,842
                                    

Profit after tax

   441,420,682      931,990,169      1,242,377,538      1,264,011,758      1,596,663,024      234,029,025   

Minority interests

   —        —        400,046      74,364      24,883      3,647   
                                    

Net profit

   441,420,682      931,990,169      1,242,777,584      1,264,086,122      1,596,687,907      234,032,672   

Unrealized gains on investments

   —        —        —        1,332,300      —        —     
                                    

Comprehensive Income

   441,420,682      931,990,169      1,242,777,584      1,265,418,422      1,596,687,907      234,032,672   
                                    

Earnings per ordinary share, basic

   0.14      0.29      0.38      0.41      0.51      0.07   
                                    

Earnings per ordinary share, diluted

   0.13      0.26      0.36      0.38      0.49      0.07   
                                    

Earnings per ADS, basic (Note 2)

   3.49      7.22      9.61      10.24      12.81      1.88   
                                    

Earnings per ADS, diluted (Note 2)

   3.24      6.59      8.91      9.55      12.34      1.81   
                                    

Weighted average number of ordinary shares
outstanding, basic

   3,157,841,781      3,225,684,510      3,231,832,008      3,086,451,412      3,117,117,306      3,117,117,306   
                                    

Weighted average number of ADSs
outstanding, basic (Note 2)

   126,313,671      129,027,380      129,273,280      123,458,056      124,684,692      124,684,692   
                                    

Weighted average number of ordinary shares
outstanding, diluted

   3,491,430,437      3,565,412,019      3,498,405,110      3,307,538,379      3,234,214,324      3,234,214,324   
                                    

Weighted average number of ADSs
outstanding, diluted (Note 2)

   139,657,217      142,616,481      139,936,204      132,301,535      129,368,573      129,368,573   
                                    

Share compensation cost included in:

            

Cost of revenues

   —        —        (16,614,309   (14,890,378   (13,678,836   (2,004,959

Selling and marketing expenses

   —        —        (21,147,343   (14,357,336   (8,564,177   (1,255,284

General and administrative expenses

   (55,340   (13,835   (37,360,433   (33,887,323   (23,586,590   (3,457,177

Research and development expenses

   —        —        (26,164,591   (32,293,138   (22,119,058   (3,242,075
                                    
   (55,340   (13,835   (101,286,676   (95,428,175   (67,948,661   (9,959,495
                                    

Other Financial Data:

            

Capital expenditures

   (60,142,252   (92,608,975   (142,513,502   (71,515,551   (133,329,185   (19,542,570

Net cash provided by (used in):

            

Operating activities

   614,153,858      1,104,789,431      1,596,108,793      1,379,902,442      2,017,799,188      295,756,567   

Investing activities

   105,834,484      (1,618,749,356   (1,218,242,458   952,298,424      (3,409,258,149   (499,708,045

Financing activities

   32,043,212      105,497,366      (829,055,812   (960,409,501   (157,293,144   (23,055,060
     As of December 31,  
     2004     2005     2006     2007     2008     2008  
     RMB     RMB     RMB     RMB     RMB     US$ (Note 1)  

Balance Sheet Data:

            

Cash

   2,123,891,537      1,685,744,081      1,206,476,526      2,482,820,821      793,407,922      116,292,843   

Time deposits

   —        1,691,976,255      2,731,396,687      1,675,813,944      4,820,000,100      706,485,907   

Property, equipment and software, net

   77,303,013      126,341,533      224,207,833      183,471,666      258,787,534      37,931,482   

Total assets

   2,450,140,398      3,624,985,519      4,373,707,830      4,685,659,381      6,345,893,303      930,141,929   

Total current liabilities

   257,495,300      415,479,050      676,408,475      1,276,825,952      829,048,062      121,516,756   

Total long-term liabilities

   839,399,578      818,413,108      791,631,174      10,200,000      200,000      29,315   

Working capital (Note 3)

   2,108,955,067      3,081,823,774      3,452,777,455      3,159,467,168      5,144,731,429      754,083,024   

Total shareholders’ equity

   1,353,245,520      2,391,093,361      2,905,668,181      3,398,425,631      5,516,435,976      808,565,185   

 

Note 1:   Translations of amounts from RMB into U.S. dollars for the convenience of the reader were calculated at the noon buying rate of US$1.00: RMB6.8225 on December 31, 2008 in The City of New York for cable transfers of RMB as certified for customs purposes by the Federal Reserve Bank of New York. No representation is made that the RMB amounts could have been, or could be, converted into United States dollars at that rate on December 31, 2008, or at any other rate.
Note 2:   Effective from March 27, 2006, the company changed its ADS to ordinary share ratio from one ADS for every 100 ordinary shares to one ADS for every 25 ordinary shares. Therefore, the basic and diluted earnings per ADS as well as the basic and diluted weighted average number of ADS outstanding for the two years ended December 31, 2004 and 2005 have been retroactively restated.
Note 3:   Working capital represents total current assets less total current liabilities.

 

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Table of Contents

Exchange Rate Information

We have published our financial statements in Renminbi, or RMB. Our business is currently conducted in and from China in Renminbi. In this annual report, all references to Renminbi and RMB are to the legal currency of China and all references to U.S. dollars, dollars, $ and US$ are to the legal currency of the United States. The conversion of Renminbi into U.S. dollars in this annual report is based on the noon buying rate in The City of New York for cable transfers of Renminbi as certified for customs purposes by the Federal Reserve Bank of New York. For your convenience, this annual report contains translations of some Renminbi or U.S. dollar amounts for 2008 at US$1.00: RMB6.8225, which was the prevailing rate on December 31, 2008. The prevailing rate on June 19, 2009 was US$1.00: RMB6.8360. We make no representation that any Renminbi or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or Renminbi, as the case may be, at any particular rate, the rates stated below, or at all. The Chinese government imposes control over its foreign currency reserves in part through direct regulation of the conversion of Renminbi into foreign exchange and through restrictions on foreign trade.

The following table sets forth the average buying rate for Renminbi expressed as per one U.S. dollar for the years 2004, 2005, 2006, 2007 and 2008.

 

Year

   Renminbi Average(1)

2004

   8.2768

2005

   8.1826

2006

   7.9579

2007

   7.5806

2008

   6.9193

 

(1) Determined by averaging the rates on the last business day of each month during the relevant period.

The following table sets forth the high and low exchange rates for Renminbi expressed as per one U.S. dollar during the past six months.

 

Month Ended

   High    Low

December 31, 2008

   6.8842    6.8225

January 31, 2009

   6.8403    6.8225

February 28, 2009

   6.8470    6.8241

March 31, 2009

   6.8438    6.8240

April 30, 2009

   6.8361    6.8180

May 31, 2009

   6.8326    6.8176

 

B. Capitalization and Indebtedness

Not Applicable.

 

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Table of Contents
C. Reasons for the Offer and Use of Proceeds

Not Applicable.

 

D. Risk Factors

RISKS RELATED TO OUR COMPANY

Our business model continues to change, and our prospects may be difficult to evaluate based on historical performance.

Commencing with the launch of the NetEase websites in 1999 until 2001, the majority of our revenues came from online advertising. In 2001, we began focusing on wireless value-added services and, to a lesser extent other fee-based premium services, which grew to account for 69.4% of total revenues in 2002 but declined each year thereafter to 2.7% of total net revenues in 2008. In recent years, we have devoted significant resources to our online games business, which accounted for 35.7% of our total revenues in 2003 and grew to account for 84.6%, 84.4% and 85.2% of our total net revenues in 2006, 2007 and 2008, respectively. With the licensing of certain online games by Blizzard Entertainment Inc. (together with its affiliated companies, referred to as Blizzard in this annual report) to Shanghai EaseNet Network Technology Limited, or Shanghai EaseNet, for operation in the PRC in August 2008 and April 2009, we significantly expanded our commitment to operate online games licensed from third parties, although no revenue has been generated from such licensed online games as of the date of the filing of this annual report. The evolution of our business focus over the past few years from solely operating the NetEase websites and selling online advertisements to providing wireless value-added and other fee-based premium services to developing and distributing online games, as well as licensing online games from third parties, could make it difficult for you to evaluate our future performance based on historical results. We cannot assure you that we will be able to increase or maintain our revenues from online games or any other services.

Our business depends to a significant extent on two online games, which accounted for 84.6%, 81.4% and 73.5% of our total net revenues in 2006, 2007 and 2008, respectively. We may not be able to maintain the popularity of these games for a variety of reasons.

Two of our in-house developed massively multi-player online role-playing games, known as MMORPGs, Westward Journey Online II (which was commercially launched in August 2002) and Fantasy Westward Journey (which was commercially launched in January 2004), contributed 84.6%, 81.4% and 73.5% of our total net revenues in 2006, 2007 and 2008, respectively. With the launch of our other new games as set forth in the next risk factor, the percentage of our total net revenues contributed by these two games has decreased from 2006 to 2008. Nevertheless, we expect that we will need to continually introduce new versions or substantive upgrades of these and our other online games on a frequent basis to maintain their popularity, although changes in users’ tastes or in the overall market for online games in China could alter the anticipated life cycle of each version or upgrade or even cause our users to stop playing our games altogether. Because of the limited history of the online games market in China, we cannot at this time estimate the total life cycle of any of our games, particularly our more recently launched games. If we are unable to maintain the popularity of Westward Journey Online II, Fantasy Westward Journey, or our other existing online games or are unable to introduce new online games which are popular with online game users in China (as discussed in the next risk factor), our business and results of operations could be materially and adversely affected.

 

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Table of Contents

If we fail to develop and introduce new online games timely and successfully, we will not be able to compete effectively and our ability to generate revenues will suffer.

We operate in a highly competitive, quickly changing environment, and our future success depends not only on the popularity of our existing online games but also on our ability to develop and introduce new games that our customers and users choose to buy. If we are unsuccessful at developing and introducing new online games that are appealing to users with acceptable prices and terms, our business and operating results will be negatively impacted because we would not be able to compete effectively and our ability to generate revenues would suffer. The development of new games can be very difficult and requires high levels of innovation.

New technologies in online game programming or operations could render our current online titles or other online games that we develop in the future obsolete or unattractive to our subscribers, thereby limiting our ability to recover development costs and potentially adversely affecting our future revenues and profitability. In particular, the online game industry in China is transitioning from 2D to 3D games, with numerous new 3D game titles being launched in the market in recent years. In response to this trend, we have been devoting additional resources to developing or licensing 3D games and software components for such games, and we cannot assure you that such games will be successful. In particular, we have been devoting a significant portion of our research and development efforts to develop new games including fee-based and item-based games. Datang, our first 2.5D game, was commercially launched in July 2006, Westward Journey Online III, an enhanced version of our popular Westward Journey game series, was commercially launched in September 2007, and the open beta testing versions of our item-based online games, Tianxia II and Legend of Westward Journey, were launched in June and September 2008, respectively. We also launched an expansion pack for Tianxia II in September 2008. Further, we have other new games currently in development such as Datang II (Heroes of Tang Dynasty). Both Tianxia II and Datang II (Heroes of Tang Dynasty) have been in development for a significant period of time, in particular Tianxia II which was altered following unsatisfactory results from the initial beta testing in 2007. Nevertheless, with our continuous efforts, both the number of online players and consumption level of in-game items of Tianxia II have grown steadily since the commencement of its open beta testing in June 2008. This development involves significant cost, and we are not able to predict if or when we will commercially launch any of our new games and whether such games will ultimately become popular.

In addition, we are required to devote significant resources to the ongoing operations of our online games, such as staff costs related to our “Games Masters” which supervise the activities within our games. If we fail to anticipate our users’ needs and technological trends accurately or are otherwise unable to complete the development of games in a timely fashion, we will be unable to introduce new games into the market to successfully compete.

The demand for new games is difficult to forecast, in part due to the relative immaturity of the market and relatively short life cycles of Internet-based technologies. As we introduce and support additional games and as competition in the market for our games intensifies, we expect that it will become more difficult to forecast demand. In particular, competition in the online game market is growing as more and more online games are introduced by existing and new market participants.

Substantially all of our online game revenues have been generated by games that use the pay-to-play revenue model, and we may be unable to effectively address ongoing or future market trends regarding new revenue models for online games in China.

Except for our casual games which have contributed an insignificant amount of our revenue since their launch in 2005, substantially all of our online game revenues have been generated by games that use the pay-to-play revenue model whereby players purchase our prepaid point cards to pay for playing time.

 

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A number of our competitors have been transitioning to an item-based revenue model where end users are able to play the basic functions of the online games for free and may choose to purchase in-game value-added services, including certain in-game items and premium features, which enhance the game experience. Currently, we are developing games that use the item-based revenue model, and the open beta testing versions of our item-based online games, Tianxia II and Legend of Westward Journey, were launched in June and September 2008, respectively. We cannot be certain that these or our future item-based online games will be popular or generate the revenue our management expects. Moreover, it is possible that users of our existing pay-to-play games find that the item-based games offered by our competitors provide a more enjoyable gaming experience in which case the popularity of our existing games could be materially adversely affected. If there is an overall shift in the online game market in China to an item-based or another revenue model, we may be unable to launch new games or new versions of existing games which effectively use such model in a timely manner or at all, and we may be required to make significant research and development and selling and marketing expenditures to develop and promote such games.

We may not be able to maintain a stable relationship with Blizzard, and we may experience difficulties in the operation of the online games licensed from it or its affiliates.

In August 2008 and April 2009, Blizzard agreed to license certain online games developed by it to Shanghai EaseNet for operation in the PRC, including StarCraft II and World of Warcraft. Shanghai EaseNet is a PRC company owned by William Lei Ding, our Chief Executive Officer, director and major shareholder, and has contractual arrangements with the joint venture established between Blizzard and us, and with us. For further details, see Item 4.B. “Business Overview – Our Services – Game Licensing and Joint Venture with Blizzard.” We lack experience in licensing online games from third parties and have limited experience working with Blizzard. If we are unable to maintain a stable relationship with Blizzard, or if Blizzard either establishes similar or more favorable relationships with our competitors in violation of its contractual arrangements with us or otherwise, we may not be able to ensure a smooth operation of these licensed online games, and Blizzard could terminate the license and joint venture agreements with us, which in either case could harm our operating results and business. Also, the benefits of our arrangements with Blizzard may take considerable time to develop, and we cannot be certain that such arrangements will produce its intended benefits.

On behalf of Shanghai EaseNet as licensee of the games, we have paid to Blizzard initial license fees, with an additional initial license fee to be paid upon the commencement of the open beta testing and commercial release in the PRC of a localized version of Blizzard’s Battle.net platform. In addition, over the three-year terms of the licenses, Shanghai EaseNet is required to pay royalties and consultancy fees to Blizzard for the games, and it also has a minimum marketing expenditure commitment. Shanghai EaseNet is also obligated to provide funds for hardware to operate the games. We have guaranteed the payment of the foregoing amounts if and to the extent Shanghai EaseNet has insufficient funds to make such payments. We will be entitled to reimbursement of any amounts paid for the marketing of the games and hardware support to operate the games under the guarantee from any net profits subsequently generated by Shanghai EaseNet, after the deduction of, among others, various fees and expenses payable to Blizzard, us and our joint venture with Blizzard which will provide technical services to Shanghai EaseNet.

We believe that our current cash and cash equivalents and cash flow from operations will be sufficient to meet our foregoing obligations. To the extent our obligations exceed our cash resources, we may seek to sell additional equity or debt securities or to obtain a credit facility. The sale of additional equity or convertible debt securities could result in additional dilution to shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financial covenants that would restrict operations. Financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to meet our foregoing obligations, our licensed games operation and financial condition could be adversely affected and our licenses with Blizzard could be terminated.

 

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In addition, we cannot be certain that these licensed online games will be viewed by the regulatory authorities as complying with content restrictions, will be launched or re-launched as scheduled, or at all, will be attractive to users or will be able to compete with games operated by our competitors. In particular, StarCraft II has not been launched yet, and the relaunch of World of Warcraft by Shanghai EaseNet is also subject to certain risks as discussed in the following risk factor. We may not be able to fully recover the costs associated with licensing these online games if the games are not popular among users in the PRC, and any difficulties in the operation of these licensed games could harm our results of operations and financial condition.

Any difficulties or delays in the transition of World of Warcraft from the prior licensee and operator of the game in the PRC, The9 Limited, or The9, to Shanghai EaseNet could adversely affect that game’s popularity and profitability.

Following the expiration of Blizzard’s current license agreement with The9 for World of Warcraft in June 2009, World of Warcraft ceased operation during the transition period from The9 to Shanghai EaseNet. The relaunch of World of Warcraft is subject to a number of factors, some of which are beyond our control, including receipt of necessary governmental approvals including approval and a publication number from the PRC General Administration of Press and Publications. We cannot be certain of the duration of the transition period and if the transition will be completed satisfactorily. If such relaunch is significantly delayed, the game’s popularity and profitability may be adversely affected.

Future alliances may have an adverse effect on our business.

Strategic alliances with key players in the online game industry and other related industry sectors form part of our strategy to expand our portfolio of online games. For example, in August 2008 and April 2009, Blizzard agreed to license certain online games developed by it to Shanghai EaseNet for operation in the PRC, and we have formed a joint venture with Blizzard to provide technical services to Shanghai EaseNet. However, our ability to grow through future alliances, including through joint ventures, will depend on the availability of suitable partners at reasonable terms, our ability to compete effectively to attract these partners, the availability of financing to complete larger joint ventures, and our ability to obtain any required governmental approvals. Further, the benefits of an alliance may take considerable time to develop, and we cannot be certain that any particular alliance will produce its intended benefits.

Future alliances could also expose us to potential risks, including risks associated with the assimilation of new operation technologies and personnel, unforeseen or hidden liabilities, the inability to generate sufficient revenue to offset the costs and expenses of alliances and potential loss of, or harm to, our relationships with employees, customers, licensors and other suppliers as a result of integration of new businesses. Further, we may not be able to maintain a satisfactory relationship with our partners, which could adversely affect our business and results of operations. We have limited experience in identifying, financing or completing strategic alliances. Such transactions and the subsequent integration process would require significant attention from our management. The diversion of our management’s attention and any difficulties encountered with respect to the alliances or in the process of integration could have an adverse effect on our ability to manage our business.

 

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A prolonged slowdown in the PRC economy may materially and adversely affect our results of operations, financial condition, prospects and future expansion plans.

Since the second half of 2008, global credit and capital markets, particularly in the United States and Europe, have experienced difficult conditions. These challenging market conditions have resulted in reduced liquidity, greater volatility, widening of credit spreads, lack of price transparency in credit markets, a reduction in available financing and lack of market confidence. These factors, combined with declining business and consumer confidence and increased unemployment in the United States and elsewhere in the world, have precipitated a global economic slowdown, including a slowdown in the rate of economic growth in recent quarters in China. Given the dramatic change in the overall credit environment and economy, it is difficult to predict how long these conditions will exist and the extent to which we may be affected. The uncertainty and volatility of credit and capital markets and the overall slowdown in the PRC economy has had and may continue to have an adverse effect on our business. Furthermore, there can be no assurance that measures implemented by governments around the world to stabilize the credit and capital markets and new economic stimulus measures in China will improve market confidence and the overall credit environment and economy. As a result, prolonged disruptions to the global credit and capital markets and the global economy may materially and adversely affect the Chinese economy, consumer spending in China and our business, results of operations, financial condition, prospects and future expansion plans.

Reports of violence and theft related to online games may result in negative publicity or governmental response that could have a material and adverse impact on our business.

The media in China has reported incidents of violent crimes allegedly inspired by online games and theft of virtual items between users in online games. While we believe that such events were not related to our online games, it is possible that our reputation, as one of the leading online game providers in China, could be adversely affected by such behavior. In response to the media reports, in August 2005, the Chinese government enacted new regulations to prohibit all minors under the age of 18 from playing online games in which players are allowed to kill other players, an activity that has been termed Player Kills, or PK. The Chinese government has also taken steps to limit online game playing time for all minors under the age of 18. See below “—Risks Related to the Telecommunications and Internet Industries in China—The Chinese government has taken steps to limit online game playing time for all minors. These and any other new restrictions may materially and adversely impact our business and results of operations.” If the Chinese government should determine that online games have a negative impact on society, it may impose certain restrictions on the online game industry, which could in turn have a material and adverse effect on our business and results of operations.

Acts of cheating by users of online games could lessen the popularity of our online games, adversely affect our reputation and our results of operations.

There have been a number of incidents in previous years where users, through a variety of methods, were able to modify the rules of our online games. Although these users did not gain unauthorized access to our systems, they were able to modify the rules of our online games during game play in a manner that allowed them to cheat and disadvantage our other online game users which often has the effect of causing players to stop using the game and shortening the game’s lifecycle. Although we have taken a number of steps to deter our users from engaging in cheating when playing our online games, we cannot assure you that we or the third parties from whom we license some of our online games will be successful or timely in taking corrective steps necessary to prevent users from modifying the terms of our online games.

 

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Illegal game servers could harm our business and reputation and materially and adversely affect our results of operations.

Several of our competitors have reported that some Internet cafés have installed illegal copies of such competitors’ games on the cafés’ servers and let their customers play such games on illegal servers without paying for the game playing time. While we already have in place numerous internal control measures to protect the source codes of our games from being stolen and to address illegal server usage and, to date, our games have not experienced such usage, our preventive measures may not be effective. The misappropriation of our game server installation software and installation of illegal game servers could harm our business and reputation and materially and adversely affect our results of operations.

Efforts to supervise the operation of our online games and portal may expose us to potential claims by our users.

In our daily supervision of the operation of our online games and portal or during the investigation of users’ complaints, we may take actions to regulate the behavior of our users. For example, if we suspect a player of installing cheating program on our online games, we may freeze his game account or even ban the player from logging on to our games and portal. Such regulatory activities are essential to maintain a fair playing environment for our users. However, if any of our regulatory activities are found to be wrongly implemented, our users may institute legal proceedings against us for damages or claims. Our operation, business and financial performance may be materially and adversely affected as a result.

We depend upon multiple printing companies and distributors to produce and deliver our prepaid point cards to the various points of sale. If such parties mishandle our cards or the related passcodes, our reputation and results of operations could be materially and adversely affected.

We appoint multiple printers and distributors throughout China to produce and deliver our prepaid point cards to the various points of sale. We generally have cards produced by individual printers in batches of thousands, or ten of thousands, of cards, with each card having an individual passcode which enables the purchaser to deposit the points on the card into their online user account to pay for game playing time, in-game items or our other fee-based services. In addition, before the cards are purchased by users of the NetEase websites, we activate them on our internal systems.

In one instance in 2005, one of our printers created unauthorized duplicate batches of our cards with the same passcodes as the cards which we ordered. Because our internal system only allows a passcode for a particular card to be used once, a small number of customers were not able to use their cards because the passcode for the duplicate card had already been used. Although this incident had no material impact on our business or financial results, we have enhanced our efforts to ensure that our cards are produced and distributed in accordance with our instructions. In particular, we have focused our customer service team on quickly responding to customer complaints regarding our cards, both to maintain our reputation in the market and to identify any issues which may indicate a potential problem with a printer or distributor. We are also highly selective in our choice of such parties, and have begun activating our cards on our internal system as close as possible to the purchase of such cards by the end-user to prevent any duplicate cards. If, however, these efforts are unsuccessful and our printers or distributors mishandle our cards or the related passcodes, our reputation and results of operations could be materially and adversely affected.

 

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We expect that a portion of our future revenues will continue to come from our advertising services, which represented approximately 12.0% of our total net revenues for 2008, but we may not be able to compete effectively in this market because it is relatively new and intensely competitive, in which case our ability to generate and maintain advertising revenue in the future could be adversely affected.

Although we anticipate that the revenues generated by our online games will continue to constitute the major portion of our future revenues, we believe that we will continue to rely on advertising revenues as one of our primary revenue sources for the foreseeable future. Online advertising in China is still relatively new and many of our current and potential advertisers have limited experience with the Internet as an advertising medium, have not traditionally devoted a significant portion of their advertising expenditures or other available funds to Web-based advertising, and may not find the Internet to be effective for promoting their products and services relative to traditional print and broadcast media. Our ability to generate and maintain significant advertising revenue will depend on a number of factors, many of which are beyond our control, including:

 

   

the development of a large base of users possessing demographic characteristics attractive to advertisers;

 

   

the development of software that blocks Internet advertisements before they appear on a user’s screen;

 

   

downward pressure on online advertising prices; and

 

   

the effectiveness of our advertising delivery and tracking system.

Changes in government policy could also restrict or curtail our online advertising services. For example, as a result of the enactment of a series of regulations, administrative instructions and policies by the PRC government to restrict online medical advertising since July 2006, we can only carry those advertisements which comply with the relevant regulations. Moreover, the acceptance of the Internet as a medium for advertising depends on the development of a measurement standard. No standards have been widely accepted for the measurement of the effectiveness of online advertising. Industry-wide standards may not develop sufficiently to support the Internet as an effective advertising medium. If these standards do not develop, advertisers may choose not to advertise on the Internet in general or through our portals or search engines.

In addition, the competition in the online advertising industry in China has intensified since Baidu.com, Inc., or Baidu, Tencent Inc., or Tencent, and Alibaba.com Limited, or Alibaba and other vertical Internet portals came into the market. The entry of additional, highly competitive Internet companies, whether domestic or international companies, into the Chinese market would further heighten competition for advertising spending in China.

If the Internet does not become more widely accepted as a medium for advertising, our ability to generate increased revenue will be negatively affected.

 

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We experienced a decline in the rate of growth of our online games which appears to be a result of the outbreak of severe acute respiratory syndrome, or SARS, in 2003 and any recurrence of SARS, an outbreak of the H5N1 strain of bird flu (avian influenza), H1N1 or another widespread public health problem could further adversely affect our business and results of operations.

During April and May 2003, we experienced a decline in the rate of growth of our online game services which we believe resulted from the closure of Internet cafés in Beijing and elsewhere to prevent the spread of SARS. Many users of our online game services can only access those services at Internet cafés. A renewed outbreak of SARS or another widespread public health problem in China where virtually all of our revenue is derived and in Beijing, Shanghai, Guangzhou and Hangzhou where most of our employees are located could have a negative effect on our operations.

In addition, there has been confirmed human cases of avian influenza in PRC, Vietnam, Iraq, Thailand, Indonesia, Turkey, Cambodia and other countries which have proven fatal in some instances. If such an outbreak or any other similar epidemic were to spread in the PRC, where our operations are located, it may adversely affect our business and operating results. Further, in April 2009, H1N1, a new strain of flu virus commonly referred to as “swine flu,” was first discovered in North America and quickly spread to other parts of the world, including China. If H1N1 continues to spread in China, where all of our operations are located, it may adversely affect our business and operating results.

Our operations may be impacted by a number of health-related factors, including, among other things:

 

   

quarantines or closures of some of our offices which would severely disrupt our operations;

 

   

the sickness or death of our key officers and employees;

 

   

closure of Internet cafés and other public areas where people access the Internet; and

 

   

a general slowdown in the Chinese economy.

Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business and results of operations.

The success of our business is dependent on our ability to retain our existing key employees and to add and retain senior officers to our management.

We depend on the services of our existing key employees. Our success will largely depend on our ability to retain these key employees and to attract and retain qualified senior and middle level managers to our management team. Future changes in management could cause material disruptions to our business. We also depend on our ability to attract and retain in the future highly skilled technical, editorial, marketing and customer service personnel, especially experienced online game software developers. We cannot assure you that we will be able to attract or retain such personnel or that any personnel we hire in the future will successfully integrate into our organization or ultimately contribute positively to our business. In particular, the market for experienced online game software programmers is intensely competitive in China. While we believe we offer compensation packages that are consistent with market practice, we cannot be certain that we will be able to hire and retain sufficient experienced programmers to support our online games business. We may also be unsuccessful in training and retaining less-experienced programmers on a cost-effective basis. The loss of any of our key employees would significantly harm our business. We do not maintain key person life insurance on any of our employees.

 

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Our revenues fluctuate significantly and may adversely impact the trading price of our American Depositary Shares, or ADSs, or any other securities which become publicly traded.

Our revenues and results of operations have varied significantly in the past and may continue to fluctuate in the future. Many of the factors that cause such fluctuation are outside our control. Steady revenues and results of operations will depend largely on our ability to:

 

   

attract and retain users to the NetEase websites in the increasingly competitive Internet market in China;

 

   

successfully implement our business strategies as planned; and

 

   

update and develop our Internet applications, services, technologies and infrastructure.

Historically, advertising revenue has followed the same general seasonal trend throughout each year with the first quarter of the year being the weakest quarter due to the Chinese New Year holiday and the traditional close of advertisers’ annual budgets and the third quarter as the strongest. Usage of our wireless value-added services and online games has generally increased around the Chinese New Year holiday and other Chinese holidays, in particular winter and summer school holidays during which school-aged users have more time to use such services and play games. Accordingly, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. It is possible that future fluctuations may cause our results of operations to be below the expectations of market analysts and investors. This could cause the trading price of our ADSs or any other securities of ours which may become publicly traded to decline.

Changes in accounting rules for share-based compensation may adversely affect our operating results, our stock price and our competitiveness in the employee marketplace.

Our future success depends to a large degree on our continuing ability to identify, develop, motivate and retain highly skilled personnel for all areas of our organization. We have a history of using employee stock options to align employees’ interest with the interests of our shareholders and encourage quality employees to join us and retain our quality employees by providing competitive compensation packages. On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based compensation to be based on estimated fair values. As a result, our operating results contain a charge for share-based compensation expense related to employee stock options. For the years ended December 31, 2006, 2007 and 2008, we recorded share-based compensation cost of RMB101.3 million, RMB95.4 million and RMB67.9 million (US$10.0 million), respectively. This cost has been allocated to (i) cost of revenues, (ii) selling and marketing expenses, (iii) general and administrative expenses and (iv) research and development expenses, depending on the responsibilities of the relevant employees. The recognition of share-based compensation in our statement of operations has had and may continue to have a negative effect on our reported results and earnings per share, which could in turn negatively affect our stock price. On the other hand, if we alter our employee share incentive plan to minimize the share-based compensation expenses, it may limit our ability to continue to use share-based awards as a tool to attract and retain our employees, and it may adversely affect our operations.

 

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If we fail to establish and maintain relationships with content providers, we may not be able to attract traffic to the NetEase websites.

We rely on a number of third party relationships to attract traffic and provide content in order to make the NetEase websites more attractive to users and advertisers. Most of our arrangements with content providers are short-term and may be terminated at the convenience of the other party. Some content providers have increased the fees they charge us for their content. This trend could increase our costs and operating expenses and could adversely affect our ability to obtain content at an economically acceptable cost. Moreover, our agreements with content providers are usually non-exclusive, although certain of our competitors have been entering into exclusive arrangements for certain content, particularly online video content. If we are not able to renew our agreements with content providers or our competitors obtain exclusive rights to content which we wish to offer on the NetEase websites, the attractiveness of our portal to users will be severely impaired. Also, if other Internet companies present the same or similar content in a superior manner, it would adversely affect our visitor traffic.

We expect that the increasing popularity of online video content among Internet users in China will increase our costs in future periods because it requires significant bandwidth to deliver and will likely necessitate our investments in new video streaming technology.

We believe that online video content is becoming increasingly popular among Internet users in China and that we will need to offer a wide range of video content on the NetEase websites to attract users. Although advances in video compression technology have allowed reductions in the bandwidth required to deliver video content, such content still requires significantly more bandwidth than the other forms of content we offer on the NetEase websites. If we are unable to pass on such increased costs to users, which we believe is unlikely for the foreseeable future, our costs will increase which could materially adversely affect our business and profitability. In addition, the technology for video content processing, transmission and high-speed data access systems is characterized by rapid developments and evolving industry standards. To enable users to access our video content quickly and reliably and remain competitive with other Internet portals in China and elsewhere, we anticipate that we will be required to invest in new video streaming technologies, including technologies developed by third parties, on a regular basis which will also increase our costs.

We do not own Guangzhou NetEase Computer System Co., Ltd., or Guangzhou NetEase, Beijing Guangyitong Advertising Co., Ltd., or Guangyitong Advertising, or Shanghai EaseNet, and if they or their ultimate shareholders violate our contractual arrangements with them, our business could be disrupted, our reputation may be harmed and we may have to resort to litigation to enforce our rights which may be time consuming and expensive.

Guangzhou NetEase and Guangyitong Advertising are owned by shareholders whose interests may differ from ours and those of our shareholders because they own a larger percentage of Guangzhou NetEase and Guangyitong Advertising than of our company. Specifically, the business and operations of Guangzhou NetEase, as the operator of the NetEase websites and a provider of online games and wireless value-added and other fee-based premium services, and Guangyitong Advertising, as an advertising firm, are subject to Chinese laws and regulations that differ from the laws and regulations that govern the business and operations of NetEase. For example, Chinese laws and regulations require us to verify the content of third party advertising content we place on the NetEase websites, and we are partly dependent upon the conduct of Guangyitong Advertising, which is not directly subject to those laws and regulations, in order to ensure that we remain compliant with those laws and regulations. Guangzhou NetEase, Guangyitong Advertising or their ultimate shareholders could violate our arrangements with them by, among other things, failing to operate and maintain the NetEase websites or their various businesses in an acceptable manner, failing to remit revenue to us on a timely basis or at all or diverting customers or business opportunities from our company. In addition, the operation of the online games licensed by Blizzard is dependent on Shanghai EaseNet, which is owned by William Lei Ding, our Chief Executive Officer, director and major shareholder, and has contractual arrangements with the joint venture established between Blizzard and us, and with us.

 

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The interests of Mr. Ding and the joint venture may differ from ours and those of our shareholders. A violation of the foregoing agreements could disrupt our business and adversely affect our reputation in the market. If Guangzhou NetEase, Guangyitong Advertising, Shanghai EaseNet or their ultimate shareholders violate our agreements with them, we may have to resort to litigation to enforce our rights. This litigation could result in the disruption of our business, diversion of our resource and the incurrence of substantial costs.

Because our contractual arrangements with Guangzhou NetEase, Guangyitong Advertising and their ultimate shareholders do not detail the parties’ rights and obligations, our remedies for a breach of these arrangements are limited.

Our current relationship with Guangzhou NetEase, Guangyitong Advertising and their ultimate shareholders is based on a number of contracts. The terms of these agreements are often statements of general intent and do not detail the rights and obligations of the parties. Some of these contracts provide that the parties will enter into further agreements on the details of the services to be provided. Others contain price and payment terms that are subject to monthly adjustment. These provisions may be subject to differing interpretations, particularly on the details of the services to be provided and on price and payment terms. It may be difficult for us to obtain remedies or damages from Guangzhou NetEase, Guangyitong Advertising or their ultimate shareholders for breaching our agreements. Because we rely significantly on Guangzhou NetEase and Guangyitong Advertising for our business, the realization of any of these risks may disrupt our operations or cause degradation in the quality and service provided on, or a temporary or permanent shutdown of, the NetEase websites.

A majority of the share capital of Guangzhou NetEase and Guangyitong Advertising and the entire share capital of Shanghai EaseNet is held by our major shareholder, who may cause these agreements to be amended in a manner that is adverse to us.

Our major shareholder, William Lei Ding, holds the majority interest in Guangzhou NetEase and Guangyitong Advertising. As a result, Mr. Ding may be able to cause the agreements related to Guangzhou NetEase and Guangyitong Advertising to be amended in a manner that will be adverse to our company, or may be able to cause these agreements not to be renewed, even if their renewal would be beneficial for us. Prior to our initial public offering of ADSs in 2000, a number of these agreements were amended. Although we have entered into an agreement that prevents the amendment of these agreements without the approval of the members of our Board other than Mr. Ding, we can provide no assurances that these agreements will not be amended in the future to contain terms that might differ from the terms that are currently in place. These differences may be adverse to our interests. In addition, William Lei Ding also holds the entire share capital of Shanghai EaseNet, and we can provide no assurance that Mr. Ding will not cause the agreements related to Shanghai EaseNet to be amended in the future in a manner that will be adverse to us or to contain terms that might differ from the terms that are currently in place. These differences may be adverse to our interests.

We may not be able to conduct our operations without the services provided by Guangzhou NetEase and Guangyitong Advertising.

Our operations are currently dependent upon our commercial relationships with Guangzhou NetEase and Guangyitong Advertising, and we derive most of our revenues from these companies. A portion of our revenues under our contracts with these companies is based upon preliminary and tentative amounts that have been agreed upon in advance and is subject to adjustment at our company’s discretion by the end of each quarter. If these companies are unwilling or unable to perform the agreements which we have entered into with them, we may not be able to conduct our operations in the manner in which we currently plan. In addition, Guangzhou NetEase and Guangyitong Advertising may seek to renew these agreements on terms that are disadvantageous to us.

 

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Although we have entered into a series of agreements that provide us with substantial ability to control these companies, we may not succeed in enforcing our rights under them. If we are unable to renew these agreements on favorable terms, or to enter into similar agreements with other parties, our business may not expand, and our operating expenses may increase.

One of our shareholders has significant influence over our company.

Our founder, Chief Executive Officer and director, William Lei Ding, beneficially owned approximately 43.8% as of March 31, 2009 of our outstanding ordinary shares and is our largest shareholder. Accordingly, Mr. Ding has significant influence in determining the outcome of any corporate transaction or other matter submitted to the shareholders for approval, including mergers, consolidations, the sale of all or substantially all of our assets, election of directors and other significant corporate actions. He also has significant influence in preventing or causing a change in control. In addition, without the consent of this shareholder, we may be prevented from entering into transactions that could be beneficial to us. The interests of Mr. Ding may differ from the interests of our other shareholders.

Our arrangements with Guangzhou NetEase, Guangyitong Advertising and their respective shareholders may cause a transfer pricing adjustment and may be subject to scrutiny by the PRC tax authorities.

We could face material and adverse tax consequences if the PRC tax authorities determine that our contracts with Guangzhou NetEase, Guangyitong Advertising and their respective shareholders were not entered into based on arm’s length negotiations. Although our contractual arrangements are similar to other companies conducting similar operations in China, if the PRC tax authorities determine that these contracts were not entered into on an arm’s length basis, they may adjust our income and expenses for PRC tax purposes in the form of a transfer pricing adjustment which may result in an increase in our taxes.

Our business benefits from certain PRC government incentives. Expiration of, or changes to, these incentives and PRC tax laws could have a material adverse effect on our operating results.

Prior to January 1, 2008, foreign invested enterprises were generally subject to a national and local enterprise income tax, or EIT, at statutory rates of 30.0% and 3.0%, respectively, under the previous income tax law. Our subsidiaries, NetEase Information Technology (Beijing) Co., Ltd., or NetEase Beijing, Guangzhou NetEase Interactive Entertainment Limited, or Guangzhou Interactive, Guangzhou Boguan Telecommunication Limited, or Boguan, NetEase (Hangzhou) Network Co., Ltd., or NetEase Hangzhou, and NetEase Youdao Information Technology (Beijing) Limited (formerly named NetEase Yodao Information Technology (Beijing) Limited), or Youdao Information, and our VIE, Guangzhou NetEase, had been granted various preferential tax treatments because the local tax authorities had approved such companies as “High and New Technology Enterprises” or “Software Enterprises” or similar designations under the then applicable tax rules and regulations.

Effective as of January 1, 2008, the Chinese government adopted the Corporate Income Tax Law (“the new income tax law”), as further clarified by subsequent tax regulations implementing the new income tax law, which unified the EIT payable by domestic and foreign-invested enterprises at 25.0%. Preferential tax treatments continue to be granted to entities that are classified as “High and New Technology Enterprises Strongly Supported by the State” or conduct business in encouraged sectors, whether foreign invested enterprises or domestic companies, pursuant to which qualified enterprises can enjoy a reduced EIT rate of 15.0%.

 

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Under the new income tax law, enterprises that were established and already enjoyed preferential tax treatments before March 16, 2007, other than companies qualifying as “High and New Technology Enterprises,” continue to enjoy such treatments (i) in the case of preferential tax rates, for a period of five years from January 1, 2008, or (ii) in the case of preferential tax exemption or reduction for a specified term, until the expiration of such term. Our subsidiaries, NetEase Beijing, Guangzhou Interactive, Boguan and NetEase Hangzhou, were included in the published High and New Technology Enterprises, or HNTEs, list of the Science and Technology Department/Commission issued in December 2008. These subsidiaries received their respective certificates dated December 2008 from the relevant tax authorities confirming their respective HNTE tax status for fiscal years 2008 to 2010. We cannot assure you that our subsidiaries will continue to maintain the qualifications of High and New Technology Enterprise after 2010. If our subsidiaries fail to maintain the qualification of High and New Technology Enterprise, their applicable EIT rate may increase to up to 25.0%, which could have a material adverse effect on our results of operations. We cannot assure you that we will be able to maintain our current effective tax rate in the future. In addition, Guangzhou Interactive was also qualified as a “Key Software Enterprise” in 2008 and enjoyed a preferential tax rate of 10.0% in 2008. NetEase Hangzhou was also recognized as a “Software Enterprise” in April 2007.

Apart from its status as a “High and New Technology Enterprise,” our subsidiary, Boguan, enjoyed preferential tax status as a “Software Enterprise” and continues to be entitled to the preferential tax treatments currently enjoyed by it during the transition period so long as it qualifies as a “Software Enterprise.” Boguan paid its EIT at a rate of 12.5% for the first three quarters of 2008 on the understanding that when it was granted the HNTEs tax status in 2008, it would be entitled to a preferential tax rate of 7.5% based on the interpretation of the grandfather provisions under the new income tax law and the related implementation guidelines. This rate was calculated by applying the 50.0% reduction for Software Enterprises against the 15.0% preferred tax rate applicable to its HNTEs status. When Boguan was granted the HNTEs tax status in December 2008, the relevant local tax authority refunded the excess income tax paid which was computed on the basis of applying the preferred tax rate of 7.5%. Following the issuance of a new tax circular by the State Administration of Taxation in April 2009, the local tax authority notified Boguan in June 2009 that it was required to pay the income tax liability for 2008 at the rate of 12.5%. Accordingly, Boguan recorded an additional tax payable of RMB23.3 million in June 2009.

Nevertheless, we believe the relevant tax rules are still not clear, and we will further discuss with the local tax authority to clarify whether Boguan is subject to EIT at a rate of 7.5% or 12.5%. See item 5.A. “Operating Results – Income Taxes.” The qualification as a “Software Enterprise” is subject to an annual assessment by the relevant government authorities in China. We cannot assure you that Boguan will continue to meet the qualifications or that the relevant government authority will not revoke its “Software Enterprise” status. Also, if there are further changes to the relevant income tax laws and their implementation, Boguan and our other subsidiaries may need to pay additional taxes which could have a material adverse effect on our results of operations.

We may be treated as a resident enterprise for PRC tax purposes following the promulgation of the new income tax law on January 1, 2008, which may subject us to PRC income tax for our global income and withholding income tax for any dividends we pay to our non-PRC corporate shareholders on profits earned after January 1, 2008.

Under the new PRC income tax law, enterprises established outside of China whose “de facto management bodies” are located in China are considered “resident enterprises,” and will generally be subject to the uniform 25.0% enterprise income tax rate for their global income. Under the implementation rules of the new income tax law, “de facto management body” is defined as the body that has material and overall management and control over the business, personnel, accounts and properties of the enterprise.

 

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Some of our management is currently located in the PRC. Accordingly, we may be considered a “resident enterprise” and may therefore be subject to the enterprise income tax of 25.0% of our global income and as a result, the amount of dividends we can pay to our shareholders could be reduced. We cannot confirm whether we will be considered a “resident enterprise” as the implementation rules are unclear at this time.

Under the implementation rules of the new income tax law, dividends paid to “non-resident enterprises” by “resident enterprises” on profits earned after January 1, 2008 are regarded as income from “sources within the PRC” and therefore subject to a 10.0% withholding income tax, while dividends on profits earned before January 1, 2008 are not subject to the withholding income tax. A lower withholding income tax rate of 5.0% is applied if the “non-resident enterprises” are registered in Hong Kong or other jurisdictions that have a tax treaty arrangement with China. In addition, because we may be treated as a “resident enterprise,” any dividends paid to the corporate shareholders or shareholders appearing as corporate entities on the share registers of NetEase.com, Inc. which are considered “non-resident enterprises” may be subject to withholding income tax and the value of the investment in our shares or ADSs may be adversely and materially affected.

While we believe that we currently have adequate internal control procedures in place, we are still exposed to potential risks from legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002.

While we believe that we currently have adequate internal control procedures in place, we are still exposed to potential risks from legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002. Under the supervision and with the participation of our management, we have evaluated our internal controls systems in order to allow management to report on, and our registered independent public accounting firm to attest to, our internal controls, as required by Section 404 of the Sarbanes-Oxley Act. We have performed the system and process evaluation and testing required in an effort to comply with the management certification and auditor attestation requirements of Section 404. As a result, we have incurred additional expenses and a diversion of management’s time. If we are not able to continue to meet the requirements of Section 404 in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by regulatory authorities, such as the SEC or NASDAQ. Any such action could adversely affect our financial results and the market price of our ordinary shares.

Unexpected network interruption caused by system failures may reduce visitor traffic and harm our reputation.

Both the continual accessibility of the NetEase websites and the performance and reliability of our technical infrastructure are critical to our reputation and the ability of the NetEase websites to attract and retain users and advertisers. Any system failure or performance inadequacy that causes interruptions in the availability of our services or increases the response time of our services could reduce user satisfaction and traffic, which would reduce the NetEase websites’ appeal to users and advertisers. As the number of NetEase Web pages and traffic increase, we cannot assure you that we will be able to scale our systems proportionately. In addition, any system failures and electrical outages could materially and adversely impact our business.

 

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Our operations are vulnerable to natural disasters and other events.

We have limited backup systems and have experienced system failures and electrical outages from time to time in the past, which have disrupted our operations. Most of our servers and routers are currently located at several different locations in China. Our disaster recovery plan cannot fully ensure safety in the event of damage from fire, floods, typhoons, earthquakes, power loss, telecommunications failures, break-ins and similar events. If any of the foregoing occurs, we may experience a system shutdown. We do not carry any business interruption insurance. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers.

Although we carry property insurance with low coverage limits, our coverage may not be adequate to compensate us for all losses, particularly with respect to loss of business and reputation, that may occur.

In addition, fire, floods, droughts, typhoons, earthquakes and other natural disasters could result in material disruptions of our operations and adversely affect our revenues and profit. For example, a 8 Richter magnitude earthquake struck the City of Wenchuan in Sichuan province on May 12, 2008, and the PRC government declared May 19, 2008 to May 21, 2008 as national mourning days for the earthquake. In connection with the period of mourning, we and the other major online game operators in China suspended our game operations during those three days.

Computer viruses may cause delays or interruptions on our systems and may reduce visitor traffic and harm our reputation.

Computer viruses may cause delays or other service interruptions on our systems. In addition, the inadvertent transmission of computer viruses could expose us to a material risk of loss or litigation and possible liability. We may be required to expend significant capital and other resources to protect the NetEase websites against the threat of such computer viruses and to alleviate any problems. Moreover, if a computer virus affecting our system is highly publicized, our reputation could be materially damaged and our visitor traffic may decrease.

Computer hacking could damage our systems and reputation.

Any compromise of security, such as computer hacking, could cause Internet usage to decline. “Hacking” involves efforts to gain unauthorized access to information or systems or to cause intentional malfunctions or loss or corruption of data, software, hardware or other computer equipment. Hackers, if successful, could misappropriate proprietary information or cause disruptions in our service. We may have to spend significant capital and human resources to rectify any damage to our system. In addition, we cannot assure you that any measures we take against computer hacking will be effective. A well publicized computer security breach could significantly damage our reputation and materially adversely affect our business. Although we have not experienced any hacking activity that allowed unauthorized access to any information stored on our network, caused any loss or corruption of data, software or other computer equipment, we have been subject to denial of service attacks that have caused portions of our network to be inaccessible for limited periods of time. In addition, we have had denial of service attacks and viruses or worms introduced into our network. Although we take a number of measures to ensure that our systems are secure and unaffected by security breaches, including ensuring that our servers are hosted at physically secure sites, limiting access to server ports, and using isolated intranets, passwords, and encryption technology, we cannot assure you that any measures we take against computer hacking will be effective.

 

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Some of our players make sales and purchases of our game accounts and virtual items through third-party auction websites, which may have a negative effect on our net revenues.

Some of our players make sales and purchases of our game accounts and virtual items through third-party auction websites in exchange for real money. We do not generate any net revenues from these transactions. Accordingly, purchases and sales of our game accounts or virtual items on third-party websites could lead to decreased sales by us and also put downward pressure on the prices that we charge players for our virtual items and services, all of which could result in lower revenues generated for us by our games. New players may decide not to play our games as a result of any rule changes we might implement to restrict the players’ ability to trade in game accounts or virtual items, which could materially adversely affect our business, results of operations and financial conditions.

If our providers of bandwidth and server custody service fail to provide these services, our business could be materially curtailed.

We rely on affiliates of China Unicom (after its merger with China Netcom), China Telecom and CERNET to provide us with bandwidth and server custody service for Internet users to access the NetEase websites. If China Unicom, China Telecom, CERNET or their affiliates fail to provide such services or raise prices for their services, we may not be able to find a reliable and cost-effective substitute provider on a timely basis or at all. If this happens, our business could be materially curtailed.

We may be held liable for information displayed on, retrieved from or linked to the NetEase websites.

We may face liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of the materials that are published on the NetEase websites. We are involved in several intellectual property infringement claims or actions and are occasionally subject to defamation claims. We believe that the amounts claimed in these actions, in the aggregate, are not material to our business. However, these amounts may be increased for a variety of reasons as the claims progress, and we and our affiliates could be subject to additional defamation or infringement claims which, singly or in the aggregate, could have a material adverse effect on our business and results of operations, if successful. We also could be subject to claims based upon content that is accessible on the NetEase websites such as content and materials posted by users on message boards, online communities, voting systems, e-mail or chat rooms that are offered on the NetEase websites. By providing technology for hypertext links to third-party websites, we may be held liable for copyright or trademark violations by those third party sites. Third parties could assert claims against us for losses incurred in reliance on any erroneous information distributed by us. Moreover, users of the NetEase Web-based e-mail services could seek damages from us for:

 

   

unsolicited e-mails;

 

   

lost or misplaced messages;

 

   

illegal or fraudulent use of e-mail; or

 

   

interruptions or delays in e-mail service.

We may incur significant costs in investigating and defending these claims, even if they do not result in liability.

 

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Information displayed on, retrieved from or linked to the NetEase websites may subject us to claims of violating Chinese laws.

Violations or perceived violations of Chinese laws arising from information displayed on, retrieved from or linked to the NetEase websites could result in significant penalties, including a temporary or complete cessation of our business. China has enacted regulations governing Internet access and the distribution of news and other information. Furthermore, the Propaganda Department of the Chinese Communist Party has been given the responsibility to censor news published in China to ensure, supervise and control a particular political ideology. In addition, the PRC Ministry of Industries and Information Technology, or MII (prior to the PRC government restructuring in March 2008, its predecessor, the Ministry of Information Industry), has published implementing regulations that subject online information providers to potential liability for content included in their portals and the actions of subscribers and others using their systems, including liability for violation of PRC laws prohibiting the distribution of content deemed to be socially destabilizing. Furthermore, the MII may implement a requirement that users of blogs register under their real names. If such a regulation is implemented, our business may be negatively affected due to a decrease in the number of blog users.

In addition, the Ministry of Public Security has from time to time prohibited the distribution over the Internet of information which it believes to be socially destabilizing. The Ministry of Public Security also has the authority to require any local Internet service provider to block any website maintained outside China at its sole discretion.

The State Secrecy Bureau, which is directly responsible for the protection of state secrets of all PRC government and Chinese Communist Party organizations, is authorized to block any website it deems to be leaking state secrets or failing to meet the relevant regulations relating to the protection of state secrets in the distribution of online information. The term “state secrets” has been broadly interpreted by Chinese governmental authorities in the past. We may be liable under these pronouncements for content and materials posted or transmitted by users on message boards, virtual communities, chat rooms or e-mails. Furthermore, where the transmitted content clearly violates the laws of the PRC, we will be required to delete it. Moreover, if we consider transmitted content suspicious, we are required to report such content. We must also undergo computer security inspections, and if we fail to implement the relevant safeguards against security breaches, we may be shut down. In addition, under the relevant regulations, Internet companies which provide bulletin board systems, chat rooms or similar services, such as our company, must apply for the approval of the State Secrecy Bureau. As the implementing rules of these new regulations have not been issued, we do not know how or when we will be expected to comply, or how our business will be affected by the application of these regulations.

If the Chinese government takes any action to limit or eliminate the distribution of information through the NetEase websites, or to limit or regulate any current or future community functions available to users or otherwise block the NetEase websites, our business would be significantly harmed.

The information collected from our users may infringe on their privacy and may not be accurate.

We collect demographic data, such as geographic location, income level and occupation, from our registered users in order to better understand users and their needs. We provide this data to online advertisers, on an anonymous aggregate basis, without disclosing personal details such as name and home address, to enable them to target specific demographic groups. If privacy concerns or regulatory restrictions prevent us from collecting this information or from selling demographically targeted advertising, the NetEase websites may be less attractive to advertisers.

 

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In addition, if privacy concerns or regulatory restrictions prevent us from collecting or using this data, the analysis of our target market and the developing trend of the subject online game may not be accurate. Further, we rely solely on the data provided by our users and do not verify the authenticity of such data. If the information that we collect is materially inaccurate or false, this may also adversely affect our implementation of the online game developing strategy.

We may not be able to adequately protect our intellectual property, and we may be exposed to infringement claims by third parties.

We rely on a combination of copyright, trademark and trade secrecy laws and contractual restrictions on disclosure to protect our intellectual property rights. Our efforts to protect our proprietary rights may not be effective to prevent unauthorized parties from copying or otherwise obtaining and using our technology. Monitoring unauthorized use of our services is difficult and costly, and we cannot be certain that the steps we take will effectively prevent misappropriation of our technology.

From time to time, we may have to resort to litigation to enforce our intellectual property rights, which could result in substantial costs and diversion of our resources. In addition, third parties have initiated litigation against us for alleged infringement of their proprietary rights, and additional claims may arise in the future. In the event of a successful claim of infringement and our failure or inability to develop non-infringing technology or content or license the infringed or similar technology or content on a timely basis, our business could suffer. Moreover, even if we are able to license the infringed or similar technology or content, license fees that we pay to licensors could be substantial or uneconomical. See Item 4.B. “Business Overview—Intellectual Property and Proprietary Rights.”

We may be or become a passive foreign investment company, which could result in adverse U.S. federal income tax consequences to U.S. investors.

We may be classified as a passive foreign investment company, or PFIC, by the U.S. Internal Revenue Service for U.S. federal income tax purposes. Such characterization could result in adverse U.S. federal income tax consequences to you if you are a U.S. investor. For example, U.S. investors who owned our ordinary shares or ADSs during any taxable year in which we were a PFIC generally are subject to increased U.S. tax liabilities and reporting requirements for that taxable year and all succeeding years, regardless of whether we actually continue to be a PFIC, although a shareholder election to terminate such deemed PFIC status may be available in certain circumstances. The same adverse U.S. federal income tax consequences will apply to U.S. investors who acquire our ordinary shares or ADSs during the current taxable year of 2009 or any subsequent taxable year if we are treated as a PFIC for that taxable year.

The determination of whether or not we are a PFIC is made on an annual basis and depends on the composition of our income and assets, including goodwill, from time to time. Specifically, we will be classified as a PFIC for U.S. tax purposes for a taxable year if either (a) 75.0% or more of our gross income for such taxable year is passive income, or (b) 50.0% or more of the average percentage of our assets during such taxable year either produce passive income or are held for the production of passive income. For such purposes, if we directly or indirectly own 25.0% or more of the shares of another corporation, we generally will be treated as if we (a) held directly a proportionate share of the other corporation’s assets, and (b) received directly a proportionate share of the other corporation’s income.

We do not believe that we are currently a PFIC. However, because the PFIC determination is highly fact intensive and made at the end of each taxable year, there can be no assurance that we will not be a PFIC for the current or any future taxable year or that the IRS will not challenge our determination concerning our PFIC status. For further discussion of the adverse U.S. federal income tax consequences of our possible classification as a PFIC, see Item 10.E. “Additional Information – Taxation.”

 

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If our subsidiaries are restricted from paying dividends to us, our primary internal source of funds would decrease.

NetEase.com, Inc. is a holding company with no significant assets other than cash on hand and its equity interests in its directly and indirectly-owned subsidiaries, NetEase Beijing, NetEase Hong Kong, NetEase Interactive Entertainment Ltd., or NetEase Interactive, Boguan, Hong Kong NetEase Interactive, Youdao Information, Guangzhou Interactive, NetEase Hangzhou and Guangzhou NetEase Information Technology Limited, or Guangzhou Information. As a result, our primary internal source of funds is dividend payments from our subsidiaries. If these subsidiaries incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us, which in turn would limit our ability to pay dividends on our ADSs. PRC tax authorities may also require us to amend our contractual arrangements with Guangzhou NetEase, Guangyitong Advertising and their respective shareholders in a manner that would materially and adversely affect the ability of our subsidiaries to pay dividends and other distributions to us. In addition, Chinese legal restrictions permit payment of dividends only out of net income as determined in accordance with Chinese accounting standards and regulations. Under Chinese law, NetEase Beijing, Guangzhou Interactive, Boguan, Guangzhou Information and NetEase Hangzhou are also required to set aside a portion of their net income each year to fund certain reserve funds. These reserves are not distributable as cash dividends. Also see “— We may be treated as a resident enterprise for PRC tax purposes following the promulgation of the new income tax law on January 1, 2008, which may subject us to PRC income tax for our global income and withholding income tax for any dividends we pay to our non-PRC corporate shareholders on profits earned after January 1, 2008.” above for further details.

We are currently in a dispute concerning the purchase of certain property in Guangzhou and may not be able to resolve the dispute satisfactorily.

We occupy a building in Guangzhou with floor space of approximately 20,000 square meters which is owned by a third party property developer, Haobang Industrial and Trading Company Limited, or Haobang. William Lei Ding, our Chief Executive Officer, director and major shareholder, entered into an agreement with Haobang to purchase the property and has paid a deposit, representing substantially all of the purchase price for the property, to Haobang. We requested Mr. Ding to initially purchase the property because we required the office space for our operations but Haobang was not able to issue proper title to it at the time. We also agreed with Mr. Ding that he would on-sell the property to our company at cost once the title and any other legal issues associated with the property were resolved. However, we believe that Haobang has breached its agreement with Mr. Ding by, among other reasons, not completing the registration for the transfer of the title of the property to Mr. Ding and creating a new mortgage on the property. We and Mr. Ding have been negotiating with Haobang regarding these breaches, however, these negotiations have been unsuccessful thus far. We and Mr. Ding have agreed that Mr. Ding would initiate legal action against Haobang at our cost to demand, among others, that it cause the mortgage to be discharged and complete the registration for the transfer of the title of the property to Mr. Ding. Mr. Ding is currently in arbitration proceedings with Haobang, and we deposited RMB82.0 million (US$12.0 million) with a court in Guangzhou as a security deposit in connection with the arbitration proceedings. The arbitration proceedings are currently in the preliminary stage. Mr. Ding has agreed to indemnify our company for any losses or expenses we may incur due to the absence of the title. Nevertheless, we are unsure as to how long the arbitration proceedings will last, how much cost will be incurred by us in connection with the arbitration proceedings, if the dispute can be resolved satisfactorily and to our benefit, or if we will ultimately be able to obtain title of the property. If we are unable to satisfactorily resolve the dispute, we may be required to vacate the property and possibly pay damages to Haobang, including for unpaid rent as noted below, which could materially and adversely affect our operations and our financial condition.

 

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From the date we commenced occupying the property in July 2006 until the present time, we have not paid any rent for the property. However, we can provide no assurance as to whether we will be subject to future demands for past or current rental payments. In addition, we have incurred expenses for various improvements to the property and installations in the aggregate amount of approximately RMB70.1 million (US$10.3 million) as of December 31, 2008. For further details, see Item 7.B. “Related Party Transactions – Purchase of Property in Guangzhou.”

RISKS RELATED TO DOING BUSINESS IN CHINA

The uncertain legal environment in China could limit the legal protections available to you.

The Chinese legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have little precedential value. In the late 1970s, the Chinese government began to promulgate a comprehensive system of laws and regulations governing economic matters. The overall effect of legislation enacted over the past 20 years has significantly enhanced the protections afforded to foreign invested enterprises in China. However, these laws, regulations and legal requirements are relatively recent and are evolving rapidly, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to foreign investors.

Changes in China’s political and economic policies could harm our business.

The economy of China has historically been a planned economy subject to governmental plans and quotas and has, in certain aspects, been transitioning to a more market-oriented economy. Although we believe that the economic reform and the macroeconomic measures adopted by the Chinese government have had a positive effect on the economic development of China, we cannot predict the future direction of these economic reforms or the effects these measures may have on our business, financial position or results of operations. In addition, the Chinese economy differs from the economies of most countries belonging to the Organization for Economic Co-operation and Development, or OECD. These differences include:

 

   

economic structure;

 

   

level of government involvement in the economy;

 

   

level of development;

 

   

level of capital reinvestment;

 

   

control of foreign exchange;

 

   

inflation rates;

 

   

methods of allocating resources; and

 

   

balance of payments position.

 

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As a result of these differences, our business may not develop in the same way or at the same rate as might be expected if the Chinese economy were similar to those of the OECD member countries.

Fluctuation in Renminbi exchange rates could adversely affect the value of our ADSs and any cash dividend declared on them.

The value of the Renminbi may fluctuate according to a number of factors. From 1994 to July 21, 2005, the conversion of Renminbi into foreign currencies, including US dollars, was based on exchange rates published by the People’s Bank of China, which was set daily based on the previous day’s interbank foreign exchange market rates in China and current exchange rates on the world financial markets. During that period, the official exchange rate for the conversion of Renminbi to US dollars was generally stable. However, on July 21, 2005, as a result of the Renminbi being re-pegged to a basket of currencies, the Renminbi was revalued and appreciated against the US dollar. On May 19, 2007, the People’s Bank of China announced a policy to expand the maximum daily floating range of the RMB trading prices against the U.S. dollar in the inter-bank spot foreign exchange market from 0.3% to 0.5%. With this increased floating range, the RMB’s value may appreciate or depreciate significantly against the U.S. dollar in the long term. However, under the current global financial and economic conditions, we are not able to predict with any certainty how the RMB will move vis-à-vis the U.S. dollar in the future. Our revenues are primarily denominated in Renminbi, and any fluctuation in the exchange rate of Renminbi may affect the value of, and dividends, if any, payable on, our ADSs in foreign currency terms.

Restrictions on currency exchange may limit our ability to receive and use our revenues effectively.

Because almost all of our future revenues may be in the form of Renminbi, any future restrictions on currency exchanges may limit our ability to use revenue generated in Renminbi to fund our business activities outside China or to make dividend payments in US dollars. Although the Chinese government introduced regulations in 1996 to allow greater convertibility of the Renminbi for current account transactions, significant restrictions still remain. Current account transactions include payments of dividends and trade and service-related foreign exchange transactions. As a result, our subsidiaries and affiliates in China may purchase foreign exchange for the payment of dividends to NetEase.com, Inc. and of license and content fees to offshore software and content partners.

In contrast, capital account transactions, which include foreign direct investment and loans, must be approved by the State Administration for Foreign Exchange, or SAFE. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the Renminbi, especially with respect to foreign exchange transactions.

All participants in our existing equity compensation plans who are PRC citizens may be required to register with SAFE. We may also face regulatory uncertainties that could restrict our ability to adopt additional equity compensation plans for our directors, employees and other parties under PRC law.

On April 6, 2007, SAFE issued the “Operating Procedures for Administration of Domestic Individuals Participating in the Employee Stock Option Plan or Stock Option Plan of An Overseas Listed Company, Hui Zong Fa [2007] No. 78),” or Circular 78. It is not clear at this time whether Circular 78 covers only equity compensation plans which provide for the grant of stock options or any type of equity compensation plan, such as a plan which authorizes the grant of restricted share awards. For any plans which are so covered and are adopted by a non-PRC listed company such as our company after April 6, 2007, Circular 78 requires all participants who are PRC citizens to register with and obtain approvals from SAFE prior to their participation in the plan. In addition, Circular 78 also requires PRC citizens to register with SAFE and make the necessary applications and filings by July 5, 2007 if they participated in an overseas listed company’s covered equity compensation plan prior to April 6, 2007. We believe that the registration and approval requirements contemplated in Circular 78 will be burdensome and time consuming.

 

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Circular 78 has not yet been made publicly available nor formally promulgated by SAFE, but it is our understanding that SAFE has begun enforcing its provisions. Accordingly, in compliance with Circular 78, we have registered with and obtained approvals from SAFE Beijing office for the participants of our equity compensation plan who are PRC citizens. Nonetheless, we cannot predict whether SAFE will continue to enforce this circular or adopt additional or different requirements with respect to equity compensation plans. Also, regardless of our measures taken in compliance with Circular 78, if it is determined that our equity compensation plans are subject to Circular 78, failure to comply with such provisions may subject us and the participants of our equity compensation plans who are PRC citizens to fines and legal sanctions and prevent us from being able to grant equity compensation to our personnel, which is currently a significant component of the compensation of many of our PRC employees. In that case, our business operations may be materially adversely affected.

The Chinese government has strengthened the regulation of investments made by Chinese residents in offshore companies and reinvestments in China made by these offshore companies. Our business may be adversely affected by these new restrictions.

The SAFE has adopted new regulations that require registration with, and approval from, Chinese government authorities in connection with direct or indirect offshore investment activities by Chinese residents. The SAFE regulations retroactively require registration of investments in non-Chinese companies previously made by Chinese residents. In particular, the SAFE regulations require Chinese residents to file with SAFE information about offshore companies in which they have directly or indirectly invested and to make follow-up filings in connection with certain material transactions involving such offshore companies, such as mergers, acquisitions, capital increases and decreases, external equity investments or equity transfers. In addition, Chinese residents must obtain approval from SAFE before they transfer domestic assets or equity interests in exchange for equity or other property rights in an offshore company. A newly established enterprise in China which receives foreign investments is also now required to provide detailed information about its controlling shareholders and to certify whether it is directly or indirectly controlled by a domestic entity or resident.

In the event that a Chinese shareholder with a direct or indirect stake in an offshore parent company fails to make the required SAFE registration, the Chinese subsidiaries of such offshore parent company may be prohibited from making distributions of profit to the offshore parent and from paying the offshore parent proceeds from any reduction in capital, share transfer or liquidation in respect of the Chinese subsidiaries. Further, failure to comply with the various SAFE registration requirements described above can result in liability under Chinese law for foreign exchange evasion.

These regulations may have a significant impact on our present and future structuring and investment. To comply with these regulations, our founder, Chief Executive Officer and director, William Lei Ding, has successfully filed with Guangdong Branch of SAFE information about NetEase.com, Inc. and other offshore companies in which he has direct or indirect shareholding. We intend to take all necessary measures for ensuring that all required applications and filings will be duly made and all other requirements will be met. We further intend to structure and execute our future offshore acquisitions in a manner consistent with the new regulations and any other relevant legislation. However, because it is presently uncertain how the SAFE regulations, and any future legislation concerning offshore or cross-border transactions, will be interpreted and implemented by the relevant government authorities in connection with our future offshore financings or acquisitions, we cannot provide any assurances that we will be able to comply with, qualify under, or obtain any approvals required by the regulations or other legislation.

 

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Furthermore, we cannot assure you that any PRC shareholders of our company or any PRC company into which we invest will be able to comply with those requirements. The inability of our company or any PRC shareholder to secure required approvals or registrations in connection with our future offshore financings or acquisitions may subject us to legal sanctions, restrict our ability to pay dividends from our Chinese subsidiaries to our offshore holding company, and restrict our overseas or cross-border investment activities or affect our ownership structure.

RISKS RELATED TO THE TELECOMMUNICATIONS AND INTERNET INDUSTRIES IN CHINA

Government regulation of the telecommunications and Internet industries may become more burdensome.

Government regulation of the telecommunications and Internet industries is burdensome and may become more burdensome. New regulations could increase our costs of doing business and prevent us from efficiently delivering our services. These regulations may stop or slow down the expansion of our customer and user base and limit the access to the NetEase websites.

Increased government regulation of the telecommunications and Internet industries in China may result in the Chinese government requiring us to obtain additional licenses or other governmental approvals to conduct our business which, if unattainable, may restrict our operations.

The telecommunications industry, including Internet content provider, or ICP, services and online games, is highly regulated by the Chinese government, the main relevant government authority being the MII. Prior to China’s entry into the World Trade Organization, or WTO, the Chinese government generally prohibited foreign investors from taking any equity ownership in or operating any telecommunications business. ICP services are classified as telecommunications value-added services and therefore fell within the scope of this prohibition. This prohibition was partially lifted following China’s entry into the WTO. Pursuant to the Administrative Rules for Foreign Investments in Telecommunications Enterprises promulgated by the State Council dated December 5, 2001, foreign investors are allowed to hold in the aggregate up to 50.0% of the total equity in any value-added telecommunications business in China. In addition, foreign and foreign invested enterprises are currently not able to apply for the required licenses for operating online games in China.

To operate the NetEase websites in compliance with all the relevant ICP-related Chinese regulations, Guangzhou NetEase successfully obtained ICP licenses issued by the Guangdong Provincial Telecommunications Bureau in 2000. The ICP license of Guangzhou NetEase issued by the Guangzhou Provincial Telecommunications Bureau was replaced by the Value-Added Telecommunication Operating License issued by the MII in 2004. Guangzhou NetEase has also obtained the following licenses and registrations: a commercial website registration with the Beijing Municipal Administrative Bureau of Industry and Commerce, an audio-visual product operating license issued by Guangdong Culture Department to sell audio-visual products in Internet, an Internet publishing license issued by General Administration of Press and Publication, an Internet culture operating license for online game activities issued by the Ministry of Culture, or MOC, a license for online dissemination of drug-related information issued by Guangdong Food and Drug Administration, an internet news information service license issued by the State Council Information Office, a permit for the Network Transmission of Audiovisual Programs issued by the State Administration of Radio, Film and Television, a permit for the production of audiovisual programs issued by the Radio, Film and Television Administration of Guangdong and a license for the sale of security products for computer information systems issued by the Ministry of Public Security.

 

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It has also received approvals for online dissemination of health information from the Department of Health of Guangdong Province and approvals for provision of online education-related information from the Department of Education of Guangdong Province. NetEase.com, Inc. relies exclusively on contractual arrangements with Guangzhou NetEase and its approvals to operate as an Internet content provider. In addition, to operate the online games licensed by Blizzard in compliance with all the relevant ICP-related Chinese regulations, Shanghai EaseNet obtained a Value-Added Telecommunications Business Operating License issued by Shanghai Provincial Telecommunications Bureau in October 2008 and an Internet Culture Operating License from MOC in October 2008. In addition, Shanghai EaseNet is currently in the process of obtaining an Internet Publishing License from the General Administration of Press and Publication, or GAPP.

However, we cannot be certain that we or our affiliates will be granted any other additional license, permit or clearance we may need in the future. Moreover, we cannot be certain that any local or national ICP or telecommunications license requirements will not conflict with one another or that any given license will be deemed sufficient by the relevant governmental authorities for the provision of our services. The PRC began several years ago to regulate its Internet sector by making pronouncements or enacting regulations regarding the legality of foreign investment in the PRC Internet sector and the existence and enforcement of content restrictions on the Internet. We believe that our current ownership structure complies with all existing PRC laws, rules and regulations. There are, however, substantial uncertainties regarding the interpretation of current PRC Internet laws and regulations. The PRC government may issue new interpretations of the regulations regarding supervision of the Information industry from time to time. In July 2006, the MII issued a notice to strengthen management of foreign investment in and operation of value-added telecommunication services. The notice emphasizes that foreign investors who wish to engage in value-added telecommunication services must strictly follow the relevant rules and regulations on foreign investment in telecommunication sectors. The notice also prohibits domestic telecommunication services providers from leasing, transferring or selling telecommunications business operating licenses to any foreign investor in any form, or providing any resources, sites or facilities to any foreign investor for their illegal operation of a telecommunications business in China. According to the notice, either the holder of a value-added telecommunication service license or its shareholders must directly own the domain names and trademarks used by such license holders in their provision of value-added telecommunication services. The notice further requires each license holder to have the necessary facilities, including servers, for its approved business operations and to maintain such facilities in the regions covered by its license. Value-added services license holders are required to evaluate the compliance with the requirements set forth in the notice. To comply with these requirements, Guangzhou NetEase submitted its self-correction report to MII in 2007.

In addition, we are uncertain as to whether the Chinese government will reclassify our business as a media or retail company, due to our acceptance of fees for Internet advertising, online games and wireless value-added and other services as sources of revenues, or as a result of our current corporate structure. Such reclassification could subject us to penalties or fines or significant restrictions on our business. In addition, NetEase.com, Inc. may have difficulties enforcing its rights under the agreements with Guangzhou NetEase and Guangyitong Advertising if any of these parties breaches any of the agreements with them because NetEase.com, Inc. does not have approval from appropriate Chinese authorities to provide Internet content services, Internet advertising services or wireless value-added services. Future changes in Chinese government policies affecting the provision of information services, including the provision of online services, Internet access, e-commerce services and online advertising, may impose additional regulatory requirements on us or our service providers or otherwise harm our business.

 

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The PRC government has intensified its regulation of Internet cafés, which are currently one of the primary venues for our users to access the NetEase websites and our services, especially online games. Intensified government regulation of Internet cafés could restrict our ability to maintain or increase our revenues and expand our customer base.

In April 2001, the PRC government began tightening its regulation and supervision of Internet cafés, at which many of our users access the NetEase websites and our services, especially online games. In particular, a large number of unlicensed Internet cafés have been closed. In addition, the PRC government has imposed higher capital and facility requirements for the establishment of Internet cafés. Furthermore, the PRC government’s policy, which encourages the development of a limited number of national and regional Internet cafe chains and discourages the establishment of independent Internet cafés, may slow down the growth of Internet cafés. In addition, in 2007 the State Administration of Industry and Commerce, one of the government agencies in charge of Internet cafe licensing, and other government agencies jointly issued a notice temporarily suspending the issuance of new Internet cafe licenses for a period of six months. So long as Internet cafés are one of the primary venues for our users to access the NetEase websites and our services, any reduction in the number, or any slowdown in the growth, of Internet cafés in China could limit our ability to maintain or increase our revenues and expand our customer base, thereby reducing our profitability and growth prospects.

The Chinese government has taken steps to limit online game playing time for all minors. These and any other new restrictions may materially and adversely impact our business and results of operations.

As part of its anti-addiction online game policy, the Chinese government has taken several steps to discourage minors under the age of 18 from continuously playing online games once they exceed a set number of hours of continuous play. For example, in July 2005, the MOC and the MII jointly issued an opinion which requires online game operators to develop systems and software for identity certification, to implement anti-addiction modifications to game rules and to restrict players under eighteen years of age from playing certain games. Subsequently, in August 2005, GAPP proposed an online game anti-addiction system that would have reduced and eliminated experience points that a user can accumulate after three and five hours of consecutive playing, respectively. In March 2006, GAPP amended its proposal to require players to register with their real names and identity card numbers and to apply the anti-addiction system only to players under eighteen years of age. In April 2007, GAPP and several other government authorities jointly promulgated the Notice Concerning the Protection of Minors’ Physical and Mental Well-being and Implementation of Anti-addiction System on Online Games, or the Notice, which confirmed the real-name verification proposal and requires online game operators to develop and test their anti-addiction systems from April 2007 to July 2007, after which no online games can be registered or operated without an anti-addiction system in accordance with the Notice. Accordingly, we have implemented our anti-addiction system to comply with the Notice. Since its implementation, we have not experienced a significant negative impact on our business as a result of the Notice.

However, it has been reported in the Chinese media that the Chinese government has concerns about the social impact of online games, and it may impose additional regulatory restrictions on us, our customers or otherwise take actions that harm our business.

The Chinese government has not enacted any laws regarding virtual asset property rights and, accordingly, it is not clear what liabilities, if any, online game providers may have for virtual assets.

One of the features of our MMORPGs which helps to build a large user base and maintain loyalty is that users can accumulate virtual tools, powers and rankings as they play the games. We believe that these virtual assets are highly valued by our users, particularly long-term users, and are traded among users. However, on occasion, such assets can be lost if, for example, a users’ identity is stolen by another user or we experience a system error or crash. The Chinese government has not enacted any laws regarding virtual assert property rights.

 

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Accordingly, we have no basis to determine what are the legal rights, if any, associated with virtual assets and what liabilities we could be exposed to for the loss or destruction of virtual assets. We could therefore potentially be held liable for the way in which we handle and protect virtual assets.

We may be unable to compete successfully against new entrants and established industry competitors.

The Chinese market for Internet content and services is intensely competitive and rapidly changing. Many companies offer competitive products or services including online games, Chinese language-based Web search, retrieval and navigation services, wireless value-added services and extensive Chinese language content, informational and community features and e-mail. In addition, as a consequence of China joining the WTO, the Chinese government has partially lifted restrictions on foreign-invested enterprises so that foreign investors may hold in the aggregate up to 50% of the total equity ownership in any value-added telecommunications business, including an Internet business, in China.

Currently, our competition comes from Chinese language-based Internet portal companies as well as US-based portal companies. Some of our current and potential competitors are much larger than we are, and currently offer, and could further develop or acquire, content and services that compete with the NetEase websites. We also face competition from online game developers and operators, Internet service providers, wireless value-added service providers, website operators and providers of Web browser software that incorporate search and retrieval features. With respect to online games, we believe that more competitors are entering this market in China and that our competitors are becoming more active in both licensing foreign-developed games and developing games in-house, which trends, if they continue, could adversely affect our online games revenues in the future. We believe that competition in the online advertising industry in China has intensified recently as new entrants have come into the market, such as Baidu, Tencent, Alibaba and other vertical Internet portals. Any of our present or future competitors may offer products and services that provide significant performance, price, creativity or other advantages over those offered by us and, therefore, achieve greater market acceptance than ours.

Because many of our existing competitors as well as a number of potential competitors have longer operating histories in the Internet market, greater name and brand recognition, better connections with the Chinese government, larger customer bases and databases and significantly greater financial, technical and marketing resources than we have, we cannot assure you that we will be able to compete successfully against our current or future competitors. Any increased competition could reduce page views, make it difficult for us to attract and retain users, reduce or eliminate our market share, lower our profit margins and reduce our revenues.

 

Item 4. Information on the Company

 

A. History and Development of the Company

Our business was founded in June 1997, and we began offering search services and free Web-based e-mail starting mid-1997 and early-1998, respectively. In mid-1998, we changed our business model from a software developer to an Internet technology company and commenced developing the NetEase websites. In mid-1999, we established our advertising sales force to sell advertisements on the NetEase websites and also began to offer e-commerce platforms and to provide online shopping mall and other e-commerce services in China through Guangzhou NetEase, a related party.

 

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In 2001, we also began focusing on fee-based premium services and online entertainment services, including online games, wireless value-added services, premium e-mail services and other subscription-type services. We also developed our own proprietary Internet search engine, Youdao (formerly named Yodao), which was launched in December 2007 and is free of charge to users.

In connection with the restructuring of our operations which is discussed below in Item 7.B. “Major Shareholders and Related Party Transactions—Related Party Transactions,” NetEase.com, Inc. was incorporated in the Cayman Islands on July 6, 1999, and it operates under the Cayman Islands Companies Law (2007 Revision). Our principal executive offices are located at 26/F, SP Tower D, Tsinghua Science Park Building 8, No.1 Zhongguancun East Road, Haidian District, Beijing, People’s Republic of China 100084. Our telephone number is (86-10) 8255-8163. Our agent for service of process in the United States is CT Corporation System, 111 Eighth Avenue, New York, New York 10011.

Our principal capital expenditures for 2008 consisted mainly of office renovations, furniture and fixtures, computer equipment, software costs and construction in progress for a total of approximately RMB133.3 million (US$19.5 million). Our principal capital expenditures for 2006 and 2007 also consisted mainly of computer equipment as well as software for a total of RMB142.5 million and RMB71.5 million, respectively.

As of December 31, 2008, our subsidiary NetEase Hangzhou paid RMB27.8 million (US$4.1 million) for the purchase of the right to use approximately 56,000 square meters of land in Hangzhou. In June 2008, we received a subsidy from the local office of the PRC Ministry of Finance in Hangzhou of RMB15.0 million for the purchase of the land use right. We expect to spend a total of approximately RMB322.2 million (US$47.2 million) for the construction of buildings for a portion of our online game research and development team on such land. As of December 31, 2008, we had spent RMB111.7 million (US$16.4 million) for the construction work of the buildings. We expect to spend an additional RMB210.5 million (US$30.9 million) in 2009 and the following one to two years. Certain contracts have been signed for this expected spending and the related outstanding commitment as of December 31, 2008 was RMB94.6 million (US$13.9 million).

We made additional capital expenditures of approximately RMB23.0 million (US$3.4 million) from January 1, 2009 to March 31, 2009, principally for purchases of additional servers and computer equipment in order to accommodate the expected increase in usage of our online games and free email services and, to a lesser extent, for increased traffic on the NetEase websites, as well as for certain construction related to the Hangzhou property mentioned above. Our capital expenditure plans for server and computer equipment for the period from April 1, 2009 to December 31, 2009 have not yet been fixed, but we expect to spend an additional approximately RMB90.0 million (US$13.2 million), primarily for the same purposes. Certain contracts have been signed for this expected spending, and the related outstanding commitment as of December 31, 2008 was RMB4.2 million (US$0.6 million).

In addition, in connection with the licensing of certain online games by Blizzard to Shanghai EaseNet for operation in the PRC, on behalf of Shanghai EaseNet as licensee of the games, we have paid to Blizzard an aggregate of RMB232.0 million (US$34.0 million) as initial license fees as of May 31, 2009. Over the three-year terms of the licenses, Shanghai EaseNet is also required to pay royalties and consultancy fees to Blizzard for the games, and it also has a minimum marketing expenditure commitment. Shanghai EaseNet is also obligated to provide funds for hardware to operate the games. For further details, see Item 4.B. “Business Overview – Our Services – Game Licensing and Joint Venture with Blizzard.” Our capital expenditures in 2009 have been, and are expected to continue to be, funded by operating cash flows and our existing capital resources.

 

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B. Business Overview

OVERVIEW

Through our subsidiaries and contracts with our affiliates Guangzhou NetEase, Guangyitong Advertising and Shanghai EaseNet and their respective shareholders, we operate a leading interactive online community in China and are a major provider of Chinese language content and services through our online games, Internet portal and wireless value-added services businesses.

We generate revenues from fees we charge users of our online games and from selling advertisements on the NetEase websites, and to a much lesser extent, of wireless value-added and other fee-based premium services. Our basic service offerings on the NetEase websites are available without charge to our users.

Our ability to leverage our portal traffic to generate revenues in online gaming and advertising services is a key component of our growth strategy.

Online Games Services

Our online games business focuses on offering massively multi-player online games, more specifically role-playing games, to the Chinese market. These MMORPGs, as they are commonly known, are played over the Internet in “virtual worlds” that exist on networked game servers to which thousands of players simultaneously connect and interact. We develop and operate MMORPGs that are targeted at or localized to the Chinese market, and we strive to provide the highest quality game playing experience to our users. In addition, in August 2008 and April 2009 Blizzard agreed to license certain online games to Shanghai EaseNet for operation in the PRC, as discussed below under “Our Services – Game Licensing and Joint Venture with Blizzard”.

To pay for MMORPG playing time, players use our proprietary prepaid point system by purchasing physical point cards or virtual point cards online. We work with a wide range of distributors to distribute our point cards to gamers across China. Point card distribution channels include wholesalers, Internet cafés, software stores, supermarkets, bookstores and newspaper stands, as well as convenience stores mainly in Guangzhou Province, Shanghai and Beijing and in several second tier cities. In addition to this pay-to-play revenue model, the open beta version of our item-based online games, Tianxia II and Legend of Westward Journey, were launched in June and September 2008, respectively. We plan to launch other new games using the item-based revenue model in the second half of 2009.

We have also developed an online casual game platform with various multi-player games.

Our Portal

The NetEase websites provide Internet users with Chinese language online services centered around three core service categories—content, community and communication. Our wide range of content appeals to a broad audience group spanning all age groups. However, our services are particularly popular among younger audiences between the ages of 19 and 34. We are continually working to reinforce our leadership position through premium content and service development and innovation.

 

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Content

The NetEase content channels provide news, information and online entertainment to the Chinese public. The websites consolidate and distribute content from more than one hundred international and domestic content providers. Content is distributed through various channels, including channels focusing on news, entertainment, sports, finance, information technology and automobiles.

Community and Communication

The NetEase websites provide a broad array of free and fee-based community and communication services, including e-mail, blogging, photos, instant messaging, matchmaking, alumni directories, clubs, e-cards, chat rooms and community forums.

Other

In addition to the services described above, the NetEase websites provide other services to our users, including a website directory and web pages search service. Additionally, we developed our own proprietary Internet search engine, Youdao, which was launched in December 2007 and is free of charge to users.

Among the various free and fee-based services that we offer through our portal, we derived most of our revenue in 2008 from online games and advertising services.

Advertising Services

Our large and growing user base attracts well-known advertisers to our web sites. The various content channels and wide range of online services offered through our Internet portal forms an effective medium for our clients to conduct integrated marketing campaigns to the millions of loyal NetEase users. Our online advertising offerings include banner advertising, channel sponsorships, direct e-mail, interactive media-rich sites, sponsored special events, games, contests and other activities.

Wireless Value-Added Services

We offer a wide range of wireless value-added services, or WVAS, which allow users to receive news and other information, such as stock quotes and e-mails, download ringtones and logos for their mobile phones and participate in matchmaking communities and interactive games. Combining content from our Internet portal with mobile applications we have developed in-house, we can rapidly develop sophisticated WVAS.

OUR ORGANIZATIONAL STRUCTURE

We conduct our business in China solely through our subsidiaries, NetEase Beijing, Youdao Information, Boguan, Guangzhou Interactive and NetEase Hangzhou.

Under current Chinese regulations, there are restrictions on the percentage interest foreign or foreign-invested companies may have in Chinese companies providing value-added telecommunications services in China, which include the provision of Internet content, online games and wireless value-added services. In addition, the operation by foreign or foreign-invested companies of advertising businesses in China is subject to government approval.

 

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In order to comply with these restrictions and other Chinese rules and regulations, NetEase.com, Inc. and certain of its subsidiaries have entered into a series of contractual arrangements for the provision of such services with certain affiliated companies, namely Guangzhou NetEase and Guangyitong Advertising. Under the contracts, we provide our Internet and wireless value-added applications, services and technologies and advertising services to Guangzhou NetEase and Guangyitong Advertising and they operate the NetEase websites and the online advertising business. For more information on these agreements, see Item 7.B. “Major Shareholders and Related Party Transactions—Related Party Transactions.”

Under our agreements with Guangzhou NetEase, we have agreed to pay its operating costs. Under our agreements with Guangyitong Advertising, we have agreed to provide performance guarantees and guarantee loans for working capital purposes to the extent required by Guangyitong Advertising for its operations. Guangzhou NetEase and Guangyitong Advertising are each prohibited from incurring any debt without our prior approval.

Guangzhou NetEase is 90% beneficially owned by our founder, Chief Executive Officer and major shareholder, William Lei Ding, and 10% owned by his brother, Bo Ding. Guangyitong Advertising is 80% owned by Guangzhou NetEase and 20% owned by Bo Ding. We do not have any direct ownership interest in Guangzhou NetEase or Guangyitong Advertising.

As a result of our contractual arrangements with these two companies, we bear the risks of, and enjoy the rewards associated with, and therefore are the primary beneficiary of our investments in Guangzhou NetEase and Guangyitong Advertising, and we have begun to consolidate their results of operations in our historical consolidated financial statements commencing in the fiscal year 2004. See also Item 5 “Operating and Financial Review and Prospects.”

Any violations by Guangzhou NetEase or Guangyitong Advertising of our agreements with them could disrupt our operations, degrade our services or shut down our services. See Item 3.D. “Risk Factors” for a detailed discussion of the risks to NetEase.com, Inc. regarding its dependency on Guangzhou NetEase and Guangyitong Advertising.

In August 2008 and April 2009, Blizzard agreed to license certain online games to Shanghai EaseNet for operation in the PRC. Shanghai EaseNet is a PRC company owned by William Lei Ding, our Chief Executive Officer, director and major shareholder and has contractual arrangement with the joint venture established between, and owned equally by, Blizzard and us, and with us. The joint venture was established concurrently with the licensing of the games in August 2008 and will provide technical services to Shanghai EaseNet.

 

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The following diagram shows the group structure of our subsidiaries and affiliated companies.

LOGO

 

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The affiliated variable interest entities shown in the box above are controlled by NetEase.com, Inc. through contractual arrangements between it and its subsidiaries, on the one hand, and the affiliated variable interest entities and their shareholders, on the other hand.

In 2007, we established two intermediate holding companies, NetEase Hong Kong and Hong Kong NetEase Interactive. In June 2008, we established Guangzhou NetEase Information Technology Limited, or Guangzhou Information. In April 2009, Hangzhou Leihuo Network Co., Ltd., or Hangzhou Leihuo was established. The shareholders of Hangzhou Leihuo are Chinese citizens who are employees of NetEase Hangzhou.

The 27.0% equity interests in Youdao Information and Beijing NetEase Youdao Computer System Co., Ltd. (formerly named Beijing NetEase Yodao Computer System Co., Ltd.), or Youdao Computer, are Chinese citizens who are employees of Youdao Information. Youdao Computer obtained an ICP license in June 2008, and it hosts the website of www.youdao.com and owns and operates our own proprietary internet search engine, Youdao.

OUR SERVICES

Online Games

Massively Multi-player Online Role-Playing Games

We launched our first MMORPG, Westward Journey Online, in December 2001 and began charging users for playing time beginning in January 2002. Subsequently, we launched Westward Journey Online II in August 2002 and our second in-house developed MMORPG, Fantasy Westward Journey, in January 2004. For the month of December 2008, peak concurrent users for this game reached over 1.8 million.

In addition, we developed a 3D item-based MMORPG named New Fly For Fun using certain graphics licensed from a South Korean company, and its open beta testing version was launched in October 2008. We commercially launched our first 2.5D game, Datang, in July 2006, and Westward Journey Online III, an enhanced version of our popular Westward Journey game series, in September 2007. The open beta testing versions of Tianxia II and Legend of Westward Journey, our item-based games, were launched in June and September 2008, respectively. We also launched an expansion pack of Tianxia II in September 2008, and both the number of online players and consumption level of in-game items have grown steadily since the commencement of its open beta testing in June 2008. In addition, we are in the process of developing a new version of Datang, Datang II (Heroes of Tang Dynasty), and several item-based games, but we cannot predict if or when such new versions will be commercially launched.

For the month ended December 31, 2008, our time-based online games in the aggregate had 864,419 average concurrent users, or ACU. The following table sets forth the average number of concurrent users for each of our MMORPG game titles for the periods indicated:

 

     ACU for the month ended
December 31,
     2006    2007    2008

Fantasy Westward Journey

   453,295    546,135    617,293

Westward Journey Online II

   174,209    153,748    198,925

Datang

   13,326    8,349    4,431

Westward Journey Online III

   —      49,598    43,770

 

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Our MMORPG titles can be accessed from any location with an Internet connection by registered users of the NetEase websites. Users may enter our network with a password and a user-ID, after downloading our installation software or purchasing such software on a CD-ROM. Players of these games select a specific character to begin play. Over the course of play, these characters build up experience and enhanced game capabilities, wealth, weapons and other possessions, all of which may be carried over into subsequent gaming sessions. Players develop their characters according to choices they make within the construct of the game. Players also interact with computer operated characters as well as with other players that are playing on the same network server. Players are able to communicate with each other during the game through instant messaging or chatting features, allowing them to coordinate their activities with other players to form groups and achieve collective objectives.

Game play is monitored by game masters, who appear as game characters within the game world and provide assistance and guidance to players, as well as policing behavior of players in the game world to maintain an atmosphere of fun and fair play.

Game content and game-play features are expanded through the development of expansion packs, which are released periodically for each game and which contribute to the ongoing popularity of the game.

Casual Games

In 2005, we launched an online casual game platform which has various multi-player games such as billiards, card games and mahjong. Casual games are easier to play than MMORPGs and can be played to a conclusion within a short period of time. The basic versions of such games are available free-of-charge, and we sell virtual game enhancements, such as options for changing the appearance of the game-play or advanced tools, which players can use in the game, utilizing our prepaid point system. As of December 31, 2008, we had 31 casual games, including three advanced casual games that offer a greater variety to users (collectively, excluding the three advanced casual games, referred to as Popo Game).

Customer Service

We believe that providing strong, dependable customer support is a key component to success in the online games business. Our customer service center provides 24 hour-a-day customer service and technical support and can be contacted via telephone or e-mail. As of December 31, 2008, our company employed approximately 435 personnel in our call center as customer service specialists for our online games as well as for our other services.

User Fees

Users of Fantasy Westward Journey, Westward Journey Online II, Datang and Westward Journey Online III pay fees according to the amount of time they play the games, which is currently RMB0.40 (US$0.06) per hour for each game. For our recently launched item-based games, Tianxia II and Legend of Westward Journey, we charge users a separate fee for each virtual item purchased within the games.

 

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In connection with the introduction of our online games, we developed a prepaid point card to facilitate payment of fees for our online game services and, to a lesser extent, our other fee-based value-added services. Users can buy prepaid point cards at a variety of locations in China, including Internet cafés, convenience stores, software stores, bookstores and newspaper stands. Electronic point cards can also be purchased through credit cards or online e-sales systems through which players can directly credit their accounts at Internet cafés or computer stores. Each prepaid card contains an account number and a password. The points represented by these cards can then be transferred into users’ individual accounts on the NetEase websites and used to pay for our online services, primarily playing time for online games. We also utilize our point cards for the payment of virtual items as we launch item-based games for which playing time is free and players may purchase various virtual items to enhance their game-playing experience.

Revenues from our online games accounted for 84.6%, 84.4% and 85.2% of total net revenues in 2006, 2007 and 2008, respectively.

Game Licensing and Joint Venture with Blizzard

In August 2008, Blizzard agreed to license to Shanghai EaseNet on an exclusive basis in the PRC three personal computer strategy games: StarCraft II, a sequel to Blizzard’s highly popular space-themed game, which is currently in development; Warcraft III: Reign of Chaos, a fantasy-themed game; and Warcraft III: The Frozen Throne, an expansion pack to Warcraft III: Reign of Chaos. Blizzard will also license on an exclusive basis its Battle.net platform which enables multiplayer interaction within these games and other online services. The term of the license will be three years, with an additional one year extension upon agreement of the parties, commencing from the commercial release of StarCraft II in the PRC. StarCraft II has not been launched yet. Blizzard is a leading developer and publisher of online games and a subsidiary of Activision Blizzard, Inc., which is a leading online game, personal computer, console and hand-held game publisher based in the U.S. Shanghai EaseNet is a PRC company owned by William Lei Ding, our Chief Executive Officer, director and major shareholder, and has contractual arrangements with the joint venture established between Blizzard and us which is discussed below, and with us.

On behalf of Shanghai EaseNet as licensee of the above mentioned games, we have paid to Blizzard RMB27.5 million (US$4.0 million) as an initial license fee as of December 31, 2008, with an additional RMB40.9 million (US$6.0 million) to be paid as an initial license fee upon the commencement of open beta testing and commercial release in the PRC of a localized version of Blizzard’s Battle.net platform. In addition, Shanghai EaseNet has committed to pay royalties and consultancy fees to Blizzard and a minimum marketing expenditure and hardware support for the above-mentioned games in the aggregate of at least RMB592.8 million (US$86.9 million) over the three-year term of the license.

We have guaranteed the payment of the foregoing amounts if and to the extent Shanghai EaseNet has insufficient funds to make such payments. We will be entitled to reimbursement of any amounts paid for the marketing of the games and hardware support to operate the games under the guarantee from any net profits subsequently generated by Shanghai EaseNet, after the deduction of, among others, various fees and expenses payable to Blizzard, us and our joint venture with Blizzard which will provide technical services to Shanghai EaseNet.

Blizzard has the right to terminate the license of the foregoing games under certain circumstances.

Concurrently with the licensing of the foregoing games, we entered into arrangements to establish a joint venture with Blizzard. The joint venture will provide technical services to Shanghai EaseNet in return for a fee. Net profits of the joint venture will be shared equally between Blizzard and us, after the deduction of, among others, various fees and expenses payable to Blizzard and us.

 

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In addition, in April 2009 Blizzard agreed to license on an exclusive basis in the PRC World of Warcraft, one of the most popular MMORPGs worldwide, to Shanghai EaseNet, following the expiration of its current license agreement with The9 in June 2009. The term of the license will be three years, with an additional one year extension upon agreement of the parties, commencing from the commercial release of localized World of Warcraft in the PRC. World of Warcraft ceased operation during the transition period from the prior licensee and operator of the game in the PRC, The9, to Shanghai EaseNet.

Internet Portal

Our Internet portal business, which is conducted through the NetEase websites, offers Chinese Internet users a network of Chinese language-based online content channels, community and communication services, including e-mail, instant messaging, and blogging. We also offer other Web-based applications and services, including a full text Chinese language search engine and a Web directory, to enhance their Internet experience. Our Internet services are all designed with user friendly interfaces and easy to understand instructions.

Our website content and services attract a large number of visitors who generate page views, which form the audience for us to provide advertising services for advertisers on our websites.

Users

The NetEase websites have registered and unregistered users. Any user may visit the NetEase websites without registering. Both registered and unregistered users generate page views when they visit our website. Only registered users can use our personalized services such as our free e-mail system and instant messaging, and our fee-based premium services such as our premium e-mail and dating services. Additionally, when registering an account, NetEase users are asked to provide us with demographic and preference information that better allow us to identify and target audiences with relevant online advertising.

Content

The main homepage of the NetEase websites, www.163.com, provides a destination for Chinese Internet users to identify and access resources, services, content and information on the Internet. The NetEase websites aggregate, organize and deliver information to meet the needs of Internet users in China. Our media channels provide users with an efficient and easy way to explore and utilize a wealth of information and content organized around a variety of topics.

The NetEase websites currently include various channels focusing on news, entertainment, sports, finance, information technology and automobiles.

Our content distribution platform enables the NetEase websites to offer in-depth local content as well as a variety of locally relevant regional and international content. We do not produce our own content for the NetEase websites, but rather obtain content from our content partners. Our content partners display their content on one or more of the NetEase websites and media channels free of charge or in exchange for a share of revenue, a licensing fee, online advertising, access to original content produced by the NetEase user community or a combination of these arrangements. We distribute this content through our content distribution system to Guangzhou NetEase, which determines the appropriate content to publish on the NetEase websites and to distribute to users of our wireless value-added services. Our content alliances are generally non-exclusive.

 

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We believe that the breadth and relevance of our content offerings increases the number of visits our users make to the NetEase websites and the amount of time they spend on these sites. We adopt a significant amount of user-generated content from the community forums on the NetEase websites. We believe that this user-generated content is highly effective in maintaining user interest and ensuring repeat visits to the NetEase websites.

Community and Communication

The NetEase websites have established a large online community member base as a result of our leading online community technology. We launched what we believe to be one of the first online communities in China in December 1998. Users can register with us online to interact with other registered community members. We believe that as users become more involved with our online community, they will return to the NetEase websites frequently.

NetEase users can interact through a variety of community services. They include:

 

   

E-mail. We provide registered users with free and fee-based premium Web-based e-mail services which support both the Chinese and English languages. Registered users can access and send e-mail through their Web browsers or through the POP3 and SMTP standards, which allow users to handle e-mails on their own e-mail applications without opening their browsers. The free Web-based e-mail service also includes free SPAM filters and anti-virus protection as well as the convenience of an address book to maintain user contact lists online. As of December 31, 2008, we had approximately 290 million registered free email users. We also offer value-added e-mail services for individuals, known as VIP, which provide fee-paying subscribers with the latest anti-virus and anti-SPAM filtering capabilities. The VIP e-mail service also includes enhanced security features as well as several convenient online and offline payment methods and 24-hour customer support. As of December 31, 2008, we had approximately 593,000 active VIP e-mail subscribers.

 

   

Online Community Forums. We offer NetEase registered community members a variety of community forums where they can post messages and articles for viewing by other registered community members and other users. The NetEase online communities are hosted by volunteers, who are chosen by us based on their contributions to the communities. The NetEase community volunteers monitor our community forums and select appropriate articles for posting. In addition, these forums are also monitored by NetEase customer service personnel.

 

   

Instant Messaging. We offer NetEase registered users a communications platform to notify their online friends and other users with similar interests when they are online and to send and receive text messages seen by both parties nearly instantaneously, allowing NetEase registered users to participate in real-time dialogues. Users can access this service by downloading free software from the NetEase websites. During December 2008, we had approximately 73,000 peak concurrent users of our instant messaging service.

 

   

Matchmaking and Others. We offer a large number of other community services including online matchmaking services, a dedicated dating center, online greeting cards, chat rooms, alumni directories, photo album sharing, diary and blogging. Several of these services have significant subscriber bases. For example, our online matchmaking service had approximately 9.4 million accumulated registered accounts and approximately 45,000 subscribers as of December 31, 2008.

 

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Other

In addition to the services described above, the NetEase websites provide other services to our users including web search, blog search, image search, news search, online dictionary, desktop dictionary, toolbar and RSS reader, which automatically retrieves syndicated web contents and customized set of search results. Our web search service was powered by the Google search engine until July 2007. Subsequently, our web search service was powered by our own proprietary Internet search engine, Youdao, which was officially launched in December 2007. The domain name of Youdao, www.youdao.com, is owned by Youdao Computer.

Advertising Services on the Websites

We provide advertising services for advertisers on our websites, utilizing many advertising formats and techniques. These include sponsorships of our channels, advertisements such as animated and interactive banners, floating buttons, text-links and other formats throughout our websites, advertising through targeted e-mail campaigns, interactive media-rich sites, and sponsored special events that integrate live events with online promotion and other media.

Furthermore, we perform analyses of our registered users’ habits and preferences on a frequent basis and have used that information to tailor our advertising services. For example, we can deliver direct marketing advertisements via e-mail to users who fit within certain criteria based on their user profile. By developing user profiles and user behavior analyses, we intend to increase our ability to target specific user groups and thereby identify users who are attractive to online advertisers.

Fees and Revenues

Revenue generated by our Internet portal business consists mainly of fees we receive from our fee-based premium services and revenue earned from the sale of advertising space on the NetEase websites.

Generally, we price the services associated with our Internet portal as follows:

 

Service

  

Pricing

Basic Services, including:    Free of charge

•   content services (such as news, local information, finance and weather);

  

•   chat rooms;

  

•   basic e-mail services;

  

•   basic personal ads;

  

•   basic matchmaking;

  

•   basic alumni clubs;

  

•   photo album;

  

•   diary;

  

•   blogging;

  

•   clubs;

  

 

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•   dictionary;

  

•   Electronic greeting cards;

  

•   instant messaging PC to PC;

  

•   web directories;

  

•   web searching (Youdao); and

  

•   online shopping mall.

  
Fee-Based Premium Services, including:    Monthly subscription basis (ranges from RMB6.0 (US$0.9) to RMB60.0 (US$8.8) per month)

 

•   premium e-mail services;

  

•   premium matchmaking and dating services; and

  

•   premium alumni clubs.

  
Advertising Services, including:    Varies depending on service (see below).

•   channel sponsorship;

  

•   banner advertising;

  

•   direct e-mail; and

  

•   sponsored special events.

  

Pricing for our advertising services has varied based on a number of factors including the duration for which advertisements appear on the NetEase websites, how often such Web pages are viewed by users and the number of users that perform a specific action, such as registering onto an advertisers website.

Wireless Value-added Services

Our primary wireless value-added offering is short messaging services, or SMS, which allows mobile phone users to, among other things, send and receive text messages from the Internet. We offer a wide variety of SMS services in the form of individual messages and subscription packages which allow users, for example, to receive news and information such as daily news and e-mails, download ringtones and logos for their mobile phones and participate in matchmaking communities and interactive games. Internet-related services remained our most popular category of SMS services in terms of revenue, in particular e-mail-related services through which we notify subscribers via an SMS message that they have received an e-mail message in our premium VIP e-mail service. For an additional payment, we will also send subscribers the text of the e-mail message to their mobile phone via SMS.

In addition, we offer wireless application protocol, or WAP, services, which provide a browser-based platform to access and use sophisticated wireless value-added services, and multimedia messaging services, or MMS, which provide sophisticated, content-rich mobile messages. Both WAP and MMS services are available to mobile users with phones that are compatible with the advanced 2.5G mobile networks in China. We also offer interactive voice response services, or IVRS. IVRS allows users to access pre-recorded information from their mobile phones or interact with other users through voice chat simply by dialing specially designated IVRS phone numbers and responding to menu options. Our users can also order color ring-back tones, which enable users to customize the ringtone a caller hears. These ringtones can include voice recordings as well as pre-recorded music.

Revenues from wireless value-added services and others accounted for 3.4%, 3.0% and 2.7% of total net revenues in 2006, 2007 and 2008, respectively. Nonetheless, we intend to continue promoting SMS and non-SMS wireless services which have a strong tie-in with the NetEase websites, such as matchmaking community, photo album sharing and e-mail.

 

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SALES AND MARKETING

Sales

Online Games

We sell game playing time to users of the MMORPGs that we operate largely in the form of prepaid point cards. We sell prepaid point cards to end users through over 2000 distributors as of December 31, 2008. These distributors arrange for our cards to be offered at various retail points in China including, notably, Internet cafés where many of the users of our online games access our system, and to a much lesser extent, directly over the Internet. Historically, we sold prepaid point cards to distributors at a 11.0%-14.0% discount off of their face value. We reduced the discount to 6.0%—12.0% in March 2009. For the distributors selling battle.net point cards, the discount is 9.0 % -12.0%.

Users can also purchase virtual prepaid cards online by debit cards or bank transfers, and receive the prepaid point information over the Internet.

Advertising Services

We believe the growing number of Internet users in China represents an attractive demographic target for advertisers because it represents an affluent, educated and technically sophisticated market. To capitalize on this advertising opportunity, we maintain a dedicated advertising services sales force, which had 126 sales professionals located in Beijing, Shanghai and Guangzhou as of December 31, 2008.

In addition, online advertising on the NetEase websites is also sold through online advertising sales networks and advertising agencies. We believe that our focus on providing widely-used services that are designed to appeal to a broad base of Internet users attracts a variety of blue chip advertisers, ranging from technology products to consumer brands (including increasingly Chinese companies). We intend to continue to attract online advertisers by promoting the NetEase brand name to potential advertisers. We also engage in providing cooperative promotional advertising solutions in which we act as the official sponsor or co-sponsor of special events or online content, such as websites that feature movies or television series, athletic events, music awards, charity concerts and industry exhibitions.

For a discussion of the seasonality of our revenue, see Item 5 “Operating and Financial Review and Prospects—Revenue—Seasonality of Revenues.”

Marketing

We employ a variety of traditional and online marketing programs and promotional activities to build our brand as part of our overall marketing strategy. We focus on building brand awareness through proactive public relations and traditional and online advertising. We invest in a series of marketing activities to further strengthen our brand image and continue to grow our user base. Our marketing campaigns consist of corporate branding and announcements about our services through outdoor, print and online advertisements.

We have entered into a number of revenue sharing agreements with third party promoters of our online game titles. Pursuant to these agreements, promoters market our game titles to potential customers in specific locations, principally Internet cafés and university campuses, in return for a share of revenues we receive from new users they recruit.

 

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We plan to continue investing in various forms of marketing to further build awareness of our brand.

RESEARCH AND DEVELOPMENT

We believe that the ability to develop and enhance our services is an integral part of our future success. Our product development efforts and strategies consist of incorporating new technologies from third parties as well as continuing to develop our own proprietary technology in order to produce user-friendly Internet and wireless applications, services and technologies for the Chinese market.

We have utilized and will continue to utilize the products and services of third parties to enhance our platform of technologies and services to provide competitive and diverse Internet and wireless services to our users. We also have utilized and will continue to utilize third-party advertisement serving technologies in conjunction with our own proprietary software. In addition, we plan to continue to expand our technologies, services and registered user base through diverse online services developed internally. We will seek to continually improve and enhance our existing services to respond to rapidly evolving competitive and technological conditions.

Our major area of focus is the development of our proprietary online games and localizing licensed games, and we plan to continue this focus in the future. As of December 31, 2008, we had 634 programmers, network engineers and graphic designers dedicated to online game research and development.

In connection with our game development activities, we occasionally license specific game technologies which we incorporate into our in-house developed MMORPGs.

INFRASTRUCTURE AND TECHNOLOGY

Our infrastructure and technology have been designed for reliability, scalability and flexibility and are administered by our technical staff. The NetEase websites are made available primarily through network servers co-located in the facilities of China Unicom’s Beijing affiliate and China Telecom’s Beijing and Changzhou affiliates. As of December 31, 2008, there were approximately 12,000 of such co-located servers, operating with Web server software from Apache and Netscape. As of December 31, 2008, we had leased dedicated lines with a total of approximately 40.9 gigabits per second capacity substantially from China Unicom’s Beijing, Guangzhou, Changzhou and Hangzhou affiliates, China Telecom’s Beijing, Changzhou and Hangzhou affiliates, and CERNET.

We license the “Dart Enterprise” system from a third party licensor which provides the functions of sales planning, targeting, trafficking, inventory management and reporting tools for our advertising services, and we have also developed our own advertisement tracking system.

We use Oracle’s database systems to manage our registered user database. NetEase has established a comprehensive user profile system, and we analyze user information on a weekly basis. We also deploy a single sign-on system that allows users to easily access our services within the NetEase websites. We intend to continue to use a combination of internally developed software products as well as third party products to enhance our Internet media services in the future.

 

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COMPETITION

A number of companies offer competitive products or services in China, our main operating market. These include Perfect World Company Limited, or Perfect World, Giant Interactive Group Inc, or Giant, Shanda Interactive Entertainment Limited, or Shanda, The9 Limited, or The9, Sina Corporation, or Sina, Sohu.com, Inc., or Sohu, Tom Online Inc., or Tom.com, 263.net, Linktone Ltd., or Linktone, Tencent, Chinadotcom Corporation, or Chinadotcom, Baidu, 21cn.com and Changyou.com Limited, or Changyou.

Specifically, we are encountering competition from companies offering MMORPGs and casual games that target the China market, such as Perfect World, Giant, Shanda, Softworld, Softstar Entertainment Inc., Actoz Soft Co., Ltd., NCsoft Corporation, The9, 9you, Kingsoft Corporation Limited, or Kingsoft, Waei International Digital Entertainment Co., Ltd. We face competition from other websites that offer online content and online community services, including Sina, Sohu, Tom.com, Tencent, 263.net, Baidu, 21cn.com and Alibaba. Some of our existing and potential competitors in these areas have significantly greater financial and marketing resources than we do. In addition, we believe that many of our competitors have become more active in both licensing foreign-developed games and developing games in-house.

We also believe that competition in the online advertising industry in China has intensified as new entrants have come into the market such as Baidu, Tencent and other vertical Internet portals. In addition, we face potential competition from US-based portals such as Yahoo!, Yahoo! Chinese and MSN which are currently increasing their Chinese language service offerings or have announced an intention to do so. We expect that China’s entry into the WTO in 2001, and the resulting gradual opening of its telecommunications sector, may facilitate more foreign participation in the Chinese Internet market by companies such as Yahoo!, Google and Microsoft. Many of these Internet companies have longer operating histories in the Internet market, greater name and brand recognition, larger customer bases and databases and significantly greater financial, technical and marketing resources than we have. The entry of additional, highly competitive Internet companies into the Chinese market would further heighten competition. Finally, we face competition from websites that operate outside our market and offer content in the English language, which may be attractive to a portion of Chinese Internet users.

We also compete with traditional forms of media for advertising-related revenue. There can be no assurance that we will be able to compete successfully against our current or future competitors or that competition will not have a material adverse effect on our business, results of operations and financial condition.

GOVERNMENT REGULATIONS

Overview

The Chinese government has enacted an extensive regulatory scheme governing the operation of Internet-related businesses, such as telecommunications, Internet information services, international connection to computer information networks, information security and censorship. In addition to MII, the various services of the PRC Internet industry are regulated by various governmental authorities, such as the State Administration for Industry and Commerce, or SAIC, the State Council Information Office, or SCIO, the General Administration for Press and Publication, or GAPP, the Ministry of Education, or MOE, the Ministry of Health, or MOH, the State Food and Drug Administration, or SFDA, the MOC, the State Administration of Radio, Film and Television, or SARFT, the Ministry of Commerce and the Ministry of Public Security.

 

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In September 2000, China’s State Council promulgated the Telecommunications Regulations of the People’s Republic of China, or the Telecom Regulations. The Telecom Regulations categorized all telecommunications businesses in China as either basic telecommunications businesses or value-added telecommunications businesses, with ICP services and e-mail services classified as value-added telecommunications businesses. According to the Telecom Regulations, the commercial operator of such services must obtain an operating license. The Telecom Regulations also set forth extensive guidelines with respect to different aspects of telecommunications operations in China.

In December 2001, in order to comply with China’s commitments with respect to its entry into the WTO, the State Council promulgated the Regulation for the Administration of Foreign-invested Telecommunications Enterprises, or the FITE Regulations. The FITE Regulations set forth detailed requirements with respect to capitalization, investor qualifications and application procedures in connection with the establishment of a foreign invested telecom enterprise. Pursuant to the FITE Regulations, foreign investors may now hold an aggregate of no more than 50% of the total equity in any value-added telecommunications business in China.

The Circular of the MII on Intensifying the Administration of Foreign Investment in Value-Added Telecommunication Services, or the 2006 MII Circular, was promulgated by MII on July 13, 2006. The 2006 MII Circular provides that (i) any domain name used by a valued–added telecom service provider must be legally owned by the service provider or its shareholder(s); (ii) any trademark used by a value-added telecom service provider must be legally owned by the service provider or its shareholder(s); (iii) the operation site and facilities of a value-added telecom service provider must be installed within the scope as prescribed by the operating licenses obtained by the service provider and must correspond to the value-added telecom services that the service provider has been approved to provide; and (iv) a value-added telecom service provider must establish or improve the measures of ensuring information security. Companies which have obtained operating licenses for value-added telecom services are required to conduct a self-examination and self-correction according to the foregoing requirements and report the results of such self-examination and self-correction to MII. To comply with these requirements, Guangzhou NetEase submitted its self-correction report to MII in 2007.

Classified Regulations

Internet Information Services

The Measures for the Administration of Internet Information Services, or the ICP Measures, issued by the State Council went into effect on September 25, 2000. Under the ICP Measures, any entity that provides information to Internet users must obtain an operating license from MII or its local branch at the provincial level in accordance with the Telecom Regulations described above. To provide these services in compliance with all the relevant ICP-related Chinese regulations, Guangzhou NetEase successfully obtained an ICP license issued by the Guangdong Provincial Telecommunications Bureau. Subsequently, Guangzhou NetEase obtained a Value-Added Telecom Business Operating License from the Guangdong Provincial Telecommunications Bureau, which replaced its ICP license and authorizes Guangzhou NetEase to provide Internet content services. Guangzhou NetEase obtained an Inter-Provincial Value-Added Telecommunications Business Operating License from MII, which specifically authorizes it to provide Internet content services on a national basis. Also, Shanghai EaseNet obtained a Value-Added Telecommunications Business Operating License issued by Shanghai Provincial Telecommunications Bureau.

 

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The Regulations for the Administration of Internet Bulletin Board Services, which was issued by MII on October 8, 2000, provide that any ICP operator engaged in providing online bulletin board services is subject to a special approval and filing process with the relevant government telecommunications authorities. Guangzhou NetEase has obtained a permit to operate its bulletin board services.

The Provisional Regulations for the Administration of Website Operation of News Publications, which were jointly issued by SCIO and MII on November 6, 2000, stipulate that non-news organizations may not publish news items produced by themselves and require the websites of non-news organizations to be approved by SCIO after securing permission from SCIO at the provincial level. On September 25, 2005, the Regulations for the Administration of Internet News Information Services were promulgated jointly by SCIO and MII. The regulations require that any ICP operator that is a non-news organization but engaged in Internet news information services must obtain approval for those services from SCIO. Guangzhou NetEase has obtained an Internet News Information Service License from SCIO.

On June 27, 2002, MII and GAPP jointly promulgated the Provisional Measures for the Administration of Internet Publishing, which require Internet publishers to secure approval from GAPP. The term “Internet publishing” is defined as an act of online dissemination whereby Internet information service providers select, edit and process works created by themselves or others (including content from books, newspapers, periodicals, audio and video products, electronic publications, etc. that have already been formally published or works that have been made public in other media) and subsequently post the same on the Internet or transmit the same to users via the Internet for browsing, use or downloading by the public. Guangzhou NetEase has obtained a license from GAPP to engage in Internet publishing. Also, Shanghai EaseNet is in the process of obtaining a license from GAPP to engage in Internet publishing.

On July 8, 2004, SFDA issued the Measures for the Administration of Internet Drug Information Services, which stipulate that websites publishing drug-related information must obtain a license from local food and drug administrations. Guangzhou NetEase has obtained a license for publishing drug-related information from the Guangdong Food and Drug Administration.

According to the Measures for the Administration of Internet Medical and Health Information Services, which were issued by MOH on January 8, 2001, websites publishing medical and health information must gain approval from local health administrations. In compliance with the above regulation, Guangzhou NetEase has secured an approval for publishing medical and health information through a formal reply issued by the Guangdong Health Administration.

The Provisional Measures for the Administration of Educational Websites and Online Education School were released by MOE on July 5, 2000. This regulation requires that educational websites, which include websites publishing education-related information, must obtain an approval from the relevant administrative department regulating education. In a formal reply issued by the Guangdong Education Administration, Guangzhou NetEase has been approved to operate educational websites.

Pursuant to the Measures for the Administration of Internet E-mail Services, or the Internet E-mail Measures, which were issued by MII on February 20, 2006, e-mail service providers must obtain value-added telecommunications business operating licenses or file for recordation as nonprofit Internet service providers. In addition, each e-mail service provider must keep a record of the timing, sender’s or recipient’s e-mail address and IP address of each e-mail transmitted through its servers for 60 days. The Internet E-mail Measures also state that an Internet e-mail service provider is obligated to keep confidential the users’ personal registered information and Internet e-mail addresses.

 

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An Internet e-mail service provider and its employees may not illegally use any user’s personal registered information or Internet e-mail address and may not, without consent of the user, divulge the user’s personal registered information or Internet e-mail address, unless otherwise prescribed by another law or administrative regulation. Guangzhou NetEase has obtained an Inter-Provincial Value-Added Telecommunications Business Operating License.

SARFT and MII jointly issued the Regulations for the Administration of Internet Audiovisual Program Services, or the Audiovisual Regulations, on December 20, 2007, which require that online audio and video service providers must obtain a permit from SARFT in accordance with the Audiovisual Regulations. Guangzhou NetEase has obtained the Permit for the Network Transmission of Audiovisual Programs issued by SARFT.

Information Security and Censorship

Regulations governing information security and censorship include:

 

   

The Law of the People’s Republic of China on the Preservation of State Secrets (1988) and its Implementation Rules (1990).

 

   

The Law of the People’s Republic of China on the Preservation of State Security (1993) and its Implementation Rules (1994).

 

   

The Rules of the People’s Republic of China for Protecting the Security of Computer Information Systems (1994).

 

   

The Administrative Regulations for the Protection of Secrecy on Computer Information System Connected to International Networks (1997).

 

   

The Regulations for the Protection of State Secrets for Computer Information Systems on the Internet (2000).

 

   

The Notice issued by the Ministry of Public Security of the People’s Republic of China Regarding Issues Relating to the Implementation of the Administrative Measure for the Security Protection of International Connections to Computer Information Networks (2000).

 

   

The Detailed Implementation Rules for the Administration of Commercial Website Filings for the Record (2000).

 

   

The Decision of the Standing Committee of the National People’s Congress Regarding the Safeguarding of Internet Security(2002).

 

   

The Provisions on the Technical Measures for the Protection of the Security of the Internet (2005).

 

   

The Administrative Regulations for the Classified Protection of Information Security (2007).

Under the Administrative Regulations for the Protection of Secrecy on Computer Information System Connected to International Networks and various other laws and regulations, ICP operators and Internet publishers are prohibited from posting or displaying any content that:

 

   

opposes the fundamental principles set forth in China’s Constitution;

 

   

compromises state security, divulges state secrets, subverts state power or damages national unity;

 

   

harms the dignity or interests of the state;

 

   

incites ethnic hatred or racial discrimination or damages inter-ethnic unity;

 

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sabotages China’s religious policy or propagates heretical teachings or feudal superstitions;

 

   

disseminates rumors, disturbs social order or disrupts social stability;

 

   

propagates obscenity, pornography, gambling, violence, murder or fear or incites the commission of crimes;

 

   

insults or slanders a third party or infringes upon the lawful rights and interests of a third party; or

 

   

includes other content prohibited by laws or administrative regulations.

Failure to comply with these content censorship requirements may result in the revocation of licenses and the closing down of the concerned websites. To ensure compliance with these regulatory requirements, Guangzhou NetEase has taken all reasonable steps to avoid displaying any of the prohibited contents on the NetEase websites. In addition, it is mandatory for Internet companies in the PRC to complete security-filing procedures and regularly update information security and censorship systems for their websites with the local public security bureau. Guangzhou NetEase has obtained a Filing and Registration Certificate for Computer Information System Connected to International Networks issued by Guangzhou Public Security Bureau.

According to the Detailed Implementation Rules for the Administration of Commercial Website Filings for the Record, websites should register their names with the Beijing Municipal Administration of Industry and Commerce, or BAIC, and obtain electronic registration marks, which should be placed at their homepages. Guangzhou NetEase has registered the NetEase websites with BAIC and subsequently placed the electronic registration mark on its homepage.

On June 23, 2007, the Ministry of Public Security, the State Secrecy Bureau, the State Cryptography Administration Bureau and the State Council Information Office jointly issued the Administrative Regulations for the Classified Protection of Information Security, according to which websites should determine the protection classification of their information systems pursuant to a classification guideline and file such classification with the Ministry of Public Security and its bureaus at provincial level. Guangzhou NetEase has followed the requirements and filed its classification with the Guangzhou Public Security Bureau.

Online Games

The Measures for the Administration of Software Products, which were issued by MII on October 27, 2000, classify online games products as software products, and a software registration certificate issued by the MII is required for the operation and sales of each online game. In compliance with this regulation, all of our online games, including Westward Journey Online II, Fantasy Westward Journey, Datang, Tianxia II, New Fly For Fun, Westward Journey Online III, Legend of Westward Journey and Popo Game have been registered with MII and its offices at the provincial level.

Pursuant to the Provisional Regulations for the Administration of Online Culture promulgated by MOC in May 2003, online game operators are required to obtain an Internet Culture Operating License from MOC, which Guangzhou NetEase and Shanghai EaseNet have received. In 2004, MOC promulgated the Notice Regarding the Strengthening of Network Games Censorship, which provides that imported online games must be reviewed and approved by MOC before they can be put into public testing or operation. Shanghai EaseNet is in the process of obtaining MOC approval for World of Warcraft.

 

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In addition, for imported online games, the relevant license agreements for such games are regarded as technology import contracts and, accordingly, must be registered with the Ministry of Commerce. Shanghai EaseNet has registered the license agreement for StarCraft II and World of Warcraft with the local office of the Ministry of Commerce. Such license agreements also need to be registered with the State Copyright Bureau, otherwise the licensee cannot remit licensing fees out of China to the foreign game licensor. Shanghai EaseNet has registered the license agreement for World of Warcraft with the State Copyright Bureau.

The publication of online games also requires approval from GAPP in accordance with the Provisional Rules for the Administration of Internet Publishing jointly promulgated by GAPP and MII on June 27, 2002. Guangzhou NetEase has received such approval. In addition, in April 2007, GAPP and several other government authorities jointly promulgated the Notice Concerning the Protection of Minors’ Physical and Mental Well-being and Implementation of Anti-addiction System on Online Games (the “Notice”), which confirms the real-name verification scheme and anti-addiction system standard made by GAPP in previous years and requires online game operators to develop and test their anti-addiction systems from April 2007 to July 2007, after which no online games can be registered or operated without an anti-addiction system in accordance with the Notice. Accordingly, we have implemented our anti-addiction system to comply with the Notice in July 2007. Since its implementation, we have not experienced a significant negative impact of the Notice on our business.

On February 18, 1994, the State Council promulgated the Rules of the People’s Republic of China for Protecting the Security of Computer Information Systems, which define Security Products for Computer Information Systems as software and hardware products designed for the protection of computer information security and stipulate that a license must be obtained before selling Security Products for Computer Information Systems. The Ministry of Public Security issued the Measures for the Administration of Security Products for Computer Information Systems Examination and Sales License on June 28, 1997 confirming that a license for the sale of security products for computer information systems must be obtained as a precondition for sales of such products. Guangzhou NetEase has developed a technology which is designed to protect the passwords of online game players and falls into the scope of security products for computer information systems which is subject to this license requirement. Guangzhou NetEase has obtained the above-mentioned license from the Ministry of Public Security.

According to the Guidelines for the Filing for Recordation of Domestic Online Games issued by MOC in 2005, domestic online games operating in China must be filed for recordation with MOC before they can be put into operation. Our in-house developed online games, including Westward Journey Online II, Fantasy Westward Journey, Datang, Westward Journey III and Popo Game have successfully finished the recordation process.

The Regulations for the Administration of Audio and Video Products, which was released by the State Council on December 25, 2001, require that the publication, production, duplication, importation, wholesale, retail and renting of the audio and video products are subject to a license issued by competent authorities. Guangzhou NetEase has obtained such license from Guangdong Culture Administration.

Wireless Value-Added Services

The Measures for the Administration of Telecommunications Business Operating Licenses issued by MII on December 26, 2001 differentiated telecom licenses into two types: license for basic telecom services and license for value-added telecom services. Geographically, a telecom license can be granted for intra-provincial or inter-provincial activities.

In April 2004, MII issued the Notice on Certain Issues Regarding the Regulation of Short Message Services, or the SMS Notice, which required all SMS providers to obtain a relevant operating license within 30 days after the issuance of the notice, otherwise, the mobile operators in China will immediately cease to provide connection services to such provider. Guangzhou NetEase has obtained an Inter-Provincial Value-Added Telecommunications Business Operating License from MII, and has completed the requisite registrations with the local offices of MII in 31 provinces.

 

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Online Advertising

The Regulations for the Administration of Advertising and its Detailed Implementation Rules were both promulgated by the State Council and SAIC, which took effect on December 1, 1987 and January 1, 2005, respectively. According to these regulations, websites engaged in advertising must apply for a business license to conduct such business. In compliance with such regulations, Guangyitong Advertising, which operates our online advertising business through a series of agreements with Guangzhou NetEase, and Guangzhou NetEase have obtained a business license to carry out the design, production, agency and release of advertisements.

INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS

We rely on a combination of copyright, trademark and trade secrecy laws and contractual restrictions on disclosure to protect our intellectual property rights. We require our employees to enter into agreements requiring them to keep confidential all information relating to our customers, methods, business and trade secrets during and after their employment with us. Our employees are required to acknowledge and recognize that all inventions, trade secrets, works of authorship, developments and other processes, whether or not patentable or copyrightable, made by them during their employment are our property. They also sign all necessary documents to substantiate our sole and exclusive right to those works and to transfer any ownership that they may claim in those works to us.

We have full legal rights over and have registered a number of domain names, including:

 

   

www.netease.com;

 

   

www.163.com;

 

   

www.yeah.net;

 

   

www.126.com;

 

   

www.netease.net; and

 

   

www.188.com

Guangzhou NetEase and NetEase Beijing have successfully registered numerous trademarks with China’s Trademark Office, including marks incorporating the words “NetEase” and “Yeah” in English and for marks for “NetEase” as written in Chinese in traditional and simplified Chinese characters. In addition, they have registered trademarks involving Chinese characters and phrases that have meanings relating to our Web pages, products and services, including our dating and friends matching services, chat services, online gaming and our search engine. We have also registered a number of trademarks in Hong Kong incorporating the words “NetEase” in English and the marks for “NetEase” as written in Chinese in traditional and simplified Chinese characters. In addition, we have also filed and registered the marks for “NetEase” in English in the United States.

In addition, we have registered our Westward Journey Online II, Fantasy Westward Journey, Tianxia II, Datang, Westward Journey III, Legend of Westward Journey, New Fly For Fun and Popo Game with the State Copyright Bureau of China. Moreover, we have filed some patent applications with the State Intellectual Property Office of China and have obtained Certificate of Design Patent for the Password Protection Device and Certificate of Invention Patent for certain technology related to the search engine developed by Youdao Information from the State Intellectual Property Office.

 

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While we actively take steps to protect our proprietary rights, such steps may not be adequate to prevent the infringement or misappropriation of our intellectual property. Infringement or misappropriation of our intellectual property could materially harm our business. We own the intellectual property (other than the content) relating to the NetEase websites and the technology that enables on-line community, personalization and e-commerce services on those sites. We license content from various freelance providers and other content providers.

Many parties are actively developing community, online game, e-commerce, search and related Web technologies. We expect these parties to continue to take steps to protect these technologies, including seeking patent protection. There may be patents issued or pending that are held by others and that cover significant parts of our technology, business methods or services. For example, we are aware that a number of patents have been issued in areas of e-commerce, Web-based information indexing and retrieval and online direct marketing. Disputes over rights to these technologies are likely to arise in the future. We cannot be certain that our products do not or will not infringe valid patents, copyrights or other intellectual property rights held by third parties. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others.

 

C. Organizational Structure

Our organizational structure is set forth above under “— Our Organizational Structure.”

 

D. Property, Plants and Equipment

Our principal executive offices are currently located at 26/F, SP Tower D, Tsinghua Science Park Building 8, No.1 Zhongguancun East Road, Haidian District, Beijing, People’s Republic of China 100084. We lease our principal executive offices at an effective annual rent of approximately RMB6.0 million (US$0.9 million) in 2008, including management fees, for 4,354 square meters under a lease that expired in May 2009 and was renewed and will expire in May 2011. In addition, our principal executive offices also occupy 1,336 and 1,116 square meters starting from March and May 2009, respectively with an effective annual rent including management fees of approximately RMB2.9 million (US$0.4 million) and RMB2.4 million (US$0.4 million) under leases that expire in September 2010 and November 2010. We also occupy 2,197 square meters under leases in Beijing that expire in July 2009 and July 2011. In Hangzhou, we occupy 4,746 square meters under leases that expire in May and June 2010 and have also purchased land use rights for approximately 56,000 square meters of land as described in “– History and Development of the Company” above. In Guangzhou, we occupy 3,253 square meters under leases that expire in March 2011. We also occupy a building in Guangzhou with total floor area of 20,000 square meters. We currently do not have a lease for such property but have accrued imputed rent for it. For more information on this property, see Item 5 “Operating and Financial Review and Prospects” and Item 7.B. “Major Shareholder and Related Party Transactions – Related Party Transactions.” In Shanghai, we occupy 4,061 square meters under leases that expire in December 2009 and June 2013. We believe that we will be able to obtain adequate facilities, principally through the leasing and acquisition of appropriate properties, to accommodate our future expansion plans.

As of December 31, 2008, we leased dedicated lines with a total capacity of approximately 40.9 gigabits per second substantially from various affiliates of China Unicom, China Telecom and CERNET. We lease such capacity pursuant to short term contracts. Our bandwidth fees were approximately RMB71.3 million (US$10.5million) for the year ended December 31, 2008.

 

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Item 4A. Unresolved Staff Comments

Not Applicable.

 

Item 5. Operating and Financial Review and Prospects

The following discussion of our financial condition and results of operations is based upon and should be read in conjunction with our consolidated financial statements and their related notes included in this annual report. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words “expect,” “anticipate,” “intend,” “believe,” or similar language. All forward-looking statements included in this annual report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. In evaluating our business, you should carefully consider the information provided under Item 3.D. “Risk Factors.” Actual results could differ materially from those projected in the forward-looking statements. We caution you that our businesses and financial performance are subject to substantial risks and uncertainties.

 

A. OPERATING RESULTS

Overview

NetEase is a leading Internet technology company in China. Our innovative online games, communities and personalized premium services, which allow registered users to interact with other community members, have established a large and stable user base for the NetEase websites which are operated by our affiliate. As of December 31, 2008, we had registered an accumulated total of approximately 972 million accounts.

For the year ended December 31, 2008, we continued to develop our online games and advertising business. We also provide wireless value-added and other fee-based premium services, but we expect that revenue from such services will remain a relatively small part of our total revenue for the foreseeable future. In addition, in August 2008 and April 2009, Blizzard agreed to license certain online games to Shanghai EaseNet for operation in the PRC.

We achieved a net profit of RMB1,596.7 million (US$234.0 million) for 2008 and generated positive operating cash flows of RMB2,017.8 million (US$295.8 million) during the year. We recorded retained earnings of RMB2,338.1 million, RMB3,225.8 million and RMB4,739.1 million (US$694.6 million) as of December 31, 2006, 2007 and 2008, respectively.

Our Corporate Structure

NetEase.com, Inc. was incorporated in the Cayman Islands on July 6, 1999 as an Internet technology company in China. In 2007, we established two intermediate holding companies, namely NetEase Hong Kong and Hong Kong NetEase Interactive. Guangzhou Interactive and NetEase Hangzhou became wholly owned subsidiaries of Hong Kong NetEase Interactive in December 2007 and January 2008, respectively. NetEase Beijing, Boguan and Youdao Information became subsidiaries of NetEase Hong Kong in December 2007.

 

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NetEase Beijing, Guangzhou Interactive, Boguan, Youdao Information, NetEase Hangzhou and Guangzhou Information were established in China on August 30, 1999, October 15, 2002, December 8, 2003, March 21, 2006, June 2, 2006 and June 24, 2008, respectively.

NetEase.com, Inc. conducts its business in China through its subsidiaries. Under current Chinese regulations, there are restrictions on the percentage interest foreign or foreign-invested companies may have in Chinese companies providing value-added telecommunications services in China, which include the provision of Internet content, online games and wireless value-added services such as SMS. In addition, the operation by foreign or foreign-invested companies of advertising businesses in China is subject to government approval. In order to comply with these restrictions and other Chinese rules and regulations, NetEase.com, Inc. and certain of its subsidiaries have entered into a series of contractual arrangements for the provision of such services with certain affiliated companies, namely Guangzhou NetEase, Guangyitong Advertising and Guangzhou Ling Yi Electronics Technology Limited, or Ling Yi (until it was dissolved in August 2007). These affiliated companies are considered “variable interest entities” for accounting purposes (see “—Basis of Presentation” below), and are referred to collectively in this section as “VIEs.” The revenue earned by the VIEs largely flows through to NetEase.com, Inc. and its subsidiaries pursuant to such contractual arrangements. Based on these agreements, NetEase Beijing, NetEase Hangzhou, Guangzhou Interactive and Boguan provide technical consulting and related services to the VIEs.

Guangzhou NetEase is a limited liability company organized under the laws of China and is 90.0% owned by William Lei Ding, our Chief Executive Officer, director and major shareholder. Guangzhou NetEase has been approved by the Chinese authorities to operate as an Internet content provider and operates the NetEase websites. Guangzhou NetEase’s 80.0% owned subsidiary, Guangyitong Advertising, is licensed by the Chinese authorities to operate an advertising business and engages in Internet-related advertising design, production and dissemination. Ling Yi, which was formed in October 2003 and dissolved in August 2007, was also a limited liability company organized under the laws of China and was 90.0% owned by our major shareholder. Ling Yi was approved to operate as an Internet content provider. For the years ended December 31, 2005, 2006 and 2007 until its dissolution in August 2007, Ling Yi earned revenue relating to WAP services and MMS, which represented a small portion of our wireless value-added services revenue.

In September 2007, Guangzhou NetEase and three Chinese citizens incorporated a domestic enterprise, Youdao Computer, for the purpose of applying for an ICP license under the applicable Chinese telecommunication laws to operate our own proprietary internet search engine, Youdao.

In August 2008 and April 2009, Blizzard agreed to license certain online games to Shanghai EaseNet for operation in the PRC. Shanghai EaseNet is a PRC company owned by William Lei Ding, our Chief Executive Officer, director and major shareholder and has contractual arrangement with the joint venture established between, and owned equally by, Blizzard and us, and with us. The joint venture was established concurrently with the licensing of the games in August 2008 and will provide technical services to Shanghai EaseNet. Shanghai EaseNet is considered our VIE for accounting purposes (see “- Basis of Presentation” below).

We believe that our present operations are structured to comply with the relevant Chinese laws. However, many Chinese regulations are subject to extensive interpretive powers of governmental agencies and commissions. We cannot be certain that the Chinese government will not take action to prohibit or restrict our business activities.

 

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Future changes in Chinese government policies affecting the provision of information services, including the provision of online services, Internet access, e-commerce services and online advertising, may impose additional regulatory requirements on us or our service providers or otherwise harm our business.

Basis of Presentation

On January 17, 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46: Consolidation of Variable Interest Entities, an interpretation of ARB 51, or FIN 46, which was subsequently amended by a revised interpretation, or FIN 46-R. These interpretations address financial reporting for entities over which control is achieved through a means other than voting rights. According to the requirements of FIN 46 and FIN 46-R, we have evaluated our relationships with the previously unconsolidated affiliated companies, Guangzhou NetEase and Guangyitong Advertising, as well as Ling Yi (which was dissolved in August 2007). We have concluded that Guangzhou NetEase, Guangyitong Advertising and Ling Yi are VIEs, and NetEase.com, Inc. is the primary beneficiary of these affiliated companies. Accordingly, we adopted the provisions of FIN 46 and consolidated Guangzhou NetEase and Guangyitong Advertising on a prospective basis from January 1, 2004 and Ling Yi from May 17, 2004 until its dissolution in August 2007. In addition, according to the assessment under FIN 46-R, we have concluded that Shanghai EaseNet is also our VIE and have consolidated Shanghai EaseNet into our financial statements as of and for the year ended December 31, 2008. Also, NetEase.com, Inc. is the primary beneficiary of the companies comprising our joint venture with Blizzard, namely, StormNet Information Technology (Hong Kong) Limited, or StormNet IT Hong Kong, and StormNet Information Technology (Shanghai) Limited, or StormNet IT Shanghai. Accordingly, we have consolidated these two companies into our financial statements as of and for the year ended December 31, 2008.

Revenues

We generate our revenues from the provision of online games services, advertising services and wireless value-added services and others. Through our predecessor company, in mid-1998, we changed our business model from a software developer to an Internet technology company. In July 1999, we began to offer e-commerce platforms and to provide online auction services in China through Guangzhou NetEase. In 2001, we also began focusing on fee-based premium services and online entertainment services, including online games, wireless value-added services, premium e-mail services and other subscription-type services.

No customer individually accounted for greater than 10.0% of our total revenues for the years ended December 31, 2006, 2007 and 2008.

Online Games Services

We derive all our online game services revenues from customers through the sale of prepaid point cards. Customers can purchase physical prepaid point cards in different locations in China, including Internet cafés, software stores, convenience stores and bookstores, or can purchase prepaid points from vendors who register the points in our system. Customers can also purchase virtual prepaid cards online by debit cards or bank transfers, and receive the prepaid point information over the Internet. Customers can use the points to play our online games, either to pay for playing time or to purchase virtual items within the games in the case of our new games, Tianxia II and Legend of Westward Journey, and use our other fee-based services. We recognize revenues from the sale of prepaid points as the points are used by customers.

 

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In August 2008 and April 2009, Blizzard agreed to license certain online games to Shanghai EaseNet for operation in the PRC as discussed in “Business Overview – Our Services – Game Licensing and Joint Venture with Blizzard”. As these games had not yet been commercially launched, no revenue was generated from them in 2008.

We expect that we will face increasing competition as online game providers in China and abroad expand their presence in the Chinese market or enter it for the first time.

Advertising Services

We derive most of our advertising services revenue from fees we earn from advertisements placed on the NetEase websites. Approximately 92.6%, 97.7% and 99.6% of our total advertising revenue was derived from brand advertising for the years ended December 31, 2006, 2007 and 2008, respectively, with the remainder generated from advertisers in our search engine business.

We expect that the online advertising market in China will continue to grow as Internet usage in China increases and as more companies, in particular China-based companies in a variety of industries, accept the Internet as an effective advertising medium. Moreover, we expect that as the e-commerce industry further develops in China, there will be more small- to medium-size online businesses using paid search services to advertise or market their businesses and products. Accordingly, we believe that the growth rate for paid search-related advertising in the China market may increase at a faster rate than online brand advertising, although search-related advertising is still at its initial stage in China and developing from a much smaller base.

Wireless Value-Added Services and Others

We derive a portion of our wireless value-added services and others revenues from providing to our customers value-added services through SMS. Our online fee-based premium services, supplied to registered users of the NetEase websites, include premium e-mail, premium matchmaking and dating services and premium alumni clubs.

Seasonality of Revenues

Historically, advertising revenues have followed the same general seasonal trend throughout each year with the first quarter of the year being the weakest quarter due to the Chinese New Year holiday and the traditional close of advertisers’ annual budgets and the third quarter as the strongest. Usage of our online games and wireless value-added services has generally increased around the Chinese New Year holiday and other Chinese holidays, in particular winter and summer school holidays.

Cost of Revenues

Online Games Services

Cost of revenues for our online games services consist primarily of business tax payable on intra-group revenues, staff costs (in particular remuneration to employees known as the “Game Masters” who are responsible for the daily co-ordination and regulation of the activities inside our games’ virtual worlds), revenue sharing expenses paid to Internet data centers, or IDC, for the rental of servers, and printing costs for our prepaid point cards.

In addition, cost of revenues for our online games services include that portion of bandwidth and server custody fees and depreciation and amortization of computers and software which are attributable to our online games business. Our subsidiaries and VIEs have network servers co-located in facilities owned by China Telecom’s and China Unicom’s affiliates, for which we pay custody fees to China Telecom and China Unicom.

 

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Advertising Services

Cost of revenues related to our advertising services consists primarily of business tax payable on intra-group revenues, staff costs for editors of the various content channels for the NetEase websites and content fees paid to content providers for the NetEase websites as well as that portion of bandwidth and server custody fees, depreciation and amortization of computers and software which are attributable to the provision of advertising services.

Wireless Value-Added Services and Others

Cost of revenues related to our wireless value-added services and others consists primarily of staff costs (principally compensation expenses for editorial professionals) and content fees, as well as that portion of bandwidth and server custody fees, depreciation and amortization of computers and software which are attributable to the provision of wireless value-added and other services. It also includes business tax payable on intra-group revenues. We pay content fees to third party partners for the right to use proprietary content developed by them, such as ringtones and logos. We also pay content fees to newspaper and magazine publishers for the right to use their proprietary content, such as headline news and articles.

Operating Expenses

Operating expenses include selling and marketing expenses, general and administrative expenses and research and development expenses.

Selling and Marketing Expenses

Selling and marketing expenses consist primarily of salary and welfare expenses, compensation costs for our sales and marketing staff, and marketing and advertising expenses payable to third party vendors.

General and Administrative Expenses

General and administrative expenses consist primarily of salary and welfare expenses, compensation costs for our general administrative and management staff, office rental, legal, professional and consultancy fees, bad debt expenses, recruiting expenses, travel expenses and depreciation charges. General and administrative expenses also included imputed rent for a building in Guangzhou occupied by us since July 2006. We recorded an imputed rental expense on our financial statements which was calculated based on the estimated rental value of the property and totaling RMB9.4 million (US$1.4 million) in 2008. For additional information on this property, see Item 7.B. “Related Party Transactions—Purchase of Property in Guangzhou.”

Research and Development Expenses

Research and development expenses consist principally of salary and welfare expenses, compensation costs for our research and development professionals and licensing and training fees paid to a third party developer of a 3D game engine.

 

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Share-Based Compensation Cost

Under our 2000 Stock Option Plan, we grant options to our employees, directors, consultants and certain members of our senior management under that plan. The vesting periods for these options generally range from two years to four years. In addition, certain of the options granted were cancelled as a result of the resignation of these personnel.

For the years ended December 31, 2006, 2007 and 2008, we recorded share-based compensation cost of approximately RMB101.3 million, RMB95.4 million and RMB67.9 million (US$10.0 million), respectively. This cost has been allocated to (i) cost of revenues, (ii) selling and marketing expenses, (iii) general and administrative expenses and (iv) research and development expenses, depending on the responsibilities of the relevant employees.

As of December 31, 2008, total unrecognized compensation cost related to unvested awards not yet recognized related to the stock option plan, adjusted for estimated forfeitures, was US$9.1 million (RMB63.2 million) and is expected to be recognized through the remaining vesting period of each grant. As of December 31, 2008, the weighted average remaining vesting period was 1.82 years.

Income Taxes

Cayman Islands

Under the current laws of the Cayman Islands, we are not subject to tax on income or capital gain. Additionally, upon payments of dividends to our shareholders, no Cayman Islands withholding tax will be imposed.

British Virgin Islands (“BVI”)

NetEase Interactive is exempted from income tax on its foreign-derived income in the BVI. There are no withholding taxes in the BVI.

Hong Kong

Hong Kong NetEase Interactive, NetEase Hong Kong and StormNet IT Hong Kong are subject to 17.5% and 16.5% income tax for 2007 and 2008, respectively, on their taxable income generated from operations in Hong Kong. The payment of dividends by Hong Kong NetEase Interactive, NetEase Hong Kong and StormNet IT Hong Kong are not subject to any Hong Kong withholding tax.

China

Prior to January 1, 2008, foreign-invested enterprises were generally subject to a national and local enterprise income tax, at statutory rates of 30% and 3% respectively, under the previous income tax law. Effective as of January 1, 2008, the Chinese government adopted a new income tax law, as further clarified by subsequent tax regulations implementing the new income tax law, which unified enterprise income tax payable by domestic and foreign-invested enterprises at 25.0%. For further details, see Item 3.D. “Risk Factors – Our business benefits from certain PRC government incentives. Expiration of, or changes to, these incentives and PRC tax laws could have a material adverse effect on our operation results.”

 

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NetEase Beijing was recognized as an “Advanced Technology Enterprise” and entitled to a reduced EIT rate of 10.0% for 2006 to 2007 and a full exemption from the local income tax for 2006 and 2007. Based on the HNTEs status granted under the new income tax law, NetEase Beijing will enjoy the preferential tax rate of 15.0% from 2008 to 2010.

Guangzhou Interactive was recognized as a “Software Enterprise” and a “High and New Technology Enterprise” respectively under the previous income tax law and subject to a reduced EIT rate of 7.5% from 2005 to 2007. In 2006, Guangzhou Interactive received tax-exemption from the local tax rate of 3.0% from 2005 to 2007. In addition to the HNTEs status granted under the new income tax law, Guangzhou Interactive was qualified as “Key Software Enterprise” in 2008 and it therefore enjoyed a preferential tax rate of 10.0% for 2008.

Boguan was recognized as a “Software Enterprise” in September 2005 under the previous income tax law. It was exempted from EIT on its profits for 2006 and 2007 and is subject to a 50.0% reduction in EIT from 2008 to 2010. Boguan was subject to a 3.0% local income tax rate for 2006, and it was exempted from the 3.0% local income tax for 2007. In addition, Boguan was granted the HNTEs tax status and enjoys preferential tax rate of 15.0% from 2008 to 2010. Boguan paid its EIT at a rate of 12.5% for the first three quarters of 2008 on the understanding that when it was granted the HNTEs tax status in 2008, it would be entitled to a preferential tax rate of 7.5% based on the interpretation of the grandfather provisions under the new income tax law and the related implementation guidelines. This rate was calculated by applying the 50.0% reduction for Software Enterprises against the 15.0% preferred tax rate applicable to its HNTEs status. When Boguan was granted the HNTEs tax status in December 2008, the relevant local tax authority refunded the excess income tax paid which was computed on the basis of applying the preferred tax rate of 7.5%. Following the issuance of a new tax circular by the State Administration of Taxation in April 2009, the local tax authority notified Boguan in June 2009 to pay the income tax liability for 2008 at the rate of 12.5%. The decision is based on the interpretation of the new circular issued by the State Administration of Taxation in April 2009 that the 50% reduction for Software Enterprises is made against the uniform EIT rate of 25%, instead of the 15% preferred tax rate applicable to Boguan’s HNTEs status. As such, Boguan recorded an additional tax payable of RMB23.3 million (US$3.4 million) in June 2009. Nevertheless, we believe the relevant tax rules are still not clear, and we will further discuss with the local tax authority to clarify whether Boguan is subject to EIT at a rate of 7.5% or 12.5%.

NetEase Hangzhou was recognized as a “Software Enterprise” in April 2007 and as a “High and New Technology Enterprise” in September 2007 under the previous income tax law. It was exempted from EIT on its profits from 2007 and 2008. It was subject to a 3.0% local income tax rate for 2007. Based on the HNTEs status granted under the new income tax law in December 2008, NetEase Hangzhou will enjoy the preferential tax rate of 15.0% from 2008 to 2010.

Youdao Information was recognized as a “High and New Technology Enterprise” under the previous income tax law in May 2007. According to an approval granted by the Haidian State Tax Bureau in August 2007, Youdao Information was entitled to a full exemption from EIT in 2007. The applicable tax rate for Youdao Information is 25.0% in 2008 in accordance with the new income tax law.

Guangyitong Advertising, Ling Yi (dissolved in August 2007) and Youdao Computer (formed in September 2007) were subject to EIT at an overall income tax rate of 33.0% under the previous income tax law. Guangzhou NetEase was recognized as a “High and New Technology Enterprise” under the previous income tax law in December 2004. Hence, Guangzhou NetEase was subject to a reduced income tax rate of 15.0% from 2004 to 2007. Effective January 1, 2008, Guangyitong Advertising, Guangzhou NetEase, Shanghai EaseNet and StormNet IT Shanghai are subject to EIT at the uniform rate of 25.0% under the new income tax law. Youdao Computer was subject to an EIT rate of 20.0% in 2008 under the new income tax law.

 

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On January 1, 2007, we adopted Financial Interpretation No. 48 “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109”, or FIN 48, issued by the FASB in June 2006 which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. In connection with such adoption, we did not have any adjustment to the opening balance of retained earnings as of January 1, 2007, and as of December 31, 2007 and 2008, we did not have any significant unrecognized uncertain tax positions. For the years ended December 31, 2007 and 2008, we did not have any interest and penalties associated with our tax positions.

Business Taxes

In China, business taxes are imposed by the government on the revenues reported by the selling entities for the provision of taxable services in China, transfer of intangible assets and the sale of immovable properties in China. The business tax rate varies depending on the nature of the revenues. The applicable business tax rate for our revenues generally ranges from 3.0% to 5.0%. We are also subject to cultural development fee on the provision of advertising services in China. The applicable tax rate is 3.0% of the advertising services revenue.

In December 2007, Guangzhou NetEase received an approval from the Guangzhou local tax authority allowing it to deduct the service fees paid to its cooperative partners from its gross wireless value-added services revenue in deriving the amount of business tax payable in accordance with the relevant rules, implemented with retroactive effect from January 1, 2003. As a result, Guangzhou NetEase received a business tax refund in June 2008 of approximately RMB146.8 million (US$21.5 million) for the excess amount paid in previous years. Guangzhou NetEase has calculated its business taxes on this basis from January 1, 2008, subject to any change of policy by the local tax authority in the future.

Critical Accounting Policies and Estimates

The preparation of financial statements often requires the selection of specific accounting methods and policies from several acceptable alternatives. Further, significant estimates and judgments may be required in selecting and applying those methods and policies in the recognition of the assets and liabilities in our consolidated balance sheet, the revenues and expenses in our consolidated statement of operations and the information that is contained in our significant accounting policies and notes to the consolidated financial statements. We make our estimates and judgments on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates and judgments under different assumptions or conditions.

We believe that the following are some of the more critical judgment areas in the application of our accounting policies that affect our financial condition and results of operation. We do not have significant change in accounting estimates during the year.

Critical Accounting Policies and Estimates Regarding Revenue Recognition

Online Games Services

We provide online games services through Guangzhou NetEase. Regarding the revenue recognition for our online games, we sell prepaid point cards and online points to the end users who may use the points on such cards for online game services provided by us. Proceeds received from the sales of prepaid point cards and online points are initially recorded as deferred revenue.

 

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We earn revenue through providing online game services to players under two types of revenue models: a time-based revenue model and an item-based revenue model. For time-based model, revenue is recognized based upon the actual usage of the game playing time by players. For the item-based model, the basic game play functions are free of charge, and players are charged for purchases of in-game items. Revenues from the sales of in-game items are recognized when the items are consumed by the customers or over the estimated lives of the in-game items. In-game items have different life patterns: one-time use, limited life and permanent life. Revenues from the sales of one-time use in-game items are recognized upon consumption. Limited life items are either limited by the number of use, say 10 times or limited by time, says three months. Revenues from the sales of limited life in-game items are recognized ratably based on the extent of time passed or expired or when the items are fully used. Players are allowed to use permanent life in-game items without any use or time limits. Revenues from the sales of permanent life in-game items are recognized based on the estimated lives of the in-game items. We consider the average period that players typically play the games and other game player behavior patterns, as well as various other factors, including the acceptance and popularity of expansion packs, promotional events launched and market conditions to arrive at the best estimates for the estimated lives of the permanent life in-game items. However, given the relatively short operating history of our item-based games, our estimate of the period that game players typically play our games may not accurately reflect the estimated lives of the permanent life in-game items. We have adopted a policy of assessing the estimated lives of the permanent life in-game items on a quarterly basis. All paying users’ data collected since the launch of the games are used to perform the relevant assessments. Historical behavior patterns of these paying users during the period between their first log-on date and last log-on date are used to estimate the lives of the permanent life in-game items.

While we believe our estimates to be reasonable based on available game player information, we may revise such estimates in the future as we continue to gain more operating history and data of our item-based games. Any adjustments arising from changes in estimates of the lives of the permanent in-game items will be applied prospectively as such changes are resulted from new information indicating a change in the game player behavior patterns. Any changes in our estimate of lives of the permanent in-game items may result in our revenues being recognized on a basis different from prior periods and may cause our operating results to fluctuate.

Advertising Services

We derive advertising fees principally from short-term advertising contracts. With respect to the advertising contracts that do not include a fixed delivery pattern for the advertising services, revenues are generally deferred until completion of the contracts. For the advertising contracts with a fixed delivery pattern, revenues are recognized ratably over the period in which the advertisement is displayed and only if collection of the resulting receivables is probable.

Our obligations may include guarantees of a minimum number of impressions or times that an advertisement appears in pages viewed by users. To the extent that minimum guaranteed impressions are not met within the contractual time period, we defer recognition of the corresponding revenues until the remaining guaranteed impression levels are achieved. In addition, we occasionally enter into “cost per action”, or CPA, advertising contracts whereby revenue is received by us when an online user performs a specific action such as purchasing a product from or registering with the advertiser. Revenue for CPA contracts is recognized when the specific action is completed.

 

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Other Critical Accounting Policies and Estimates

Research and Development Costs

We recognize costs to develop our online game products in accordance with SFAS No. 86, “Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed.” Costs incurred for the development of online game products prior to the establishment of technological feasibility are expensed when incurred. Once an online game has reached technological feasibility with a proven ability to operate in the Chinese market, all subsequent online game development costs are capitalized until that game is marketed. Technical feasibility is evaluated on a product-by-product basis, but typically encompasses both technical design and game design documentation. The costs incurred for development of online game products are not capitalized because the period before the date when technical feasibility is reached and the time when the game is marketed is short historically and the development cost incurred in the period is insignificant. All online game development costs have been expensed when incurred for the years ended December 31, 2006, 2007 and 2008.

We recognize website and internally used software development costs in accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Accordingly, we expense all costs that are incurred in connection with the planning and implementation phases of development and costs that are associated with repair or maintenance of the existing websites and software. Direct costs incurred to develop the software during the application development stage that can provide future benefits are capitalized.

Depreciation

We depreciate our computer equipment, software and other assets (other than leasehold improvements) on a straight-line basis over their estimated useful lives, which range from two years to fifteen years. We depreciate leasehold improvements, which are included in our operating expenses, on a straight-line basis over the lesser of the relevant lease term or their estimated useful lives.

Allowances for Doubtful Accounts

We maintain allowances for doubtful accounts receivable based on various information, including aging analysis of accounts receivable balances, historical bad debt rates, repayment patterns and credit worthiness of customers, industry trend analysis and general and industry-specific economic and market conditions. We have adopted a general provisioning policy for doubtful debts for our trade receivable balances. We provide for 80.0%, in the case of direct customers, and 50.0% in the case of advertising agents, of the outstanding trade receivable balances overdue for more than six months. We provide for 100.0% in the case of all parties for outstanding trade receivable balances overdue for more than one year. In addition to the general provisions for trade receivables, we also make specific bad debt provisions for bad debts if there is strong evidence showing that the debts are likely to be irrecoverable.

Stock-Based Compensation Expense

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Stock-Based Payment” (“SFAS 123R”), which revises SFAS 123, “Accounting-Based Compensation” (“SFAS 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under the fair value recognition provisions of SFAS 123R, we are required to measure the cost of employee services received in exchange for stock-based compensation measured at the grant date fair value of the award.

 

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We recognize the stock-based compensation costs, net of a forfeiture rate, on a straight-line basis over the requisite service period of the award, which is the vesting term (generally three to four years for stock options).

We adopted the Black-Scholes option pricing model to determine the fair value of stock options under SFAS 123R. We elected to implement SFAS 123R using the modified-prospective method, with no restatement of prior results. Under the modified prospective method, the valuation provisions of SFAS 123R applied to new grants and to grants that were outstanding as of the effective date. Estimated compensation expense for grants that were outstanding as of the effective date is recognized over the remaining service period using the compensation cost estimated for the SFAS 123R pro forma disclosures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Forfeitures were estimated based on our weighted average historical forfeiture rate to date. Differences between actual and estimated forfeitures are expensed in the period that the differences occur. Prior to the adoption of SFAS 123R, we accounted for forfeitures as they occurred.

Our assumptions are based on our historical experience and expectation of future development. The assumptions used in calculating the fair value of share-based awards and related share-based compensation expenses represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change or different assumptions are used, our share-based compensation expense could be materially different for any period.

Repurchase of Shares

On August 28, 2006, our board of directors approved a share repurchase program for up to US$100 million worth of our issued and outstanding ADSs for a period not to exceed six months. Pursuant to this program, approximately 3.6 million of our issued and outstanding ADSs were repurchased for an aggregate purchase consideration of US$60.1 million (including transaction costs) in open-market transactions when the share repurchase program ended on February 27, 2007.

On March 13, 2007, our board of directors approved a share repurchase program for up to US$100 million worth of our issued and outstanding ADSs for a period not to exceed three months. Pursuant to this program, approximately 5.3 million of our issued and outstanding ADSs were repurchased for an aggregate purchase consideration of US$95.7 million (including transaction costs) in open-market transactions. The share repurchase program ended on June 12, 2007.

On July 2, 2007, our board of directors approved a share repurchase program of up to US$120 million worth of our issued and outstanding ADSs for a period not to exceed 12 months. Pursuant to this program, approximately 2.8 million of our issued and outstanding ADSs were repurchased for an aggregate purchase consideration of US$46.4 million (including transaction costs) in open-market transactions. The share repurchase program ended on July 1, 2008.

On September 12, 2008, our board of directors approved a share repurchase program of up to US$100 million worth of our issued and outstanding ADSs for a period not to exceed 12 months. As of December 31, 2008, approximately 0.7 million of our issued and outstanding ADSs were repurchased for an aggregate purchase consideration of approximately US$13.1 million (including transaction costs). There have been no share repurchases from January 2009 up to the date of this annual report. The share repurchase program will end on September 11, 2009.

 

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For details of the ADS repurchases conducted in 2008, see the share repurchase table in Item 16.E. “Purchase of Equity Securities by the Issuer and Affiliated Purchasers.”

We funded all of the foregoing repurchases from available working capital.

Consolidated Results of Operations

The following table sets forth a summary of our audited consolidated statements of operations for the periods indicated both in Renminbi and as a percentage of total revenues:

 

     For the Year Ended December 31,  
     2006           2007           2008        
     RMB     %     RMB     %     RMB     %  

Statement of Operations Data:

            

Revenues:

            

Online game services

   1,856,062,971      83.7      1,932,634,947      83.8      2,498,518,103      84.0   

Advertising services

   285,772,653      12.9      305,057,556      13.2      405,887,007      13.6   

Wireless value-added services and others

   75,406,121      3.4      68,018,461      3.0      71,718,938      2.4   
                                    

Total revenues

   2,217,241,745      100.0      2,305,710,964      100.0      2,976,124,048      100.0   

Business tax (expense)/benefit

   (52,882,275   (2.4   (92,424,200   (4.0   108,460,101      3.6   
                                    

Net revenues

   2,164,359,470      97.6      2,213,286,764      96.0      3,084,584,149      103.6   
                                    

Cost of revenues:

            

Online game services

   (178,676,915   (8.1   (187,411,229   (8.1   (268,574,306   (9.0

Advertising services

   (125,183,293   (5.6   (143,676,057   (6.2   (208,907,875   (7.0

Wireless value-added services and others

   (77,437,973   (3.5   (84,365,760   (3.7   (82,123,181   (2.8
                                    

Total cost of revenues

   (381,298,181   (17.2   (415,453,046   (18.0   (559,605,362   (18.8
                                    

Gross profit

   1,783,061,289      80.4      1,797,833,718      78.0      2,524,978,787      84.8   

Operating expenses:

            

Selling and marketing expenses

   (170,142,691   (7.7   (235,318,304   (10.2   (221,551,138   (7.4

General and administrative expenses

   (179,879,602   (8.1   (176,178,740   (7.6   (181,841,322   (6.1

Research and development expenses

   (153,162,158   (6.9   (180,734,713   (7.8   (207,023,649   (7.0
                                    

Total operating expenses

   (503,184,451   (22.7   (592,231,757   (25.6   (610,416,109   (20.5
                                    

Operating profit

   1,279,876,838      57.7      1,205,601,961      52.4      1,914,562,678      64.3   

Other income (expenses):

            

Investment income

   340,721      0.0      474,446      0.0      1,517,890      0.1   

Interest income

   94,364,852      4.3      112,599,994      4.8      144,805,368      4.9   

Exchange losses

   (958,435   (0.0   (50,891,094   (2.2   (167,101,510   (5.6

Other, net

   1,239,105      0.1      (1,084,240   (0.1   3,551,919      0.1   
                                    

Profit before tax

   1,374,863,081      62.0      1,266,701,067      54.9      1,897,336,345      63.8   

Income tax expense

   (132,485,543   (6.0   (2,689,309   (0.1   (300,673,321   (10.1
                                    

Profit after tax

   1,242,377,538      56.0      1,264,011,758      54.8      1,596,663,024      53.7   

Minority interests

   400,046      (0.0   74,364      (0.0   24,883      (0.0
                                    

Net profit

   1,242,777,584      56.0      1,264,086,122      54.8      1,596,687,907      53.7   

Unrealized gains on investments

   —        —        1,332,300      0.1      —        —     
                                    

Comprehensive Income

   1,242,777,584      56.0      1,265,418,422      54.9      1,596,687,907      53.7   
                                    

Share compensation cost included in:

            

Cost of revenues

   (16,614,309   (0.7   (14,890,378   (0.6   (13,678,836   (0.5

Selling and marketing expenses

   (21,147,343   (1.0   (14,357,336   (0.6   (8,564,177   (0.3

General and administrative expenses

   (37,360,433   (1.7   (33,887,323   (1.5   (23,586,590   (0.8

Research and development expenses

   (26,164,591   (1.2   (32,293,138   (1.4   (22,119,058   (0.7

 

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Year Ended December 31, 2008 Compare to Year Ended December 31, 2007

Revenues

Total net revenues increased by 39.4% to RMB3,084.6 million (US$452.1 million) in 2008 from RMB2,213.3 million in 2007. Net revenues from online games services, advertising services, and wireless value-added services and others constituted 85.2%, 12.1% and 2.7%, respectively, of our total net revenues in 2008. This compares with 84.4%, 12.6% and 3.0%, respectively, in 2007.

Online Games Services

Net revenues from online games services increased by 40.7% to RMB2,629.2 million (US$385.4 million) in 2008 from RMB1,868.9 million in 2007. This increase was mainly due to the continued growth in the number of users and average playing time per user of our in-house developed MMORPG, Fantasy Westward Journey. The number of peak concurrent players for Fantasy Westward Journey increased to approximately 1,809,000 in December 2008 from 1,519,000 in December 2007, and the number of average concurrent users for Fantasy Westward Journey increased to approximately 617,000 in December 2008 from approximately 546,000 in December 2007. The continued growth in popularity of Fantasy Westward Journey throughout 2008 was mainly attributable to new designs and features introduced during the year, together with the successful launching of a series of in-game marketing events and new expansion pack for the game in the year. In addition, revenue of Westward Journey Online II increased during the year. The number of peak concurrent players for Westward Journey Online II increased to approximately 575,000 in December 2008 from approximately 367,000 in December 2007, and the number of average concurrent players for Westward Journey Online II increased to approximately 198,000 in December 2008 from approximately 153,000 in December 2007. In addition, the open beta testing versions of our 3D item-based online games, Tianxia II and Legend of Westward Journey, were launched in June and September 2008, respectively, which contributed a modest portion of revenue for the year. Revenue from Westward Journey Online III increased slightly as well upon its commercial launch in September 2007.

In addition, the receipt of a business tax refund of RMB146.8 million in June 2008, of which RMB133.9 million is allocated to the online game segment resulted in lower business tax expenses for online games service in 2008. Please see the discussion under “—Business Tax” above.

Advertising Services

Net revenues from advertising services increased by 33.1% to RMB371.4 million (US$54.4 million) in 2008 from RMB279.1 million in 2007, primarily due to the overall expansion of China’s online advertising market.

Average net revenue per traditional advertiser (i.e., customers which do not advertise through our search services) increased to approximately RMB900,000 (US$132,000) in 2008 from RMB623,000 in 2007. The number of traditional advertisers using the NetEase websites decreased to 411 in 2008 from 438 in 2007, with revenues from our top ten advertisers comprising 29.4% of our total advertising services revenues in 2008 as compared to 27.9% in 2007.

 

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Wireless Value-Added Services and Others

Net revenues from wireless value-added services and others increased by 28.7% to RMB84.0 million (US$12.3 million) in 2008 from RMB65.3 million in 2007. This increase was primarily driven by the receipt of a business tax refund of RMB146.8 million in June 2008, of which RMB12.9 million is allocated to the wireless value-added service and others segment and resulted in lower business tax expenses for wireless value-added service and others segment in 2008. Please see the discussion under “—Business Tax” above.

In addition, revenues from other value-added services increased as a result of our continuing enhancements to such services and integration of other value-added services and products.

Cost of Revenues

Our cost of revenues increased by 34.7% to RMB559.6 million (US$82.0 million) in 2008 from RMB415.5 million in 2007. The year-over-year increase was mainly due to an increase in staff-related cost, business tax on intra-group revenue, cost of third party content and technology cost. In 2008, costs relating to online games services, advertising services and wireless value-added services and others represented 48.0%, 37.3% and 14.7% of total cost of revenues, respectively, as compared with 45.1%, 34.6% and 20.3% of the cost of revenues, respectively, in 2007.

Online Games Services

Cost of revenues from our online games services increased by 43.3% to RMB268.6 million (US$39.4 million) in 2008 from RMB187.4 million in 2007. This increase in cost of revenues in 2008 was primarily due to a combination of the following factors:

 

   

Staff-related costs increased by RMB57.9 million to RMB89.1 million (US$13.1 million) in 2008 from RMB31.2 million in 2007, mainly as a result of an increase in the level of salaries and bonuses and an increase in the number of employees. The number of full time employees in our online games department increased to 1,553 as of December 31, 2008 from 1,208 as of December 31, 2007.

 

   

Business tax payable on intra-group revenues related to online games from our VIEs increased by RMB23.4 million to RMB116.8 million (US$17.1million) in 2008 from RMB93.4 million in 2007 due to continued growth in the popularity of Fantasy Westward Journey, Westward Journey Online II and Westward Journey Online III and, to a lesser extent, due to the launch of the open beta testing versions of our item-based online games, Tianxia II and Legend of Westward Journey, in June and September 2008, respectively.

Advertising Services

Cost of revenues from our advertising services increased by 45.4% to RMB208.9 million (US$30.6 million) in 2008 from RMB143.7 million in 2007. The increases in cost of revenues in 2008 were primarily due to a combination of the following factors:

 

   

Cost of third party content for the NetEase websites increased by RMB37.6 million to RMB56.5 million (US$8.3 million) in 2008 from RMB18.9 million in 2007 as the 2008 Olympic Games caused an increase in the prices for content services.

 

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Staff-related costs increased by RMB22.1 million to RMB78.9 million (US$11.6 million) in 2008 from RMB56.8 million in 2007, mainly as a result of an increase in salaries and other compensation payments, such as bonuses and welfare benefits, and also due to an expansion of the number of editors of the various content channels (mostly working on 2008 Olympic Games related assignments) for the NetEase websites to 550 as of December 31, 2008 from 386 as of December 31, 2007.

Wireless Value-Added Services and Others

Cost of revenues from our wireless value-added services and others decreased by 2.7% to RMB82.1 million (US$12.0 million) in 2008 from RMB84.4 million in 2007. This decrease in cost of revenues in 2008 was primarily due to a combination of the following factors:

 

   

Depreciation and amortization costs of computers and software decreased by RMB7.1 million to RMB35.8 million (US$5.3 million) in 2008 from RMB42.9 million in 2007, mainly because our various free services such as e-mail and photo related servers became fully depreciated during 2008.

 

   

Staff-related cost decreased by RMB3.3 million to RMB6.2 million (US$0.9 million) in 2008 from RMB9.5 million in 2007, mainly due to the decrease in salaries and other compensation payments, such as bonus and welfare benefits of RMB2.2 million (US$0.3 million) and a decrease in share-based compensation cost of RMB1.1 million (US$0.2 million) in 2008.

These decreases were partially offset by the following factors:

 

   

Business tax payable by us on intra-group revenue related to wireless and other value-added services from our VIEs increased by RMB2.9 million in 2008 as a result of a 28.7% increase in net revenue in 2008 compared to 2007.

 

   

Cost of accessory products sold in 2008 increased by RMB2.6 million to RMB4.0 million (US$0.6 million) from RMB1.4 million in 2007 due to increased market demand during 2008.

 

   

Bandwidth and server custody fees increased by RMB2.4 million to RMB29.6 million (US$4.3 million) in 2008 from RMB27.2 million in 2007, as a result of an increase in bandwidth usage by our free email service in 2008.

Gross Profit

Our gross profit increased by 40.4% to RMB2,525.0 million (US$370.1 million) in 2008 from RMB1,797.8 million in 2007.

The following table sets forth the audited consolidated gross profits and gross profit margins of our business activities for the periods indicated. The gross profit margins in 2007 and 2008 were calculated by dividing our gross profits over our net revenues for the corresponding type of services. The net revenues are before netting-off the business taxes payable by us on intra-group revenues from our VIEs, which are recorded under cost of revenues.

 

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     For the Year Ended December 31,  
     2007     2008     2008  
     RMB     RMB     US$  

Gross profit (loss):

      

Online game services

   1,681,446,765      2,360,610,078      346,003,676   

Advertising services

   135,451,607      162,478,816      23,815,143   

Wireless value-added services and others

   (19,064,654   1,889,893      277,009   
                  

Total gross profit

   1,797,833,718      2,524,978,787      370,095,828   
                  

Gross profit (loss) margin:

      

Online game services

   90.0   89.8   89.8

Advertising services

   48.5   43.7   43.7

Wireless value-added services and others

   (29.2 )%    2.2   2.2
                  

Total gross profit margin

   81.2   81.9   81.9
                  

The slight decrease in gross profit margin for online game services in 2008 was mainly due to the increased cost of revenues which outpaced the increase in net revenues. Higher cost of revenues was mainly the result of increased headcount and higher level of salaries and bonuses paid to the employees in our online game business in 2008, and increased business tax payable on intra-group revenues related to online games from our VIEs driven by a 40.7% increase in net revenue in 2008.

The decrease in gross profit margin for advertising services was mainly due to the increase in salaries and other benefits paid to content editors and the increased cost of third party content in relation to the 2008 Olympic Games.

The gross profit margin for wireless value-added services and others increased significantly in 2008 as compared to the gross loss margin in 2007 as a result of an increase in net revenues primarily due to the receipt of business tax refund in June 2008, plus a general decrease in cost of revenues mainly driven by decreased depreciation expenses as some servers associated with our various free e-mail and photo services became fully depreciated during 2008.

Operating Expenses

Total operating expenses increased by 3.1% to RMB610.4 million (US$89.5 million) in 2008 from RMB592.2 million in 2007. The increase was driven primarily by the increase in both general and administrative expenses and research and development expenses, partially offset by a decrease in selling and marketing expenses.

General and administrative expenses increased by 3.2% to RMB181.8 million (US$26.7 million) in 2008 from RMB176.2 million in 2007, primarily due to a combination of the following factors:

 

   

An increase in allowance for bad and doubtful debts of approximately RMB14.0 million (US$2.0 million) in 2008.

 

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An increase in rental expenses of RMB3.3 million (US$0.5 million) in 2008.

These increases were partially offset by the following factors:

 

   

A decrease in share-based compensation cost of RMB10.3 million (US$1.5 million).

 

   

A decrease in depreciation expenses of RMB2.6 million (US$0.4 million) due to the fact that fewer fixed assets were purchased in 2008 compared to 2007 by general and administrative departments and certain fixed assets were fully depreciated during 2008.

Research and development expenses increased by 14.5% to RMB207.0 million (US$30.3 million) in 2008 from RMB180.7 million in 2007, primarily due to a combination of the following factors:

 

   

An increase in staff-related costs of approximately RMB27.5 million (US$4.0 million) in 2008, mainly as a result of increased headcount of program developers in our online games department, with higher salaries and other benefits paid to our research and development team during 2008. The above increase was partially offset by a decrease in share-based compensation cost of RMB10.3 million (US$1.5 million).

 

   

An increase in depreciation and amortization by RMB3.5 million (US$0.5 million) in 2008, mostly related to additional servers purchased to support Youdao search engine development and enhancement of new and existing services.

 

   

Licensing fees of RMB1.9 million (US$0.3 million) related to a new 3D game engine acquired in 2008.

Selling and marketing expenses decreased by 5.9% to RMB221.6 million (US$32.5 million) in 2008 from RMB235.3 million in 2007, primarily due to a combination of the following factors:

 

   

A decrease in marketing costs of approximately RMB43.6 million (US$6.4 million) in 2008 resulting from reduced advertising and marketing promotion related to Westward Journey Online III and reduced marketing spending on Fantasy Westward Journey, Westward Journey Online II and Popo Game in 2008.

 

   

A decrease in meeting fees, travel and transportation expenses of approximately RMB8.6 million (US$1.3 million) by advertising sales, content and online games departments due to tightened controls in 2008.

These decreases were partially offset by the following factors:

 

   

An increase in staff-related costs of our sales team of approximately RMB11.8 million (US$1.7 million) in 2008 due to increases in average headcount in our advertising and an increase in salaries and bonuses in online game departments in 2008.

 

   

An increase in labor cost of approximately RMB25.1 million (US$3.7 million) associated with the expansion of regional game promotion activities in China during 2008.

 

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Allowances for Doubtful Accounts

As of December 31, 2008, the gross accounts receivable balance before any allowance for bad and doubtful accounts was RMB250.9 million (US$36.8 million). After providing for doubtful accounts in the amount of RMB19.9 million (US$2.9 million), the net balance of accounts receivable was RMB231.0 million (US$33.9 million) as of December 31, 2008. The allowance for doubtful accounts consisted of general provisions of RMB13.1 million (US$1.9 million) and specific provisions of RMB6.8 million (US$1.0 million).

We periodically review our general provisioning policy for doubtful accounts. In assessing the adequacy and reasonableness of the policy, we consider the aging analysis of accounts receivable balances, historical bad debt rates, repayment patterns and credit worthiness of customers and industry trend analysis.

As of December 31, 2008, we had two customers with a receivable balance exceeding 10.0% of the total accounts receivable balance. The approximate total accounts receivable of each such customer outstanding as of December 31, 2008 (and percentage of our total accounts receivable balances) were RMB36.1 million (US$5.3 million) or 14.4% and RMB30.9 million (US$4.5 million) or 12.3%, respectively.

Other Income (Expenses)

Other income in 2008 mainly consisted of interest income after deducting foreign exchange loss. Interest income increased to RMB144.8 million (US$21.2 million) in 2008 from RMB112.6 million in 2007, mainly due to an increase in bank deposits. The cash for such deposits was generated largely from our operations. We did not incur interest expense in 2008 and 2007. In 2008, we recognized a foreign exchange loss of RMB167.1 million (US$24.5 million) primarily due to the increase in translation loss related to our bank deposits denominated in US dollars and Euros, resulting from the depreciation in the exchange rates of the US dollar and/or the Euro against the Renminbi during the year. In 2007, we recognized an exchange loss of RMB50.9 million.

Income Tax

Income tax increased significantly to RMB300.7 million (US$44.1 million) in 2008 from RMB2.7 million in 2007. Our effective tax rate in 2008 was 15.8% as compared with 0.2% in 2007. The lower effective income tax rate in 2007 was mainly due to the receipt of an investment incentive tax refund and a tax benefit resulting from the increased deferred tax assets which were booked under applicable accounting standards at the new statutory income tax rate. The effective income tax rate of 15.8% in 2008 reflects the preferred tax rates applicable to certain of our subsidiaries under the new income tax laws effective January 1, 2008.

Net Profit

As a result of the foregoing, net profit increased by 26.3% to RMB1,596.7 million (US$234.0 million) in 2008 from RMB1,264.1 million in 2007.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Revenues

Total net revenues increased by 2.3% to RMB2,213.3 million in 2007 from RMB2,164.4 million in 2006. Net revenues from online games services, advertising services, and wireless value-added services and others constituted 84.4%, 12.6% and 3.0%, respectively, of our total net revenues in 2007. This compares with 84.6%, 12.1% and 3.3%, respectively, in 2006.

 

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Online Games Services

Net revenues from online games services increased by 2.1% to RMB1,868.9 million in 2007 from RMB1,830.3 million in 2006. The number of peak concurrent players for Fantasy Westward Journey increased to approximately 1,519,000 in December 2007 from 1,335,000 in December 2006, and the number of average concurrent users for Fantasy Westward Journey increased to approximately 546,000 in December 2007 from approximately 453,000 in December 2006. The continued growth in popularity of Fantasy Westward Journey throughout 2007 was mainly attributable to the successful launching of new expansion packs for the game in the year. In addition, the number of peak concurrent players for Westward Journey Online III reached approximately 117,000 in December 2007, and the number of average concurrent users for Westward Journey Online III achieved approximately 49,000 in December 2007. This increase was offset in part by reduced revenues from our other principal online game, Westward Journey Online II. The number of peak concurrent players for Westward Journey Online II decreased to approximately 367,000 in December 2007 from approximately 440,000 in December 2006, and the number of average concurrent players for Westward Journey Online II decreased to approximately 153,000 in December 2007 from approximately 174,000 in December 2006.

Advertising Services

Net revenues from advertising services increased by 6.7% to RMB279.1 million in 2007 from RMB261.5 million in 2006, primarily due to the overall expansion of China’s online advertising market.

Average net revenue per traditional advertiser (i.e., customers which do not advertise through our search services) increased to approximately RMB623,000 in 2007 from RMB590,000 in 2006. The number of traditional advertisers using the NetEase websites increased to 438 in 2007 from 410 in 2006, with revenues from our top ten advertisers comprising 27.9% of our total advertising services revenues in 2007 as compared to 37.3% in 2006.

Wireless Value-Added Services and Others

Net revenues from wireless value-added services and others decreased by 10.1% to RMB65.3 million in 2007 from RMB72.6 million in 2006. This decrease was primarily due to reduced revenues from SMS services resulting from our reduced marketing promotion of our SMS business and under-performing SMS products. The decrease was offset in part by increased revenues from our other value-added services as a result of our continuing enhancements to such services and integration of other value-added services and products.

Cost of Revenues

Our cost of revenues increased by 9.0% to RMB415.5 million in 2007 from RMB381.3 million in 2006. The year-over-year increase was mainly due to an increase in depreciation cost, staff-related cost, business tax on intra-group revenue, cost of third party content and technology cost. In 2007, costs relating to online games services, advertising services and wireless value-added services and others represented 45.1%, 34.6% and 20.3% of total cost of revenues, respectively, as compared with 46.9%, 32.8% and 20.3% of the cost of revenues, respectively, in 2006.

 

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Online Games Services

Cost of revenues from our online games services increased by 4.9% to RMB187.4 million in 2007 from RMB178.7 million in 2006. This increase in cost of revenues in 2007 was primarily due to a combination of the following factors:

 

   

Staff-related costs increased by RMB9.9 million to RMB31.2 million in 2007 from RMB21.3 million in 2006, mainly as a result of an increase in the level of salaries and bonuses as well as an increase in the number of employees. The number of full time employees in our online games department increased to 1,208 as of December 31, 2007 from 1,052 as of December 31, 2006.

 

   

Business tax payable on intra-group revenues related to online games from our VIEs increased by RMB3.6 million to RMB93.4 million in 2007 from RMB89.8 million in 2006 due to continued growth in the popularity of Fantasy Westward Journey and the commercial launch of Westward Journey Online III in September 2007.

 

   

Depreciation and amortization costs of computers and software increased by RMB0.5 million to RMB8.9 million in 2007 from RMB8.4 million in 2006.

These increases were partially offset by the following factors:

 

   

Bandwidth and server custody fees decreased by RMB2.3 million to RMB19.3 million in 2007 from RMB21.6 million in 2006 due to the fact that reductions in fee rates charged by the service providers more than offset an increase in bandwidth usage caused by the rising volume of online game services.

 

   

Printing cost for prepaid point cards decreased by RMB1.7 million to RMB9.4 million in 2007 from RMB11.1 million in 2006, as a result of the reduced consumption of physical point cards in 2007 compared to 2006.

 

   

Revenue sharing expenses decreased by RMB1.5 million to RMB15.1 million in 2007 from RMB16.6 million in 2006 due to reduced business cooperation with the internet data centers in 2007.

Advertising Services

Cost of revenues from our advertising services increased by 14.8% to RMB143.7 million in 2007 from RMB125.2 million in 2006. The increase in cost of revenues in 2007 was primarily due to a combination of the following factors:

 

   

Cost of third party content for the NetEase websites increased by RMB7.5 million to RMB18.9 million in 2007 from RMB11.4 million in 2006, as a result of our efforts to improve the range and quality of the content we offer on those sites.

 

   

Depreciation and amortization costs of computers and software increased by RMB4.7 million to RMB20.0 million in 2007 from RMB15.3 million in 2006, mainly due to additional servers purchased during the year to satisfy our ongoing business capacity requirements and to provide capacity for our newly launched search engine service, Youdao, in 2007.

 

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Staff-related costs increased by RMB3.9 million to RMB56.8 million in 2007 from RMB52.9 million in 2006, mainly as a result of an increase in salaries and other compensation payments, such as bonuses and welfare benefits, and also due to an expansion of the number of editors of the various content channels for the NetEase websites to 386 as of December 31, 2007 from 293 as of December 31, 2006.

 

   

Bandwidth and server custody fees increased by RMB1.9 million to RMB25.1 million in 2007 from RMB23.2 million in 2006, as a result of an increase in bandwidth usage for supporting the continuous growth of traffic on the NetEase websites.

 

   

Business tax payable by us on intra-group revenues related to advertising services from our VIEs increased by RMB0.8 million to RMB13.4 million in 2007 from RMB12.6 million in 2006, primarily due to increased demand for advertising spaces on the NetEase websites.

Wireless Value-Added Services and Others

Cost of revenues from our wireless value-added services and others increased 9.0% to RMB84.4 million in 2007 from RMB77.4 million in 2006. This increase in cost of revenues in 2007 was primarily due to a combination of the following factors:

 

   

Depreciation and amortization costs of computers and software increased by RMB7.7 million to RMB42.9 million in 2007 from RMB35.2 million in 2006, mainly due to additional servers purchased during the year to meet the increase in demand for our various free services such as e-mail and album.

 

   

Bandwidth and server custody fees increased by RMB3.5 million to RMB27.2 million in 2007 from RMB23.7 million in 2006, as a result of an increase in bandwidth usage.

These increases were partially offset by the fact that staff-related costs decreased by RMB4.9 million to RMB9.5 million in 2007 from RMB14.4 million in 2006, as a result of decreased headcount due to the reorganization of our SMS business in 2007.

Gross Profit

Our gross profit increased by 0.8% to RMB1,797.8 million in 2007 from RMB1,783.1 million in 2006.

The following table sets forth the audited consolidated gross profits and gross profit margins of our business activities for the periods indicated. The gross profit margins in 2006 and 2007 were calculated by dividing our gross profits over our net revenues for the corresponding type of services. The net revenues are before netting-off the business taxes payable by us on intra-group revenues from our VIEs, which are recorded under cost of revenues.

 

     For the Year Ended December 31,  
     2006     2007  
     RMB     RMB  

Gross profit (loss):

    

Online game services

   1,651,616,697      1,681,446,765   

Advertising services

   136,298,684      135,451,607   

Wireless value-added services and others

   (4,854,092   (19,064,654
            

Total gross profit

   1,783,061,289      1,797,833,718   
            

Gross profit (loss) margin:

    

Online game services

   90.2   90.0

Advertising services

   52.1   48.5

Wireless value-added services and others

   (6.7 )%    (29.2 )% 
            

Total gross profit margin

   82.4   81.2
            

 

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The slight decrease in gross profit margin for online game services in 2007 was mainly due to the increased cost of revenues which outpaced the increase in net revenues. Higher cost of revenues was mainly the result of increased headcount and higher level of salaries and bonuses paid to the employees in our online game business in 2007.

The decrease in gross profit margin for advertising services was mainly due to the increase in salaries and other benefits paid to content editors and the increased costs associated with our online advertising business, such as cost of third party content, server depreciation charges and bandwidth and server custody fees for the purpose of maintaining and increasing the traffic of the NetEase websites.

The gross loss margin for wireless value-added services and others increased significantly in 2007 compared to 2006 as a result of an increase in the cost of revenues, including server depreciation costs and bandwidth and server custody fees, associated with our various free e-mail and photo album services. The increase in cost of revenue was offset in part by reduced salaries and revenue sharing expenses as a result of the reorganization of our SMS business in 2007.

Operating Expenses

Total operating expenses increased by 17.7% to RMB592.2 million in 2007 from RMB503.2 million in 2006. Operating expenses as a percentage of total net revenue increased from 23.2% in 2006 to 26.8% in 2007. The increase was driven primarily by the increase in both selling and marketing expenses and research and development expenses.

Selling and marketing expenses increased by 38.3% to RMB235.3 million in 2007 from RMB170.1 million in 2006, primarily due to a combination of the following factors:

 

   

An increase in marketing costs of approximately RMB47.2 million for advertising and marketing promotion of Westward Journey Online III, Fantasy Westward Journey and Tianxia II in 2007.

 

   

An increase in labor cost of approximately RMB11.2 million associated with the expansion of regional game promotion activities in China during 2007.

 

   

An increase in transportation costs by approximately RMB2.1 million due to the increased level of promotional activities and events in 2007.

 

   

An increase in staff-related costs of our online game and advertising sales team of approximately RMB5.1 million in 2007. This increase was partially offset by the decrease in staff costs of approximately RMB3.8 million resulting from the reduction of the marketing team in the wireless department in 2007.

 

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General and administrative expenses decreased by 2.1% to RMB176.2 million in 2007 from RMB179.9 million in 2006, primarily due to a combination of the following factors:

 

   

A decrease in professional fees of approximately RMB10.6 million associated with reduced expenses incurred for outside consultants by approximately RMB6.3 million in 2007, and the fact that the remaining cost of our zero coupon convertible subordinated notes of approximately RMB4.3 million was fully amortized in July 2006.

 

   

A decrease in allowance for bad and doubtful debts of approximately RMB12.8 million in 2007.

These decreases were substantially offset by the following factors:

 

   

An increase in staff-related costs by approximately RMB8.5 million in 2007, mainly as a result of an increase in the level of salaries and other compensation payments.

 

   

An increase in depreciation expense of approximately RMB11.9 million, mainly as a result of the purchase of computers and servers during 2007, and the full year depreciation expense in 2007 related to the decoration, improvements and the equipment installation expenditure for our offices in Guangzhou compared to the approximately six months of such depreciation expense in 2006.

Research and development expenses increased by 18.0% to RMB180.7 million in 2007 from RMB153.2 million in 2006, primarily due to an increase in staff-related costs by approximately RMB38.6 million in 2007, mainly as a result of increased headcount of program developers in our online games department and higher salaries and other benefits paid to our research and development team during 2007. The increase was partially offset by a decrease in research and development expense of approximately RMB11.6 million in 2007, resulting from a one-time write-off in software cost for our licensed online 3D game, Fly for Fun, in 2006.

Allowances for Doubtful Accounts

As of December 31, 2007, the gross accounts receivable balance before any allowance for bad and doubtful accounts was RMB179.3 million. After providing for doubtful accounts in the amount of RMB12.6 million, the net balance of accounts receivable was RMB166.7 million as of December 31, 2007. The allowance for doubtful accounts consisted of general provisions of RMB4.9 million and specific provisions of RMB7.7 million.

We periodically review our general provisioning policy for doubtful accounts. In assessing the adequacy and reasonableness of the policy, we consider the aging analysis of accounts receivable balances, historical bad debt rates, repayment patterns and credit worthiness of customers and industry trend analysis.

As of December 31, 2007, we had one customer with a receivable balance exceeding 10% of the total accounts receivable balance. The approximate total outstanding accounts receivable balance then outstanding (and percentage thereon) was RMB18.6 million or 10.4%.

 

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Other Income (Expenses)

Other income in 2007 mainly consisted of interest income. Interest income increased to RMB112.6 million in 2007 from RMB94.4 million in 2006, mainly due to an increase in short-term bank deposits in China and abroad. The cash for such deposits was generated largely from our operations as well as from the proceeds of our US$100 million zero coupon convertible subordinated notes issued in July 2003. We did not incur interest expense in 2007 and 2006. In 2007, we recognized an exchange loss of RMB50.9 million upon translating foreign-currency monetary assets and liabilities, primarily due to the rising value of the Renminbi against the US dollar in 2007. In 2006, we recognized an exchange loss of RMB1.0 million.

Income Tax

Income tax decreased significantly to RMB2.7 million in 2007 from RMB132.5 million in 2006. Our effective tax rate in 2007 was 0.2% as compared with 9.6% in 2006. This significant reduction in income tax was mainly due to the receipt of an investment incentive tax refund and the tax benefit resulted from the increased deferred tax assets which were booked under applicable accounting standards at the new statutory income tax rate.

Net Profit

As a result of the foregoing, net profit increased by 1.7% to RMB1,264.1 million in 2007 from RMB1,242.8 million in 2006.

 

B. LIQUIDITY AND CAPITAL RESOURCES

Our capital requirements relate primarily to financing:

 

   

our working capital requirements, such as bandwidth and server custody fees, staff costs, sales and marketing expenses and research and development, and

 

   

costs associated with the expansion of our business, such as the purchase of servers, acquisition of license rights and construction of our research and development center.

Operating Activities

Cash provided by operating activities was RMB2,017.8 million (US$295.8 million), RMB1,379.9 million and RMB1,596.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.

For the year ended December 31, 2008, cash provided by operating activities consisted primarily of our operating profit of RMB1,596.7 million (US$234.0 million), adjusted for, principally:

 

   

unrealized exchange losses of RMB166.7 million (US$24.4 million),

 

   

an increase in accounts payable and other liabilities totaling RMB162.7 million (US$23.8 million),

 

   

depreciation and amortization charges of RMB91.0 million (US$13.3 million),

 

   

an increase in accounts receivable of RMB72.9 million (US$10.7 million),

 

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share-based compensation cost of RMB67.9 million (US$10.0 million),

 

   

an increase in prepayments and other current assets of RMB52.4 million (US$7.7 million),

 

   

a decrease in deferred tax assets of RMB47.2 million (US$6.9 million), and

 

   

an increase in allowance for doubtful accounts of RMB8.6 million (US$1.3 million).

For the year ended December 31, 2007, cash provided by operating activities consisted primarily of our operating profit of RMB1,264.1 million adjusted for, principally:

 

   

a decrease in accounts payable and other liabilities totaling RMB25.9 million,

 

   

depreciation and amortization charges of RMB99.1 million,

 

   

unrealized exchange losses of RMB50.9 million,

 

   

an increase in accounts receivable of RMB29.8 million,

 

   

a decrease in allowance for doubtful accounts of RMB5.3 million,

 

   

an increase in prepayments and other current assets of RMB16.5 million, and

 

   

an increase in deferred tax assets of RMB53.7 million.

For the year ended December 31, 2006, cash provided by operating activities consisted primarily of our operating profit of RMB1,242.8 million adjusted for, principally:

 

   

an increase in accounts payable and other liabilities totaling RMB242.8 million,

 

   

depreciation and amortization charges of RMB82.7 million,

 

   

an increase in accounts receivable of RMB69.6 million,

 

   

an increase in allowance for doubtful accounts of RMB7.5 million,

 

   

an increase in prepayments and other current assets of RMB13.9 million, and

 

   

an increase in deferred tax assets of RMB11.2 million.

Investing Activities

Cash used in investing activities was RMB3,409.3 million (US$499.7 million) for the year ended December 31, 2008, cash provided by investing activities was RMB952.3 million for the year ended December 31, 2007, and cash used in investing activities was RMB1,218.2 million for the year ended December 31, 2006.

For the year ended December 31, 2008, cash used in investing activities mainly consisted of an increase in the placement/rollover of time deposits of RMB4,253.1 million (US$623.4 million), the purchase of fixed assets of RMB133.3 million (US$19.5 million), the investment in an associated company of RMB33.6 million (US$4.9 million), and the prepayment for license right of RMB27.5 million (US$4.0 million), partially offset by a receipt of government incentive on land use right of RMB15.0 million (US$2.2 million) and the uplift of matured time deposits of RMB1,042.8 million (US$152.8 million).

 

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For the year ended December 31, 2007, cash provided by investing activities mainly consisted of the uplift of matured time deposits of RMB1,530.8 million, partially offset by an increase in the placement/rollover of time deposits of RMB476.3 million, the purchase of fixed assets of RMB71.5 million, and the prepayment for land use right of RMB27.0 million.

For the year ended December 31, 2006, cash used in investing activities mainly consisted of an increase in the placement/rollover of time deposits of RMB2,164.9 million and the purchase of fixed assets of RMB142.5 million, partially offset by the uplift of matured time deposits of RMB1,125.1 million.

Financing Activities

Cash used in financing activities was RMB157.3 million (US$23.1 million), RMB960.4 million and RMB829.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.

For the year ended December 31, 2008, cash used in financing activities mainly consisted of company share repurchases of RMB165.7 million (US$24.3 million) and payment of other long-term payable of RMB10.0 million (US$1.5 million), partially offset by proceeds from the issuance of shares on the exercise of employee stock options of RMB18.4 million (US$2.7 million).

For the year ended December 31, 2007, cash used in financing activities mainly consisted of company share repurchases of RMB1,003.7 million, partially offset by proceeds from the issuance of shares on the exercise of employee stock options of RMB43.2 million.

For the year ended December 31, 2006, cash used in financing activities mainly consisted of company share repurchases of RMB873.4 million, partially offset by proceeds from the issuance of shares on the exercise of employee stock options of RMB44.1 million.

We believe that our current levels of cash and cash equivalents and cash flows from operations will be sufficient to meet our anticipated cash needs for at least the next 12 months. However, we may need additional cash resources if we experience changed business conditions or other developments. We may also need additional cash resources if we find and wish to pursue opportunities for investment, acquisition, strategic cooperation or other similar action. If we determine that our cash requirements exceed our amounts of cash and cash equivalents on hand, we may seek to issue debt or equity securities or obtain a credit facility. Any issuance of equity securities could cause dilution for our shareholders. Any incurrence of indebtedness could increase our debt service obligations and cause us to be subject to restrictive operating and finance covenants. It is possible that, when we need additional cash resources, financing will only be available to us in amounts or on terms that would not be acceptable to us or financing will not be available at all.

Indebtedness

As of July 11, 2008, our then outstanding zero-coupon convertible subordinated notes due July 15, 2023 were fully converted into ordinary shares at the request of the noteholders pursuant to a redemption notice issued by us to the noteholders dated June 13, 2008. On May 17, 2007, we entered into a revolving loan facility with a Hong Kong commercial bank, which would be available, upon our request, for the refinancing of such notes upon redemption requests by noteholders. Such loan facility was cancelled in December 2007 and no amount had been drawn prior to its cancellation.

 

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C. RESEARCH AND DEVELOPMENT

We believe that an integral part of our future success will depend on our ability to develop and enhance our services. Our product development efforts and strategies consist of incorporating new technologies from third parties as well as continuing to develop our own proprietary technology.

We have utilized and will continue to utilize the products and services of third parties to enhance our platform of technologies and services to provide competitive and diverse Internet and wireless services to our users. In addition, we plan to continue to expand our technologies, products and services and registered user base through diverse online community products and services developed internally, particularly with respect to our online game services. We will seek to continually improve and enhance our existing services to respond to rapidly evolving competitive and technological conditions. For the years 2006, 2007 and 2008, we spent RMB153.2 million, 180.7 million and RMB 207.0 million (US$30.3 million), respectively, on research and development activities.

 

D. TREND INFORMATION

Based on our observations, we believe that the following trends are likely to have a material effect on our business in the near term:

 

   

We believe that there has been increasing demand by online game users for new and unique online games and increasing competition in this area. We believe that these trends will force us to devote additional resources to developing and launching additional games, updating existing games at a faster rate than we have in the past and licensing games from third parties. In particular, the online game industry in China is transitioning from 2D to 3D games, with numerous new 3D game titles being launched in the market in recent years. In response to this trend, we have been devoting additional resources to developing or licensing 3D games. Nonetheless, we also believe that the market for 2D online games will continue to grow in popularity for the foreseeable future.

 

   

Our online games business may be adversely affected if, as is predicted by some industry commentators, the Chinese government takes additional steps to slow the growth in this market. We may not be able to adequately respond to any such regulatory changes in the online games market.

 

   

Substantially all of our online game revenues have been generated by games that use the pay-to-play revenue model whereby players purchase our prepaid point cards to pay for playing time. A number of our competitors, including Giant, Perfect World, Shanda and Kingsoft use primarily or entirely an item-based revenue model where end users are able to play the basic functions of the online games for free and may choose to purchase in-game value-added services, including certain in-game items and premium features, which enhance the game experience. Currently, we are developing games that use the item-based revenue model and launched open beta testing versions of our item-based online games, Tianxia II and Legend of Westward Journey, in June and September 2008, respectively, but we cannot be certain that Tianxia II, Legend of Westward Journey and our future item-based online games will be popular or generate the revenue our management expects. Moreover, it is possible that users of our existing pay-to-play games find that the item-based games offered by our competitors provide a more enjoyable gaming experience in which case the popularity of our existing games could be materially adversely affected.

 

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If there is an overall shift in the online game market in China to an item-based or another revenue model, we may be unable to launch new games or new versions of existing games which effectively use such model, and we may be required to make significant research and development and selling and marketing expenditures to develop and promote such games.

 

   

Online video content is becoming increasingly popular among Internet users in China. Many providers of video content prefer to enter into exclusive distribution agreements with Internet portals. Accordingly, we believe that the sources for such content are more limited in comparison to other types of content.

 

   

A general increase in competition for online services has elevated the importance of brand building and brand awareness. We believe that this trend may require us to increase our marketing and advertising efforts and budgets in order to keep our brand names and the NetEase websites visible and prominent.

 

   

We expect that for at least the next several quarters, our fixed costs in connection with our Internet portal business will increase, without a corresponding increase in revenue, due to the ongoing increase in the number of users for our free e-mail service and increasing bandwidth fees resulting from increased usage of the NetEase websites. In addition, we expect that the increasing popularity of online video content will increase our cost because it requires significant bandwidth to deliver and requires us to invest in new video streaming technology.

 

E. OFF-BALANCE SHEET ARRANGEMENTS

We do not have any outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. We do not engage in trading activities involving non-exchange traded contracts.

 

F. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

We have entered into leasing arrangements relating to our office premises. We also have contractual obligations in respect of server custody fees and capital expenditures related to the construction of the research and development center in Hangzhou. In addition, we have contractual obligations in connection with the licensing of certain online games by Blizzard to Shanghai EaseNet for operation in the PRC. The following sets forth our contractual obligations for long-term payables, operating leases, server custody fees, capital expenditures, and games licensed by Blizzard as of December 31, 2008:

 

     Rental
commitments
   Server custody
fee
commitments
   Long-term
payables
   Capital
commitments
   Office machine
commitments
   Total
     RMB    RMB    RMB    RMB    RMB    RMB

2009

   12,185,649    59,514,459    —      98,752,147    89,430    170,541,685

2010

   3,664,270    —      —      —      75,191    3,739,461

2011

   710,800    —      —      —      28,243    739,043

2012

   —      —      —      —      11,400    11,400

Beyond 2012

   —      —      200,000    —      3,325    203,325
                             
   16,560,719    59,514,459    200,000    98,752,147    207,589    175,234,914
                             

 

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After Commercial Launch

   Blizzard licensed game
commitment*

RMB

Contract Year One

   202,469,100

Contract Year Two

   161,534,100

Contract Year Three

   160,169,600
    

Total

   524,172,800
    

 

* The figures are calculated on the possibility that StarCraft II is launched in 2009 and do not include our contractual obligations with regard to the licensing of World of Warcraft which was agreed in April 2009. In addition, as of December 31, 2008, Shanghai EaseNet is obligated to provide RMB109.6 million (US$16.1 million) for hardware to support the games over the three-year term of the license. The figures represent the amount of payments that we have guaranteed if and to the extent Shanghai EaseNet has insufficient funds to make such payments in connection with the licensing of certain online games by Blizzard to Shanghai EaseNet for operation in the PRC. We will be entitled to reimbursement of any amounts paid for the marketing of the games and for hardware support to operate the games under the guarantee from any net profits subsequently generated by Shanghai EaseNet, after the deduction of, among others, various fees and expenses payable to Blizzard, us and our joint venture with Blizzard which will provide technical services to Shanghai EaseNet. Please refer to Item 4.B. “Business Overview – Our Services – Game Licensing and Joint Venture with Blizzard” for further details.

Other than the obligations set forth above, we do not have any long-term commitments.

Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

Our exposure to market rate risk for changes in interest rates relates primarily to the interest income generated by excess cash invested in short term money market accounts and certificates of deposit. We have not used derivative financial instruments in our investment portfolio. Interest earning instruments carry a degree of interest rate risk. We have not been exposed nor do we anticipate being exposed to material risks due to changes in interest rates. However, our future interest income may fall short of expectations due to changes in interest rates.

 

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Foreign Currency Risk

Substantially all our revenues and expenses are denominated in Renminbi, but as noted above, certain portion of our cash is kept in U.S. dollars and Euro. Although we believe that, in general, our exposure to foreign exchange risks should be limited, the value of our ADSs will be affected by the foreign exchange rate between U.S. dollars, Euro and Renminbi. For example, to the extent that we need to convert U.S. dollars or Euro into Renminbi for our operational needs and the Renminbi appreciates against the U.S. dollars or Euro at that time, our financial position and the price of our ADSs may be adversely affected. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of declaring dividends on our ADSs or otherwise and the U.S. dollar or Euro appreciates against the Renminbi, the U.S. dollar equivalent of our earnings from our subsidiaries and controlled entities in China would be reduced.

In July 2005, the Chinese government announced that it is pegging the exchange rate of the Chinese Renminbi against a number of currencies, rather than just the US dollar. This change in policy has resulted in an appreciation in the value of the Renminbi against the US dollar. Although we generate substantially all of our revenues in Renminbi which has become more valuable in US dollar terms, we translate our monetary assets and liabilities which are denominated in currencies other than Renminbi into Renminbi as of each accounting period end, in accordance with applicable accounting standards. As a result of this foreign currency translation, we reported a RMB167.1million (US$24.5 million) exchange loss in 2008. We have not engaged in any hedging activities, and we may experience additional economic loss as a result of any foreign currency exchange rate fluctuations. In addition, we cannot predict at this time what will be the long-term effect of the Chinese government’s decision to tie the Renminbi to a basket of currencies, rather than just to the U.S. dollar.

Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standard Boards, or FASB, issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). This statement establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. Adoption is prospective and early adoption is not permitted. Accordingly, any business combinations we engage in will be recorded and disclosed following existing US GAAP until January 1, 2009. Adoption of SFAS 141R will not impact our accounting for business combinations closed prior to its adoption. We believe that the adoption of SFAS 141R will not have a material impact on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51” (“SFAS 160”). This Statement amends Accounting Research Bulletin No. 51, Consolidated Financial Statements, to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. It requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. This statement establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We believe that the adoption of SFAS 160 will not have a material impact on our consolidated financial statements.

 

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In December 2007, the SEC issued Staff Accounting Bulletin No. 110 (“SAB 110) relating to SFAS 123R which provides that in developing an estimate of expected term of “plain vanilla” share options in accordance with SFAS 123R, under certain circumstances, the use of the simplified method beyond December 31, 2007 will remain acceptable. This SAB is effective January 1, 2008. The adoption of SAB 110 has not resulted in a material impact on our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities”, an amendment of FASB statement No. 133 (“SFAS 161”). SFAS 161 expands the disclosure requirements about an entity’s derivative instruments and hedging activities. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We believe that the adoption of SFAS 161 will not have a material impact on our consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position No. FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends paragraph 11(d) of Statement 142 so that an entity will use its own assumptions about renewal or extension of an arrangement, adjusted for the entity-specific factors even when there is likely to be substantial cost or material modifications. In addition, FSP FAS 142-3 expands the required disclosure requirements about accounting policy on the treatment of costs incurred to renew or extend the term of a recognized intangible asset, the weighted-average period prior to the next renewal or extension by major intangible asset class and the total amount of costs incurred in the period to renew or extend the term of a recognized intangible asset by major intangible asset class. This FSP shall be effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. We believe that the adoption of FSP FAS 142-3 will not have a material impact on our consolidated financial statements.

In May 2008, the FASB issued FASB Staff Position APB 14-1, “Accounting for Convertible Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 requires issuers to account separately for the liability and equity components of certain convertible debt instruments in a manner that reflects the issuer’s nonconvertible debt (unsecured debt) borrowing rate when interest cost is recognized. FSP APB 14-1 requires bifurcation of a component of the debt, classification of that component in equity and the accretion of the resulting discount on the debt to be recognized as part of interest expense in a company’s consolidated statement of operations. FSP APB 14-1 requires retrospective application to the terms of instruments as they existed for all periods presented. FSP APB 14-1 is effective as of January 1, 2009 and early adoption is not permitted. As required by FSP APB 14-1, we estimated the fair value, as of the date of issuance, of our convertible notes as if the instrument was issued without the conversion option. The difference between the fair value and the principal amount of the instrument was retrospectively recorded as debt discount and as a component of equity. The amortization of the debt discount was recognized over the expected three-year life of the convertible notes as a non-cash increase to interest expense in the historical periods. Although FSP APB 14-1 will have no impact on our actual past or future cash flows, it requires us to record a significant amount of non-cash interest expense as the debt discount is amortized that would not have occurred under previous GAAP. FSP APB 14-1 is applicable to us effective January 1, 2009. We estimate that the adoption of FSP APB 14-1 would have resulted in a total interest expense of RMB133.8 million recorded for the period from July 2003 to July 2006, thus it would have required us to record a transfer of RMB133.8 million from our retained earnings to additional paid-in capital as of January 1, 2009.

 

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In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. This statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” We do not expect SFAS 162 to have a material impact on our consolidated financial statements.

 

Item 6. Directors, Senior Management and Employees

 

A. Directors and Senior Management

The names of our directors and executive officers, their ages as of June 1, 2009 and the principal positions with NetEase held by them are as follows:

 

Name

  

Age

  

Position

William Lei Ding

   37    Director and Chief Executive Officer

Onward Choi

   38    Acting Chief Financial Officer

Zhonghui Zhan

   37    Co-Chief Operating Officer

Alice Cheng(1)

   48    Director

Denny Lee

   41    Director

Joseph Tong(1)

   46    Director

Lun Feng

   49    Director

Michael Leung(1)

   55    Director

Michael Tong

   38    Director

 

(1) Member of the audit, compensation and nominating committees.

Biographical Information

William Lei Ding, our founder, has served as a director since July 1999 and as our Chief Executive Officer since November 2005. From March 2001 until November 2005, Mr. Ding served as our Chief Architect, and, from June 2001 until September 2001, he served as our Acting Chief Executive Officer and Acting Chief Operating Officer. Mr. Ding stepped down as Chairman of the board of directors in September 2001 (the company currently has no permanently appointed Chairman). From July 1999 until March 2001, Mr. Ding served as Co-Chief Technology Officer, and from July 1999 until April 2000, he also served as our interim Chief Executive Officer. Mr. Ding established Guangzhou NetEase and Shanghai EaseNet, our affiliates, in May 1997 and January 2008. Mr. Ding holds a Bachelor of Science degree in Communication Technology from the University of Electronic Science and Technology of China.

Onward Choi has served as our Acting Chief Financial Officer when Denny Lee stepped down from such position on June 30, 2007. Mr. Choi was our Financial Controller and Corporate Finance Director for the periods from January 2005 to June 2007 and November 2003 to December 2004, respectively. Prior to that, Mr. Choi worked at Ernst & Young Beijing, including as a senior manager of the assurance and advisory business services department. Mr. Choi also worked at KPMG (assurance) and the Hong Kong Trade Development Council (finance and accounting).

 

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Mr. Choi is a member of the Institute of Chartered Accountants in England and Wales, a member of the Association of Chartered Certified Accountants, a member of the Hong Kong Institute of Certified Public Accountants and a registered practising Certified Public Accountant in Hong Kong. Mr. Choi holds a Bachelor of Arts degree in accountancy with honors from the Hong Kong Polytechnic University.

Zhonghui Zhan joined our company in October 1999 and has since served in various positions. Mr. Zhan was appointed as our Co-Chief Operating Officer in May 2006. Mr. Zhan has extensive experience in software and product development and management, and has had a leading role in many projects since joining us, including the development of our EaseBar browser toolbar and our proprietary content delivery system. Mr. Zhan received his Bachelor of Science and Master’s Degree in Automation from the South China University of Technology.

Alice Cheng has served as a director since June 2007. Ms. Cheng has been the Chief Financial Officer of BBK Electronics Corp., Ltd., a PRC-based manufacturer of audio/visual equipment, since May 2005. From January 2002 to April 2005, she served as Financial Controller of Wistron Corporation, a Taiwanese original design manufacturer of notebook computers and other electronics. Prior to that, she held various positions with Acer Inc., a Taiwanese computer manufacturer, culminating in the position of Financial Controller. Ms. Cheng received a Bachelor of Accounting from the Chinese Culture University in Taiwan in 1983 and a Masters of Business Administration from the Thunderbird School of Global Management in Arizona in 2003. She is licensed as a certified public accountant in Taiwan and the PRC.

Denny Lee has served as a director since April 2002. Mr. Lee previously served as our Chief Financial Officer from April 2002 until June 2007 and as our Financial Controller from November 2001 until April 2002. Prior to joining our company, Mr. Lee worked in the Hong Kong office of KPMG for more than ten years, culminating in the position of Senior Manager in one of the audit departments where he specialized in auditing international clients. During his employment with KPMG, he also worked with a number of Chinese companies with respect to accounting and other aspects of their initial public offerings on the Hong Kong Stock Exchange, due diligence work in relation to potential investments in Chinese companies and financial and operational reviews of Chinese companies in connection with proposed investments in such companies by foreign investors. Mr. Lee serves as a director of New Oriental Education & Technology Group Inc., which is listed on the New York Stock Exchange. Mr. Lee graduated from the Hong Kong Polytechnic University majoring in accounting and is a member of the Hong Kong Institute of Certified Public Accountants and the Association of Chartered Certified Accountants.

Joseph Tong has been a director of, and management consultant to, Parworld Investment Management Limited, which provides financial and investment advisory services, since April 2004. From December 2002 until April 2004, Mr. Tong was engaged in establishing offices and operations in Hong Kong and China, setting up accounting and internal control policies and overseeing the overall operations for TLM Apparel Co., Ltd., a garment trading company operating in Hong Kong and China which he co-founded. Prior to that, from September 2000 to September 2002, he was the e-Commerce Director of the Asia Region for Universal Music Limited where he was responsible for forming e-business development strategies and overseeing new promotional opportunities. Mr. Tong has a Bachelor of Science degree and Second Honors Degree in Accounting and Statistics from the University of Southampton, England. He is a member of the American Institute of Certified Public Accountants and has served as a director since March 2003.

Lun Feng has served as a director since July 2005. He has been the Chairman of Beijing Vantone Real Estate Co., Ltd., a private real estate investment company in China, since 1991. Mr. Feng has a Juris Doctor from the Chinese Academy of Social Sciences, a Masters of Law degree from the Party School of the Chinese Communist Party and a Bachelor of Arts in Economics from Northwest University.

 

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Michael Leung has served as a director since July 2002. Mr. Leung held senior positions with Peregrine Capital (China) Limited, SG Securities (HK) Limited (previously known as Crosby Securities (Hong Kong) Limited), Swiss Bank Corporation, Hong Kong Branch, and Optima Capital Limited (previously known as Ke Capital (Hong Kong) Limited) where he provided financial advisory services. Mr. Leung was also a director at Emerging Markets Partnership (Hong Kong) Limited, which was the principal advisor to the AIG Asian Infrastructure Fund L.P. Mr. Leung serves as an independent non-executive director for China Ting Group Holdings Limited, Anhui Expressway Company Limited, Junefield Department Store Group Limited and Golden Harvest Entertainment (Holdings) Limited, all of which are companies listed on the Stock Exchange of Hong Kong Limited. Mr. Leung is also the Responsible Officer of North Asia Strategic Advisors, which provides advice on corporate finance. Mr. Leung received a Bachelor’s Degree in Social Sciences from the University of Hong Kong with a major in accounting, management and statistics.

Michael Tong became a director of our company in June 2003. Mr. Tong previously served as our Co-Chief Operating Officer from July 2004 to March 2009. He has also served as one of our directors since December 1999. Previously, he was an Executive Director with techpacific.com Venture Capital Limited. In that capacity, he was primarily responsible for portfolio management of the funds managed by techpacific.com and its subsidiaries. Prior to joining techpacific.com in December 2000, Mr. Tong worked at Softbank China Venture Investments Limited in Hong Kong, where he was responsible for the evaluation, financial modeling, due diligence review and structuring of Softbank’s investments. He also worked at Nomura China Venture Investments Limited, Jardine Fleming Securities Limited and Ernst & Young, all in Hong Kong. Mr. Tong graduated with a Bachelor of Business Administration from the University of Wisconsin, Madison with a major in Accounting and an extra concentration in Computer Science in 1993. He is a member of the American Institute of Certified Public Accountants and the CFA Institute and is a Chartered Financial Analyst.

Relationships Among Directors or Executive Officers; Right to Nominate Directors

There are no family relationships among any of the directors or executive officers of our company. None of our directors were nominated pursuant to a contractual or other right.

 

B. Compensation

Director Compensation

In 2008, we paid each of Alice Cheng, Joseph Tong and Michael Leung the amount of US$4,500 per month for their services as independent non-executive directors for a total of US$162,000.

In addition, in 2008 we paid each of Denny Lee and Lun Feng US$1,000 per month for their services as non-executive directors for a total of US$24,000. We also paid Alice Cheng and Lun Feng US$12,860 and US$2,320 for Chinese individual income taxes on their behalf, respectively. Other than the foregoing payments, we did not pay any other compensation in any form to our non-executive directors in 2008.

In 2008, we did not grant any stock options to our directors.

 

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All of our current directors have entered into indemnification agreements in which we agree to indemnify, to the fullest extent allowed by Cayman Islands law, our charter documents or other applicable law, those directors from any liability or expenses, unless the liability or expense arises from the director’s own willful negligence or willful default. The indemnification agreements also specify the procedures to be followed with respect to indemnification.

Executive Officer Compensation

The following table sets forth certain information concerning compensation paid during 2006, 2007 and 2008 to our executive officers, including Chief Executive Officer, Acting Chief Financial Officer, Co-Chief Operating Officer and former Co-Chief Operating Officer. In 2008, we did not grant any stock options to our executive officers.

 

     Annual Compensation     Long-Term Compensation  

Fiscal Year

   Salary
(US$)
   Housing and
Cash Living
Allowance (US$)
   Bonus
(US$)
    Securities
Underlying
Options (#)
   All Other
Compensation

(US$)
 

2008

   556,177    96,536    1,241,650 (1)    —      467,815 (2) 

2007

   491,091    70,124    890,274 (1)    5,125,000    391,934 (2) 

2006

   296,561    33,673    550,974 (1)    —      54,623 (2) 

 

(1) Represents fixed and discretionary bonuses in the year earned and monthly bonuses in which such bonus amount was paid.
(2) Represents PRC individual income taxes paid by our company on behalf of Mr. Michael Tong, a director and former Co-Chief Operating Officer and Mr. Onward Choi, Acting Chief Financial Officer.

Employment Agreements

We have entered into employment and related agreements with William Lei Ding, Onward Choi and Zhonghui Zhan, as described below.

William Lei Ding. In August 1999, we entered into an employment agreement with Mr. Ding which provided for an initial annual salary of US$85,000, plus a discretionary bonus, if any. This employment agreement was amended on May 1, 2003 to lower such salary to RMB1,000 per month and again on November 25, 2005 to increase his salary to RMB30,000 per month. Under this employment agreement, Mr. Ding is obligated to keep all proprietary information regarding our company confidential, except in limited circumstances. He is further precluded during his employment with us from carrying on or being employed by any business in China which is in competition with us or, directly or indirectly, solicit away from our company any of our existing or prospective clients or customers.

Onward Choi. In July 2007, we entered into a new employment agreement with Onward Choi in connection with his promotion to the position of Acting Chief Financial Officer. This agreement provides for an annual salary of RMB1,524,600, plus a discretionary bonus to be determined by our company. Mr. Choi’s discretionary bonus in 2007 and 2008 were US$200,000 and US$220,000, respectively. He is also entitled to receive a housing allowance and tax equalization benefits. If Mr. Choi is terminated without cause or resigns for good reason, he is entitled to receive a payment by us equal to his then- current monthly base salary multiplied by six plus the number of years between July 2007 and the termination date. He is also entitled to exercise his stock options which have vested at the time of his termination without cause or resignation for good reason (as such terms are defined in his employment agreement).

 

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Mr. Choi is prohibited from directly or indirectly (i) being employed by or participate in the management or operation of any business or entity that is or may be directly competitive with and offering similar products or services as us, for a period of one year after termination of employment for any reason, (ii) soliciting for employment any person who was employed by us during his employment with us, for a period of two years after termination of employment for any reason or (iii) working for any customer or potential customer of ours during his employment with us, for a period of two years after termination of employment for any reason. Mr. Choi has also entered into a key employee invention assignment and confidentiality agreement in which he agrees to assign all rights in company-related inventions to us, and to keep our proprietary information confidential.

Zhonghui Zhan. In May 2006, we entered into a new employment agreement with Zhonghui Zhan in connection with his promotion to the position of Co-Chief Operating Officer. The employment agreement provides for an annual salary of RMB456,000, plus a discretionary bonus to be determined by our company. With effective from February 1, 2007, his annual salary was increased from RMB456,000 to RMB600,000. Mr. Zhan is also entitled to receive tax advisory services reimbursement up to RMB30,000 per year and a bonus equal to one-month’s pay. If Mr. Zhan is terminated without cause or resigns for good reason, he is entitled to receive a payment by us equal to his then-current monthly base salary multiplied by six plus the number of years between May 2006 and the termination date. He is also entitled to exercise his stock options which have vested at the time of his termination without cause or resignation for good reason (as such terms are defined in his employment agreement).

Mr. Zhan is prohibited from directly or indirectly (i) being employed by or participate in the management or operation of any business or entity that is or may be directly competitive with and offering similar products or services as us, for a period of one year after termination of employment for any reason, (ii) soliciting for employment any person who was employed by us during his employment with us, for a period of two years after termination of employment for any reason or (iii) working for any customer or potential customer of ours during his employment with us, for a period of two years after termination of employment for any reason. Mr. Zhan has also entered into a key employee invention assignment and confidentiality agreement in which he agrees to assign all rights in company-related inventions to us, and to keep our proprietary information confidential.

Aggregate Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values

The following table sets forth certain information with respect to stock options exercised by our Chief Executive Officer, Acting Chief Financial Officer, Co-Chief Operating Officer and former Co-Chief Operating Officer during 2008. In addition, the table sets forth the number of shares covered by stock options as of December 31, 2008, and the value of “in-the-money” stock options, which represents the difference between the exercise price of a stock option and the market price of the shares subject to such option on December 31, 2008.

 

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Shares

Acquired on

  

Value

Realized

   Number of Securities
Underlying Unexercised
Options at
December 31, 2008 (#)
   Value of Unexercised
In-the-Money Options at
December 31, 2008 (US$) (2)

Name

   Exercise    (US$)(1)    Exercisable    Unexercisable    Exercisable    Unexercisable

William Lei Ding

   —      —      —      —      —      —  

Onward Choi

   675,000    436,358    312,500    1,312,500    48,750    295,388

Zhonghui Zhan

   1,000,000    761,900    4,765,000    1,755,000    2,425,891    335,414

Michael Tong (3)

   —      —      5,468,750    2,656,250    2,759,875    716,500

 

(1) The value realized upon the exercise of stock options represents the positive spread between the exercise price of stock options and the closing market price of the shares on the exercise date.
(2) The value of unexercised in-the-money options is calculated based upon the closing price of US$22.10 per ADS on the NASDAQ Global Select Market on December 31, 2008, less the exercise price of the applicable option.
(3) Mr. Tong resigned from the position of our Co-Chief Operating Officer with effect from March 2009.

Amended and Restated 2000 Stock Incentive Plan

General

Our shareholders approved the NetEase.com, Inc. Amended and Restated 2000 Stock Incentive Plan, or the Amended Plan, at our annual general meeting held on May 25, 2001. The Amended Plan replaced the 2000 Stock Incentive Plan, or the Prior Plan, in its entirety. Under the Prior Plan, a total of 223,715,000 of our ordinary shares were reserved for issuance. The Amended Plan increased the number of ordinary shares reserved for issuance to 323,715,000, which amount was automatically further increased to 504,756,924 ordinary shares in accordance with the provisions of that plan. On March 25, 2002, our board suspended any further automatic increases in the number of authorized shares reserved for issuance under the Amended Plan.

The purpose of the Amended Plan is to attract and retain the best available personnel, to provide additional incentive to employees, directors and consultants and to promote the success of our business. Our board of directors believes that our company’s long term success is dependent upon our ability to attract and retain superior individuals who, by virtue of their ability and qualifications, make important contributions to our business. The Amended Plan provides for the granting of incentive awards of our ordinary shares, options to purchase our ordinary shares and any other securities the value of which is derived from the value of our ordinary shares.

Grantees under the Amended Plan will not receive any account status reports. The Amended Plan is not subject to the U.S. Employee Retirement Income Security Act of 1974, as amended, nor is the Amended Plan a “qualified plan” within the meaning of Section 401(a) of the Code.

The Amended Plan continues to be administered by our board, and it has delegated the power to award options under those plans for non-executive officers to NetEase’s chief executive officer.

The Amended Plan provides that in the event of certain corporate transactions, including specified types of reorganizations and acquisition transactions, each outstanding award granted under the Amended Plan shall automatically become fully vested and exercisable and be released from any restrictions in transfer (other than transfer restrictions applicable to the award) and repurchase or forfeiture rights, immediately prior to the specified effective date of such corporate transaction, unless the award is assumed by the successor company or its parent company in connection with the corporate transaction. Upon consummation of such corporate transactions, each outstanding award shall be terminated unless the award is assumed by the successor company or its parent company in connection with the applicable corporate transaction. Our board of directors will determine whether an award was assumed in the manner contemplated by the Amended Plan.

 

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Under the Amended Plan, awards can be issued to employees, directors or consultants of the company or our subsidiaries, although incentive stock options, referred to as ISOs, may only be issued to our employees or the employees of our subsidiaries.

Awards under the Amended Plan are evidenced by an award agreement which contains, among other things, provisions concerning exercisability and forfeiture upon termination of employment or consulting arrangement (by reason of death, disability, retirement or otherwise) as have been determined by our board. In addition, the award agreement also specifies whether the option constitutes an ISO or a non-incentive stock option, referred to as NQSOs, and may, but need not, include a provision whereby a grantee may at any time during his or her employment with us exercise any part or all of the award prior to full vesting of the award.

An option may be exercised by delivering written notice of such exercise to us. The option price to exercise the option for our ordinary shares must be paid at the time of exercise in full in cash or in check, by promissory note with such terms as the board deems appropriate or in whole ordinary shares with a fair market value at least equal to the option price (or in another appropriate manner approved by us, such as in a combination of cash and whole ordinary shares or by cashless exercise of options through a broker-dealer).

Under the Amended Plan, the exercise price for the options is specified in the award agreement for those options. In any event, the exercise price of ISOs cannot be less than the fair market value of our ordinary shares on the date of grant. However, in the case of an ISO granted to a grantee, who, at the time the ISO was granted, owned stock possessing more than 10% of the combined voting power of all classes of our share capital, the option price may not be less than 110% of the fair market value of our ordinary shares on the date of grant of such ISO. To the extent that the aggregate fair market value of shares subject to options granted as ISOs under the Amended Plan which become exercisable for the first time by a recipient during any calendar year exceeds US$100,000, then options represented by ordinary shares in excess of the US$100,000 limitation shall be treated as NQSOs.

NQSOs granted pursuant to the Amended Plan can have an exercise price of no less than 85% of the fair market value of our ordinary shares on the date of grant.

In the event of any extraordinary dividend, share dividend, recapitalization, share split, rights issuance, or combination or exchange of such shares, or other similar transactions, our board may equitably adjust the option price of our outstanding options so as to reflect such event.

The term of all ISOs and NQSOs will be stated in the applicable award agreement. The term of an ISO granted to a person, who, at the time the ISO was granted, owned stock possessing more than 10% of the combined voting power of all classes of our share capital, may not be more than five (5) years from the date of the grant of the award.

Under the Amended Plan, if the employment, director or consultant relationship of a grantee with us terminates for cause, the grantee’s right to exercise the option will expire upon the termination of such relationship. If the employment, director or consultant relationship of a grantee with us terminates without cause, all options then exercisable may be exercised within six months of the date of such termination or such shorter period as may be specified in the award agreement. Any ISO granted under the Amended Plan, if not exercised within the time period provided by law for the exercise of ISOs following the termination of a grantee’s employment with us, shall automatically convert to a NQSO thereafter.

 

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If the termination of a grantee’s employment, director or consultant relationship with us is (i) by reason of death or (ii) by reason of disability, all options then exercisable may be exercised by such grantee, such grantee’s estate or by a person who acquired the right of exercise of such options by bequest or inheritance or otherwise by reason of death or disability of such grantee, at any time within a period not less than 12 months (but in no event later than the expiration date of the options) after the date of such termination.

Under the Amended Plan, our board may at any time terminate, suspend, or amend the Amended Plan in any respect, except that no termination, suspension or amendment will be effective without shareholder approval if such approval is required to comply with any law, regulation or stock exchange rule and no such change may adversely affect any award previously granted without the written consent of the recipient. The Amended Plan will expire in February 2010.

 

C. Board Practices

At each annual general meeting of our shareholders, our shareholders are asked to elect the directors nominated to serve for the ensuing year or until their successors are elected and duly qualified or until such director’s earlier death, bankruptcy, insanity, resignation or removal. For information regarding the period during which our officers and directors have served in their respective positions, please refer to Item 6.A. “Directors and Senior Management.”

During the year 2008, our board met in person or passed resolutions by unanimous written consent 13 times. We have no specific policy with respect to director attendance at our annual general meetings of shareholders, and two of our directors attended the annual general meeting of shareholders held on September 5, 2008.

Our board has three committees, the audit committee, the compensation committee and the nominating committee. Alice Cheng, Joseph Tong and Michael Leung are currently the members of each of these committees.

In 2008, the audit committee met in person or passed resolutions by unanimous written consent six times. The board of directors has determined that Mr. Joseph Tong is an “audit committee financial expert” as defined by Item 16A of Form 20-F. The board of directors has adopted a written audit committee charter pursuant to which the audit committee is responsible for overseeing the accounting and financial reporting processes of our company, including the appointment, compensation and oversight of the work of our independent auditors, monitoring compliance with our accounting and financial policies and evaluating management’s procedures and policies relative to the adequacy of our internal accounting controls.

In 2008, the compensation committee held two meetings. The board of directors has adopted a written compensation committee charter pursuant to which the compensation committee is responsible for, among other things, annually reviewing and approving our company’s corporate goals and objectives relevant to the compensation of our chief executive officer, evaluating such officer’s performance in light of those goals and objectives, and, either as a committee or together with the other independent directors (as directed by our board), determining and approving the chief executive officer’s compensation level based on this evaluation. The committee also annually reviews and makes recommendations to the board with respect to non-chief executive officer compensation, incentive-compensation plans and equity based-plans, administers our incentive-compensation plans and equity-based plans as in effect and as adopted from time to time by our board (the board retains, however, the authority to interpret such plans), and approves any new equity compensation plan or any material change to an existing plan where shareholders approval has not been obtained.

 

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In 2008, the nominating committee held one meeting. The board of directors has adopted a written nominating committee charter pursuant to which the nominating committee is responsible for monitoring the size and composition of our board and considering and making recommendations to our board with respect to the nominations or elections of directors of our company.

The audit, compensation and nominating committees are composed solely of non-employee directors, as such term is defined in Rule 16b-3 under the Exchange Act and the board of directors has determined that all such members are “independent” as that term is defined in Rule 4200(a)(15) of the Marketplace Rules of NASDAQ.

Compensation Committee Interlocks

No interlocking relationships have existed between our board of directors or compensation committee and the board of directors or compensation committee of any other company.

 

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D. Employees

As of December 31, 2006, 2007 and 2008, we had 2,304, 2,368 and 3,048 full-time employees, respectively.

The following table sets forth information regarding our staff as of December 31, 2008:

 

Accounting department

   34

Administration

   28

Advertising sales department

   147

Content

   550

Customer service

   147

Human resources

   17

Internal audit department

   7

Investor relations

   1

Legal

   11

Marketing

   21

Network administration department

   33

Online game department

   1,553

Product quality control and promotion

   2

Product development

   241

Search engine development department

   114

Technology

   64

Wireless department

   57

Other

   21
    

Total

   3,048
    

In addition, as of December 31, 2008, we had 122 part-time employees.

None of our employees are represented by a labor union.

All employees of our company and of our affiliated companies are employed under employment contracts which specify, among other things, the employee’s responsibilities, remuneration and grounds for termination of employment. Each employee signs a confidentiality agreement in respect of our intellectual property rights.

 

E. Share Ownership

The following table sets forth certain information known to us with respect to the beneficial ownership as of March 31, 2009 (unless otherwise indicated) by:

 

   

all persons who are beneficial owners of five percent or more of our ordinary shares,

 

   

each of our directors,

 

   

our Chief Executive Officer, Acting Chief Financial Officer and Co-Chief Operating Officer, and

 

   

all current directors and executive officers as a group.

As of March 31, 2009, 3,210,732,881 of our ordinary shares were outstanding. The amounts and percentages of ordinary shares beneficially owned are reported on the basis of regulations of the Securities and Exchange Commission, or the SEC, governing the determination of beneficial ownership of securities.

 

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Under the rules of the SEC, a person is deemed to be a “beneficial owner” of a security if that person has or shares “voting power,” which includes the power to vote or to direct the voting of such security, or “investment power,” which includes the power to dispose of or to direct the disposition of such security. A person is also deemed to be a beneficial owner of any securities of which that person has a right to acquire beneficial ownership within 60 days. Under these rules, more than one person may be deemed a beneficial owner of securities as to which such person has no economic interest. The shareholders listed below do not have different voting rights.

 

     Number of Shares
Beneficially Owned
 

Name

   Number    Percentage  

5% Shareholder

     

Shining Globe International Limited/William Lei Ding (1)

c/o NetEase.com, Inc., 26/F, SP Tower D, Tsinghua Science Park Building 8, No. 1 Zhongguancun East Road, Haidian District, Beijing, People’s Republic of China 100084

   1,406,000,000    43.8

Executive Officers and Directors (2)

     

Onward Choi(3)

   1,000,000    *   

Zhonghui Zhan(5)

   8,120,000    *   

Alice Cheng

   —      —     

Denny Lee(6)

   3,693,325    *   

Joseph Tong

   —      —     

Lun Feng

   —      —     

Michael Leung

   —      —     

Michael Tong(4)

   7,187,500    *   

All current directors and executive officers as a group (9 persons)(7)

   1,426,000,825    44.4

 

* Less than 1%
(1) Shining Globe International Limited is 100% owned by William Lei Ding, our founder, Chief Executive Officer and a director.
(2) The address of our current executive officers and directors is c/o NetEase.com, Inc., 26/F, SP Tower D, Tsinghua Science Park Building 8, No. 1 Zhongguancun East Road, Haidian District, Beijing, the People’s Republic of China 100084.
(3) Includes 375,000 and 625,000 shares subject to stock options exercisable within 60 days of March 31, 2009, which have an exercise price of US$0.4863 and US$0.728 per ordinary share, respectively, and an expiration date of May 13, 2010 and March 14, 2012, respectively.
(4) Includes 3,750,000, 2,500,000 and 937,500 shares subject to stock options exercisable within 60 days of March 31, 2009, which have an exercise price of US$0.3001, US$0.4863 and US$0.728 per ordinary share, respectively, and an expiration date of August 16, 2009, May 13, 2010 and March 14, 2012, respectively.

 

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(5) Includes 3,600,000 ordinary shares held by Mr. Zhan and options for 2,500,000, 1,020,000 and 1,000,000 shares which are exercisable within 60 days of March 31, 2009, and have an exercise price of US$0.3001, US$0.4863 and US$0.728 per ordinary share, respectively, and an expiration date of August 16, 2009, May 13, 2010 and March 14, 2012, respectively.
(6) Includes 2,443,325 ordinary shares held by Mr. Lee and options for 1,250,000 shares which are exercisable within 60 days of March 31, 2009, and have an exercise price of US$0.4863 per ordinary share, and an expiration date of May 13, 2010.
(7) Shares owned by all of our current directors and executive officers as a group includes shares beneficially owned by William Lei Ding. This amount includes 6,043,325 ordinary shares held by Mr. Zhan and Mr. Lee and options for 1,419,957,500 shares which are exercisable within 60 days of March 31, 2009.

As of March 31, 2009, based on public filings with the SEC, there are no major shareholders holding 5% or more of our ordinary shares or ADSs representing ordinary shares, except as described above.

As of March 31, 2009, none of our ordinary shares were held by U.S. holders of record. On that date, a total of 72,045,305 ADSs were outstanding; and our ADSs were held by 24 U.S. holders of record.

To our knowledge, except as disclosed above, we are not owned or controlled, directly or indirectly, by another corporation, by any foreign government or by any other natural or legal person or persons, severally or jointly.

To our knowledge, there are no arrangements the operation of which may at a subsequent date result in us undergoing a change in control.

Our major shareholders do not have different voting rights than any of our other shareholders.

 

Item 7. Major Shareholders and Related Party Transactions

 

A. Major Shareholders

Please refer to Item 6.E. “Directors, Senior Management and Employees—Share Ownership.”

 

B. Related Party Transactions

Our business was founded in June 1997. In July 1999, we established a new holding company, NetEase.com, Inc., in the Cayman Islands. In September 1999, we restructured our operations in order to comply with increasing regulation of the Internet industry in China. As part of this restructuring, substantially all of Guangzhou NetEase’s fixed and intangible assets and existing Internet applications, services and technologies were acquired by NetEase Information Technology (Beijing) Co., Ltd., or NetEase Beijing, a wholly owned subsidiary of NetEase formed in August 1999. Guangzhou NetEase, which is 90% owned by our founder, Chief Executive Officer, director and major shareholder, William Lei Ding, has received approval from the Guangzhou telecommunications administrative authorities to provide Internet content services, and its 80% owned subsidiary, Beijing Guangyitong Advertising Co., Ltd., or Guangyitong Advertising, holds a license to operate an advertising business.

 

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NetEase and NetEase Beijing entered into a series of agreements with Guangzhou NetEase, Guangyitong Advertising and the shareholders of Guangzhou NetEase and Guangyitong Advertising under which we provide our Internet and e-commerce applications, services and technologies and advertising services to Guangzhou NetEase and Guangyitong Advertising, and Guangzhou NetEase and Guangyitong Advertising operate the NetEase websites and our online advertising business. We believe that the terms of each agreement are no less favorable than the terms that we could obtain from disinterested third parties and that the shareholders of Guangzhou NetEase and Guangyitong Advertising will not receive material benefits from these agreements except as shareholders of NetEase. These agreements are described below.

 

   

Domain Name License Agreement between NetEase and Guangzhou NetEase. NetEase granted Guangzhou NetEase the right to use the domain names “netease.com,” “163.com,” “126.com,” “yeah.net” and “nease.net” on the NetEase websites in China for license fees of RMB10,000 per year. NetEase may waive this fee at any time.

 

   

Copyright License Agreement between NetEase Beijing and Guangzhou NetEase. NetEase Beijing granted Guangzhou NetEase the right to use NetEase Beijing’s web page layout in China for a royalty of RMB10,000 per year. NetEase Beijing may waive this fee at any time.

 

   

Trademark License Agreement between NetEase Beijing and Guangzhou NetEase. NetEase Beijing granted Guangzhou NetEase a license to use NetEase Beijing’s registered trademarks on the NetEase websites in China for license fees of RMB10,000 per year. NetEase Beijing may waive this fee at any time.

 

   

Cooperative Agreement between Guangzhou NetEase, Guangzhou Interactive and NetEase Beijing. Under the Cooperative Agreement, Guangzhou Interactive has agreed to provide the following services:

 

   

computer software development (including but not limited to online games) and technical support and maintenance for the operation of the computer software;

 

   

provide technical support for systems related to point card generation and customer service, including but not limited to the development, update and maintenance of those systems; and

 

   

provide bandwidth.

Under the Cooperative Agreement, NetEase Beijing has also agreed to provide the following services:

 

   

development of Internet communication products and Internet-related application software;

 

   

provide technical service for Internet portal, including but not limited to the server maintenance and the development and update of server application software;

 

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provide technical service for e-commerce, including but not limited to the development and maintenance of NetEase’s e-commerce platform;

 

   

provide technical support for e-publishing; and

 

   

software development and maintenance related to online advertising.

Furthermore, Guangzhou NetEase has agreed to pay a monthly service fee to Guangzhou Interactive and NetEase Beijing in accordance with a formula based on the expenses incurred by the respective companies. The Cooperative Agreement was effective from January 2006 and will continue to be effective unless any one of the three parties object.

 

   

Cooperative Agreement between Guangzhou NetEase and Boguan. Under the Cooperative Agreement, Boguan has agreed to provide the following services:

 

   

computer software development (including but not limited to online games) and technical support and maintenance for the operation of the computer software; and

 

   

provide bandwidth.

Guangzhou NetEase has agreed to pay a monthly service fee to Boguan in accordance with a formula based on its expenses incurred. The Cooperative Agreement was effective from January 2006 and will continue to be effective unless any one of the two parties object.

 

   

Cooperative Agreement between Guangzhou NetEase and NetEase Hangzhou. Under the Cooperative Agreement, NetEase Hangzhou has agreed to provide the following services:

 

   

computer software development (including but not limited to online games) and technical support and maintenance for the operation of the computer software; and

 

   

provide bandwidth.

Guangzhou NetEase has agreed to pay a monthly service fee to NetEase Hangzhou in accordance with a formula based on its expenses incurred. The Cooperative Agreement was effective from January 2007 and will continue to be effective unless any one of the two parties object.

 

   

Cooperative Agreement between NetEase Beijing and Guangyitong Advertising. Under the Cooperative Agreement, NetEase Beijing has agreed to provide the following services:

 

   

computer software development (including but not limited to the publishing, delivery and management of online advertisement) and technical support and maintenance for the operation of the computer software;

 

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software development and maintenance related to online advertising;

 

   

provide technical service for internet portal, including but not limited to the server maintenance and the development and update of server application software;

 

   

provide technical service for e-commerce, including but not limited to the development and maintenance of NetEase’s e-commerce platform; and

 

   

provide technical support for e-publishing.

Guangyitong has agreed to pay a monthly service fee to NetEase Beijing in accordance with a formula based on its expenses incurred. The Cooperative Agreement was effective from January 2006 and will continue to be effective unless any one of the two parties object.

 

   

Cooperative Agreement between Guangzhou Interactive and Guangyitong Advertising. Under the Cooperative Agreement, Guangzhou Interactive has agreed to provide the following services:

 

   

computer software development (including but not limited to the publishing, delivery and management of online advertisement) and technical support and maintenance for the operation of the computer software.

Guangyitong has agreed to pay a monthly service fee to Guangzhou Interactive in accordance with a formula based on its expenses incurred. The Cooperative Agreement was effective from January 2006 and will continue to be effective unless any one of the two parties objects.

 

   

Exclusive Advertising Agency Agreement between NetEase and Guangzhou NetEase. Guangzhou NetEase appointed NetEase as its advertising agent to solicit advertising customers on behalf of Guangzhou NetEase in markets outside of China. NetEase pays Guangzhou NetEase 10% of the total advertising revenue under this agreement per month.

 

   

Online Advertising Agreement between Guangzhou NetEase and Guangyitong Advertising. Guangzhou NetEase sells all of the banner space on the NetEase websites to Guangyitong Advertising and publishes the advertisements provided by Guangyitong Advertising on the banner space purchased by Guangyitong Advertising. Guangyitong Advertising pays Guangzhou NetEase RMB10,000 per year. Guangzhou NetEase may waive this fee at any time.

 

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By supplemental agreements entered into between the relevant parties in August 2005, the respective terms of the foregoing agreements are automatically renewable for successive one year terms, unless NetEase objects to such renewal.

 

   

Trademark Transfer Agreement between Guangzhou NetEase and NetEase Beijing. Guangzhou NetEase has agreed to transfer its registered trademarks to NetEase Beijing.

 

   

Supplemental Agreement between NetEase Beijing and Guangzhou NetEase. NetEase Beijing may not grant the license to use its domain name, copyright and trademark to any third party without Guangzhou NetEase’s consent and may not provide technical service to any third party.

 

   

Operating Agreement among NetEase Beijing, Guangyitong and the ultimate shareholders of Guangyitong Advertising. To ensure the successful performance of the various agreements between the parties, Guangyitong Advertising and its ultimate shareholders have agreed that they will not enter into any transaction, or fail to take any action, that would substantially affect the assets, liabilities, equity or operations of Guangyitong Advertising without the prior written consent of NetEase Beijing.

The parties have agreed that upon NetEase Beijing’s determination and at any time when NetEase Beijing is able to obtain approval to invest in and operate all or any part of Guangyitong Advertising, NetEase Beijing may acquire all or any part of the assets or equity interests of Guangyitong Advertising, to the extent permitted by Chinese law. The consideration for such acquisitions will be based on the book value of Guangyitong Advertising at the time of acquisition.

NetEase Beijing has agreed that it will provide performance guarantees and guarantee loans for working capital purposes to the extent required by Guangyitong Advertising for its operations.

The ultimate shareholders of Guangyitong Advertising have agreed that upon instruction from NetEase Beijing, they will appoint or terminate Guangyitong Advertising’s board members, General Manager, Chief Financial Officer and other senior officers.

NetEase Beijing has the right to transfer and sell its interests in the Operating Agreement or any other agreements between it and Guangyitong Advertising. The term of this agreement is 20 years from February 3, 2000.

 

   

Shareholder Voting Rights Trust Agreement among William Lei Ding, Bo Ding and NetEase Beijing. Bo Ding irrevocably appoints NetEase Beijing to represent him to exercise all the voting rights to which he is entitled as a shareholder of Guangyitong Advertising and William Lei Ding and Bo Ding agree to cause Guangzhou NetEase to irrevocably appoint NetEase Beijing to represent Guangzhou NetEase to exercise all the voting rights to which Guangzhou NetEase is entitled as a shareholder of Guangyitong Advertising. The term of this agreement is ten years from May 12, 2000.

 

   

Agreement between NetEase Beijing and Guangzhou NetEase. NetEase Beijing agrees to pay the operating costs of Guangzhou NetEase.

 

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Letter of Agreement. Each of William Lei Ding and Bo Ding have agreed that any amendments to be made to the Exclusive Consulting and Services Agreement, the Shareholder Voting Rights Trust Agreement, and the Operating Agreement described above, as well as all other agreements to which Guangzhou NetEase, Guangyitong Advertising and/or William Lei Ding and Bo Ding are parties, shall be subject to the approval by the vote of a majority of our board, excluding the vote of William Lei Ding. Messrs. Ding have also agreed that, if any amendments to the above mentioned agreements require a vote of the shareholders of NetEase, Guangzhou NetEase or Guangyitong Advertising, as applicable, both of them will vote in their capacity as direct or indirect shareholders of these companies to act based upon the instructions of our board. This letter of agreement was supplemented in May and July 2004 to extend to the agreements with Ling Yi and the agreements with Guangzhou Interactive.

In October 2003, we also established a new VIE, Ling Yi, and entered into a series of agreements with it to provide us with control over such company. Ling Yi was dissolved in August 2007.

In addition, in connection with the licensing of certain online games by Blizzard to Shanghai EaseNet for operation in the PRC in August 2008 and April 2009, there are certain contractual arrangements among Shanghai EaseNet, the joint venture established between Blizzard and us, and us. We have consolidated Shanghai EaseNet into our financial statements as of and for the year ended December 31, 2008 as discussed in Item 5.A. “Operating Results – Basis of Presentation”.

Purchase of Property in Guangzhou

We occupy a building in Guangzhou with floor space of approximately 20,000 square meters which is owned by a third party property developer, Haobang. William Lei Ding, our Chief Executive Officer, director and major shareholder, entered into an agreement with Haobang to purchase the property and has paid a deposit, representing substantially all of the purchase price for the property, to Haobang. We requested Mr. Ding to initially purchase the property because we required the office space for our operations but Haobang was not able to issue proper title to it at the time. We also agreed with Mr. Ding that he would on-sell the property to our company at cost once the title and any other legal issues associated with the property were resolved. However, we believe that Haobang has breached its agreement with Mr. Ding by, among other reasons, not completing the registration for the transfer of the title of the property to Mr. Ding and creating a new mortgage on the property. We and Mr. Ding have been negotiating with Haobang regarding these breaches, however, these negotiations have been unsuccessful thus far. We and Mr. Ding have agreed that Mr. Ding would initiate legal action against Haobang at our cost to demand, among others, that it cause the mortgage to be discharged and complete the registration for the transfer of the title of the property to Mr. Ding. Mr. Ding is currently in arbitration proceedings with Haobang, and we deposited RMB82.0 million (US$12.0 million) with a court in Guangzhou as a security deposit in connection with the arbitration proceedings. The arbitration proceedings are currently in the preliminary stage. Mr. Ding has agreed to indemnify our company for any losses or expenses we may incur due to the absence of the title.

From the date we commenced occupying the property in July 2006 until the present time, we have not paid any rent for the property. However, we can provide no assurance as to whether we will be subject to future demands for past and current rental payments. In addition, we have incurred expenses for various improvements to the property and installations in the aggregate amount of approximately RMB70.1 million (US$10.3 million) as of December 31, 2008.

 

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Moreover, although we have not been required to pay rent for the property, we have recorded an imputed rental expense on our financial statements which was calculated based on the estimated rental value of the property and totaled RMB9.4 million and RMB9.4 million (US$1.4 million) in 2007 and 2008, respectively. See Item 5.A. “Operating and Financial Review and Prospects – Operating Results – Operating Expenses – General and Administrative Expenses.”

 

C. Interests of Experts and Counsel

Not applicable.

 

Item 8. Financial Information

 

A. Consolidated Statements and Other Financial Information

See Item 18. “Financial Statements” for our audited consolidated financial statements filed as part of this annual report.

 

A.7 Legal Proceedings

There are no material legal proceedings pending or, to our knowledge, threatened against us, except for our arbitration proceedings with Haobang as set forth above under Item 7.B. “Related Party Transaction – Purchase of Property in Guangzhou.”

From time to time we become subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights, and a variety of claims arising in connection with our email, message boards and other communications and community features, such as claims alleging defamation or invasion of privacy. However, such legal proceedings or claims, even if not meritorious, could result in the expenditure of significant financial and management resources.

 

A.8 Dividend Policy

We have never declared or paid any cash dividends on our ordinary shares, but it is possible that we may declare dividends in the future. We have historically retained earnings to finance operations and the expansion of our business. Any future determination to pay cash dividends will be at the discretion of the board of directors and will be dependent upon our financial condition, operating results, capital requirements and such other factors as the board of directors deems relevant.

 

B. Significant Changes

We have not experienced any significant changes since the date of our audited consolidated financial statements included in this annual report.

 

Item 9. The Offer and Listing

Not applicable except for Item 9.A.4. and Item 9.C.

 

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Our ADSs have been listed on the NASDAQ Global Select Market (formerly the NASDAQ National Market) since June 30, 2000. Information relating to our ADSs has been restated to give effect to the ADS ratio change from one ADS for every 100 ordinary shares to one ADS for every 25 ordinary shares effective March 27, 2006. The ADS ratio change had the effect of a four-for-one share split. Our ADSs trade under the symbol “NTES.”

The following table provides the high and low prices for our ADSs on the NASDAQ Global Select Market for (1) each of the most recent five financial years, (2) each quarter in the two most recent financial years and the most recent quarter and (3) each of the most recent six months.

 

     Sales Price
     High    Low

Annual highs and lows

     

2004

   $ 14.62    $ 7.04

2005

   $ 24.00    $ 9.39

2006

   $ 25.25    $ 14.07

2007

   $ 24.00    $ 13.45

2008

   $ 27.16    $ 15.00

Quarterly highs and lows

     

First Quarter 2007

   $ 21.86    $ 17.51

Second Quarter 2007

   $ 19.54    $ 16.52

Third Quarter 2007

   $ 19.35    $ 13.45

Fourth Quarter 2007

   $ 24.00    $ 16.49

First Quarter 2008

   $ 21.84    $ 16.23

Second Quarter 2008

   $ 25.70    $ 18.97

Third Quarter 2008

   $ 27.16    $ 19.02

Fourth Quarter 2008

   $ 23.50    $ 15.00

First Quarter 2009

   $ 27.12    $ 16.61

Monthly highs and lows

     

December 2008

   $ 22.43    $ 17.34

January 2009

   $ 22.92    $ 16.61

February 2009

   $ 21.06    $ 18.25

March 2009

   $ 27.12    $ 20.08

April 2009

   $ 31.50    $ 25.54

May 2009

   $ 34.98    $ 28.23

 

Item 10. Additional Information

 

A. Share Capital

Not applicable.

 

B. Memorandum and Articles of Association

The following presents a description of the terms and provisions of our restated memorandum and articles of association.

 

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General

We were incorporated in the Cayman Islands on July 6, 1999 and operate under the Cayman Islands Companies Law (2007 Revision), as revised and amended from time to time, or the Companies Law. Our corporate objectives and purpose are unrestricted.

Directors

A director may vote in respect of any contract or transaction in which he is interested provided however that the nature of the interest of any director in any such contract or transaction shall be disclosed by him at or prior to its consideration and any vote on that matter. A general notice or disclosure to the directors or otherwise contained in the minutes of a meeting or a written resolution of the directors or any committee thereof that a director is a shareholder of any specified firm or company and is to be regarded as interested in any transaction with such firm or company shall be sufficient disclosure and after such general notice it shall not be necessary to give special notice relating to any particular transaction.

The directors may determine remuneration to be paid to the directors. The directors may exercise all the powers of our company to borrow money and to mortgage or charge its undertaking, property and uncalled capital or any part thereof, to issue debentures, debenture stock and other securities whenever money is borrowed or as security for any of our debts, liabilities, or obligations or those of any third party.

There are no membership qualifications for directors. Further, there are no age limitations or retirement requirements and no share ownership qualifications for directors unless so fixed by shareholders in a general meeting.

Rights, Preferences and Restrictions of Ordinary Shares

General. All of our outstanding ordinary shares are fully paid and non-assessable. Certificates representing the ordinary shares are issued in registered form. Our shareholders who are nonresidents of the Cayman Islands may freely hold and vote their shares.

Dividends. The holders of ordinary shares are entitled to such dividends as may be declared by our board of directors.

Voting Rights. Each ordinary share is entitled to one vote on all matters upon which the ordinary shares are entitled to vote, including the election of directors. Voting at any meeting of shareholders is by show of hands unless a poll is demanded. A poll may be demanded by the Chairman or any other shareholder present in person or by proxy. A quorum required for a meeting of shareholders consists of at least two shareholders present or by proxy.

Any ordinary resolution to be made by the shareholders requires the affirmative vote of a simple majority of the votes attaching to the ordinary shares cast in a general meeting, while a special resolution requires the affirmative vote of no less than two-thirds of the votes cast attaching to the ordinary shares. A special resolution is required for matters such as a change of name. Holders of the ordinary shares may by ordinary resolution, among other things, elect directors, appoint auditors, and make changes in the amount of our authorized share capital.

Liquidation. On a return of capital on winding up or otherwise (other than on conversion, redemption or purchase of shares) assets available for distribution among the holders of ordinary shares shall be distributed among the holders of the ordinary shares pro rata. If the assets available for distribution are insufficient to repay all of the paid-up capital, the assets will be distributed so that the losses are borne by our shareholders proportionately.

 

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Calls on Shares and Forfeiture of Shares. Our board of directors may from time to time make calls upon shareholders for any amounts unpaid on their shares in a notice served to such shareholders at least 14 days prior to the specified time and place of payment. The shares that have been called upon and remain unpaid are subject to forfeiture.

Redemption of Shares. We may issue shares on the terms that they are, or at our option or at the option of the holders are, subject to redemption on such terms and in such manner as we may determine by special resolution.

Variations of Rights of Shares

All or any of the special rights attached to any class of shares may, subject to the provisions of the Companies Law, be varied either with the consent in writing of the holders of three-fourths of the issued shares of that class or with the sanction of a special resolution passed at a general meeting of the holders of the shares of that class.

General Meetings of Shareholders

The directors may whenever they think fit, and they shall on the requisition of our shareholders holding at the date of the deposit of the requisition not less than one-tenth of our paid-up capital as at the date of the deposit carries the right of voting at general meetings of the company, proceed to convene a general meeting of the company. If the directors do not within 21 days from the date of the deposit of the requisition duly proceed to convene a general meeting, the requisitionists, or any of them representing more than one-half of the total voting rights of all of them, may themselves convene a general meeting, but any meeting so convened shall not be held after the expiration of three months after the expiration of such 21 days. Advanced notice of at least five days is required for the convening of the annual general meeting and other shareholders meetings.

Limitations on the Right to Own Shares

There are no limitations on the right to own our shares.

Limitations on Transfer of Shares

There are no provisions in our restated memorandum or articles of association that would have an effect of delaying, deferring or preventing a change in control and that would operate only with respect to a merger, acquisition or corporate restructuring.

Disclosure of Shareholder Ownership

There are no provisions in our restated memorandum or articles of association governing the ownership threshold above which shareholder ownership must be disclosed.

Changes in Capital

We may from time to time by ordinary resolution increase the share capital by such sum, to be divided into shares of such amount, as the resolution shall prescribe. The new shares shall be subject to the same provisions with reference to the payment of calls, lien, transfer, transmission, forfeiture and otherwise as the shares in the original share capital. We may by ordinary resolution:

 

  (a) consolidate and divide all or any of our share capital into shares of larger amount than our existing shares;

 

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  (b) sub-divide our existing shares, or any of them into shares of smaller amount than is fixed by our restated memorandum of association, subject nevertheless to the provisions of Section 12 of the Companies Law; and

 

  (c) cancel any shares which, at the date of the passing of the resolution, have not been taken or agreed to be taken by any person.

We may by special resolution reduce our share capital and any capital redemption reserve fund in any manner authorized by law.

Differences in Corporate Law

The Companies Law is modeled after that of the United Kingdom but does not follow recent United Kingdom statutory enactments and differs from laws applicable to United States corporations and their shareholders. Set forth below is a summary of the significant differences between the provisions of the Companies Law applicable to NetEase.com, Inc. and the laws applicable to companies incorporated in the United States and their shareholders.

Mergers and Similar Arrangements. The Companies Law permits mergers and consolidations between Cayman Islands companies and between Cayman Islands companies and non-Cayman Islands companies. For these purposes, (a) “merger” means the merging of two or more constituent companies and the vesting of their undertaking, property and liabilities in one of such companies as the surviving company and (b) a “consolidation” means the combination of two or more constituent companies into a consolidated company and the vesting of the undertaking, property and liabilities of such companies to the consolidated company. In order to effect such a merger or consolidation, the directors of each constituent company must approve a written plan of merger or consolidation (a “Plan”), which must then be authorized by either (a) a special resolution of the shareholders of each constituent company voting together as one class if the shares to be issued to each shareholder in the consolidated or surviving company will have the same rights and economic value as the shares held in the relevant constituent company or (b) a shareholder resolution of each constituent company passed by a majority in number representing 75% in value of the shareholders voting together as one class. The Plan must be filed with the Registrar of Companies together with a declaration as to the solvency of the consolidated or surviving company, a list of the assets and liabilities of each constituent company and an undertaking that a copy of the certificate of merger or consolidation will be given to the members and creditors of each constituent company and published in the Cayman Islands Gazette. Dissenting shareholders have the right to be paid the fair value of their shares (which, if not agreed between the parties, will be determined by the Cayman Islands court) if they follow the required procedures, subject to certain exceptions. Court approval is not required for a merger or consolidation which is effected in compliance with these statutory procedures.

In addition, there are statutory provisions that facilitate the reconstruction and amalgamation of companies, provided that the arrangement in question is approved by a majority in number of each class of shareholders and creditors with whom the arrangement is to be made, and who must in addition represent three-fourths in value of each such class of shareholders or creditors, as the case may be, that are present and voting either in person or by proxy at a meeting, or meetings convened for that purpose. The convening of the meetings and subsequently the arrangement must be sanctioned by the Grand Court of the Cayman Islands. While a dissenting shareholder would have the right to express to the court the view that the transaction ought not to be approved, the court can be expected to approve the arrangement if it satisfies itself that:

 

   

the statutory provisions as to majority vote have been complied with;

 

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the shareholders have been fairly represented at the meeting in question;

 

   

the arrangement is such as a businessman would reasonably approve; and

 

   

the arrangement is not one that would more properly be sanctioned under some other provision of the Companies Law.

When a take-over offer is made and accepted by holders of 90% of the shares within four months, the offeror may, within a two month period, require the holders of the remaining shares to transfer such shares on the terms of the offer. An objection can be made to the Grand Court of the Cayman Islands but this is unlikely to succeed unless there is evidence of fraud, bad faith or collusion.

If the arrangement and reconstruction is thus approved, the dissenting shareholder would have no rights comparable to appraisal rights, which would otherwise ordinarily be available to dissenting shareholders of United States corporations, providing rights to receive payment in cash for the judicially determined value of the shares.

Shareholders’ Suits. The Cayman Islands courts can be expected to follow English case law precedents. The common law principles (namely the rule in Foss v. Harbottle and the exceptions thereto) which permit a minority shareholder to commence a class action against or derivative actions in the name of the company to challenge (a) an act which is ultra vires the company or illegal, (b) an act which constitutes a fraud against the minority where the wrongdoers are themselves in control of the company, and (c) an action which requires a resolution with a qualified (or special) majority which has not been obtained) have been applied and followed by the courts in the Cayman Islands.

Indemnification. Cayman Islands law does not (other than as set forth hereafter) limit the extent to which a company’s organizational documents may provide for indemnification of officers and directors, except to the extent any such provision may be held by the Cayman Islands courts to be contrary to public policy, such as to provide indemnification against civil fraud or the consequences of committing a crime. Our Articles of Association provide for indemnification of officers and directors for losses, damages, costs and expenses incurred in their capacities as such, except through their own willful neglect or default.

Insofar as indemnification or liability arising under the Securities Act of 1933 may be permitted to directors, officers or persons controlling the registrant pursuant to the foregoing provisions, we have been informed that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is therefore unenforceable.

 

C. Material Contracts

We have not entered into any material contracts other than in the ordinary course of business and other than those described in Item 4. “Information on the Company” or elsewhere in this annual report.

 

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D. Exchange Controls

China’s government imposes control over the convertibility of the Renminbi into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes a daily exchange rate for the Renminbi, or the PBOC Exchange Rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC Exchange Rate according to market conditions.

Pursuant to the Foreign Exchange Control Regulations issued by the State Council on January 29, 1996 and effective as of April 1, 1996 (and amended on January 14, 1997) and the Administration of Settlement, Sale and Payment of Foreign Exchange Regulations which came into effect on July 1, 1996 regarding foreign exchange control, or the Regulations, conversion of the Renminbi into foreign exchange by foreign investment enterprises for current account items, including the distribution of dividends and profits to foreign investors of joint ventures, is permissible. Foreign investment enterprises are permitted to remit foreign exchange from their foreign exchange bank account in China on the basis of, inter alia, the terms of the relevant joint venture contracts and the board resolutions declaring the distribution of the dividend and payment of profits. Conversion of the Renminbi into foreign currencies and remittance of foreign currencies for capital account items, including direct investment, loans and security investment, is still subject to the approval of the State Administration of Foreign Exchange, or SAFE, in each such transaction. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations to provide, among other things, that the State shall not impose restrictions on recurring international payments and transfers.

Under the Regulations, foreign investment enterprises are required to open and maintain separate foreign exchange accounts for capital account items (but not for other items). In addition, foreign investment enterprises may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business upon the production of valid commercial documents and, in the case of capital account item transactions, document approval from SAFE.

Currently, foreign investment enterprises are required to apply to SAFE for “foreign exchange registration certificates for foreign investment enterprises.” With such foreign exchange registration certificates (which are granted to foreign investment enterprises upon fulfilling specified conditions and which are subject to review and renewal by SAFE on an annual basis) or with the foreign exchange sales notices from the SAFE (which are obtained on a transaction-by-transaction basis), foreign-invested enterprises may enter into foreign exchange transactions at banks authorized to conduct foreign exchange business to obtain foreign exchange for their needs.

In addition, pursuant to regulations recently promulgated by SAFE, PRC subsidiaries of offshore parent companies may be prohibited from making distributions of profits to such offshore parent companies and from paying the offshore parent companies proceeds from any reduction in capital, share transfer or liquidation in respect of such PRC subsidiaries, if PRC shareholders with a direct or indirect stake in the offshore parent company fail to make the required SAFE registrations.

These regulations require PRC residents to file with the competent SAFE offices information about offshore companies in which they have directly or indirectly invested (including with respect to investments already made as of the inception of the new regulation) and to make follow-up filings in connection with certain material transaction involving such offshore companies, such as mergers or acquisitions, capital increases or decreases, and external equity investments or equity transfers. For additional information on the new SAFE regulations and the related risks to our company, see Item 3.D. “Risk Factors—Risks Related to Doing Business in China—The Chinese government has strengthened the regulation of investments made by Chinese residents in offshore companies and reinvestments in China made by these offshore companies. Our business may be adversely affected by these new restrictions.”

 

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E. Taxation

The following summary of the material Cayman Islands and United States federal income tax consequences relevant to the purchase, ownership or sale of our ADSs is based upon laws and relevant interpretations thereof in effect as of the date of this annual report, all of which are subject to change. To the extent that the discussion relates to matters of Cayman Islands tax law, it represents the opinion of Maples and Calder, our Cayman Islands counsel.

Cayman Islands Taxation

The Cayman Islands currently levies no taxes on individuals or corporations based upon profits, income, gains or appreciation and there is no taxation in the nature of inheritance tax or estate duty. There are no other taxes likely to be material to us levied by the Government of the Cayman Islands except for stamp duties which may be applicable on instruments executed in, or after execution brought within the jurisdiction of the Cayman Islands. The Cayman Islands is not party to any double tax treaties. There are no exchange control regulations or currency restrictions in the Cayman Islands.

United States Federal Income Taxation

The following is a summary of the material U.S. federal income tax consequences of the ownership and disposition of ordinary shares or ADSs. The following discussion is not exhaustive of all possible tax considerations. This summary is based upon the Internal Revenue Code of 1986, as amended, or the Code, regulations promulgated under the Code by the U.S. Treasury Department (including proposed and temporary regulations), rulings, current administrative interpretations and official pronouncements of the Internal Revenue Service, or the IRS, and judicial decisions, all as currently in effect and all of which are subject to differing interpretations or to change, possibly with retroactive effect. Such change could materially and adversely affect the tax consequences described below. No assurance can be given that the IRS will not assert, or that a court will not sustain, a position contrary to any of the tax consequences described below.

This discussion does not address state, local, or foreign tax consequences of the ownership and disposition of ordinary shares or ADSs. See “– Cayman Islands Taxation” above. The United States does not have an income tax treaty with the Cayman Islands.

This summary is for general information only and does not address all aspects of U.S. federal income taxation that may be important to a particular holder in light of its investment or tax circumstances or to holders subject to special tax rules, such as: banks; financial institutions; insurance companies; dealers in stocks, securities, or currencies; traders in securities that elect to use a mark-to-market method of accounting for their securities holdings; tax-exempt organizations; real estate investment trusts; regulated investment companies; qualified retirement plans, individual retirement accounts, and other tax-deferred accounts; expatriates of the United States; persons subject to the alternative minimum tax; persons holding ordinary shares or ADSs as part of a straddle, hedge, conversion transaction, or other integrated transaction; persons who acquired ordinary shares or ADSs pursuant to the exercise of any employee stock option or otherwise as compensation for services; persons actually or constructively holding 10% or more of our voting stock; and U.S. Holders (as defined below) whose functional currency is other than the U.S. dollar.

 

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This discussion is not a comprehensive description of all of the U.S. federal tax consequences that may be relevant with respect to the ownership and disposition of ordinary shares or ADSs. We urge you to consult your own tax advisor regarding your particular circumstances and the U.S. federal income and estate tax consequences to you of owning and disposing of ordinary shares or ADSs, as well as any tax consequences arising under the laws of any state, local, or foreign or other tax jurisdiction and the possible effects of changes in U.S. federal or other tax laws.

This summary is directed solely to persons who hold their ordinary shares or ADSs as capital assets within the meaning of Section 1221 of the Code, which generally means as property held for investment. For purposes of this discussion, the term “U.S. Holder” means a beneficial owner of ordinary shares or ADSs that is any of the following:

 

   

a citizen or resident of the United States or someone treated as a U.S. citizen or resident for U.S. federal income tax purposes;

 

   

a corporation (or other entity taxable as a corporation for U.S. federal income tax purposes) created or organized in or under the laws of the United States, any state thereof, or the District of Columbia;

 

   

an estate, the income of which is subject to U.S. federal income taxation regardless of its source;

 

   

a trust if a U.S. court can exercise primary supervision over the trust’s administration and one or more U.S. persons have the authority to control all substantial decisions of the trust; or

 

   

a trust in existence on August 20, 1996 that has a valid election in effect under applicable Treasury Regulations to be treated as a U.S. person.

The term “Non-U.S. Holder” means a beneficial owner of ordinary shares or ADSs that is not a U.S. Holder. As described in “Taxation of Non-U.S. Holders” below, the tax consequences to a Non-U.S. Holder may differ substantially from the tax consequences to a U.S. Holder.

If a partnership (including for this purpose any entity treated as a partnership for U.S. federal income tax purposes) is a beneficial owner of ordinary shares or ADSs, the U.S. federal income tax consequences to a partner in the partnership will generally depend on the status of the partner and the activities of the partnership. A holder of ordinary shares or ADSs that is a partnership and the partners in such partnership should consult their own tax advisors regarding the U.S. federal income tax consequences of the ownership and disposition of ordinary shares or ADSs.

ADSs

As relates to the ADSs, this discussion is based in part upon the representations of the depositary and the assumption that each obligation in the deposit agreement and any related agreement will be performed in accordance with its terms.

Generally, a holder of ADSs will be treated as the owner of the underlying ordinary shares represented by those ADSs for U.S. federal income tax purposes. Accordingly, no gain or loss will be recognized if the holder exchanges ADSs for the underlying ordinary shares represented by those ADSs. The holder’s adjusted tax basis in the ordinary shares will be the same as the adjusted tax basis of the ADSs surrendered in exchange therefor, and the holding period for the ordinary shares will include the holding period for the surrendered ADSs.

 

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TAXATION OF U.S. HOLDERS

The discussion in “— Distributions on Ordinary Shares or ADSs” and “— Dispositions of Ordinary Shares or ADSs” below assumes that we will not be treated as a passive foreign investment company or PFIC, for U.S. federal income tax purposes. For a discussion of the rules that apply if we are treated as a PFIC, see the discussion in “Passive Foreign Investment Company” below.

Distributions on Ordinary Shares or ADSs

General. Subject to the discussion in “Passive Foreign Investment Company” below, if you actually or constructively receive a distribution on ordinary shares or ADSs, you must include the distribution in gross income as a taxable dividend on the date of your (or in the case of ADSs, the depositary’s) receipt of the distribution, but only to the extent of our current or accumulated earnings and profits, as calculated under U.S. federal income tax principles. Such amount must be included without reduction for any foreign tax withheld. Dividends paid by us will not be eligible for the dividends received deduction allowed to corporations with respect to dividends received from certain domestic corporations. Dividends paid by us may or may not be eligible for preferential rates applicable to qualified dividend income, as described below.

To the extent a distribution exceeds our current and accumulated earnings and profits, it will be treated first as a non-taxable return of capital to the extent of your adjusted tax basis in the ordinary shares or ADSs, and thereafter as capital gain. Preferential tax rates for long-term capital gain may be applicable to non-corporate U.S. Holders.

We do not intend to calculate our earnings and profits under U.S. federal income tax principles. Therefore, you should expect that a distribution will generally be reported as a dividend even if that distribution would otherwise be treated as a non-taxable return of capital or as capital gain under the rules described above.

Qualified Dividend Income. With respect to non-corporate U.S. Holders (i.e., individuals, trusts, and estates), for taxable years beginning before January 1, 2011, dividends that are treated as qualified dividend income or QDI, are taxable at a maximum tax rate of 15%. Among other requirements, dividends generally will be treated as QDI if either (i) our ordinary shares or ADSs are readily tradable on an established securities market in the United States, or (ii) we are eligible for the benefits of a comprehensive income tax treaty with the United States which includes an information exchange program and which is determined to be satisfactory by the U.S. Treasury. It is expected that our ADSs will be “readily tradable” as a result of being listed on the NASDAQ Global Select Market. However, if you exchange your ADSs for underlying ordinary shares, dividends received by you will not be treated as QDI because the ordinary shares are not readily tradable on an established securities market in the United States.

In addition, for dividends to be treated as QDI, we must not be a PFIC (as discussed below) for either the taxable year in which the dividend was paid or the preceding taxable year. We do not believe that we were a PFIC for the preceding taxable year or will be a PFIC for the current taxable year. However, please see the discussion under “—Passive Foreign Investment Company” below. Additionally, in order to qualify for QDI treatment, you generally must have held the ordinary shares or ADSs for more than 60 days during the 121-day period beginning 60 days prior to the ex-dividend date. However, your holding period will be reduced for any period during which the risk of loss is diminished.

 

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Moreover, a dividend will not be treated as QDI to the extent you are under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. Since the QDI rules are complex, you should consult your own tax advisor regarding the availability of the preferential tax rates for dividends paid on ordinary shares or ADSs.

Foreign Currency Distributions. A dividend paid in foreign currency (e.g., Renminbi) must be included in your income as a U.S. dollar amount based on the exchange rate in effect on the date such dividend is received, regardless of whether the payment is in fact converted to U.S. dollars. If the dividend is converted to U.S. dollars on the date of receipt, you generally will not recognize a foreign currency gain or loss. However, if you convert the foreign currency to U.S. dollars on a later date, you must include in income any gain or loss resulting from any exchange rate fluctuations. The gain or loss will be equal to the difference between (i) the U.S. dollar value of the amount you included in income when the dividend was received and (ii) the amount that you receive on the conversion of the foreign currency to U.S. dollars. Such gain or loss will generally be ordinary income or loss and U.S. source for U.S. foreign tax credit purposes.

In-Kind Distributions. Distributions to you of new ordinary shares or ADSs or rights to subscribe for new ordinary shares or ADSs that are received as part of a pro rata distribution to all of our shareholders will not be subject to U.S. federal income tax. The adjusted tax basis of the new ordinary shares or ADSs or rights so received will be determined by allocating your adjusted tax basis in the old ordinary shares or ADSs between the old ordinary shares or ADSs and the new ordinary shares or ADSs or rights received, based on their relative fair market values on the date of distribution. However, in the case of a distribution of rights to subscribe for ordinary shares or ADSs, the adjusted tax basis of the rights will be zero if the fair market value of the rights is less than 15% of the fair market value of the old ordinary shares or ADSs on the date of distribution and you do not make an election to determine the adjusted tax basis of the rights by allocation as described above. Your holding period for the new ordinary shares or ADSs or rights will generally include the holding period for the old ordinary shares or ADSs on which the distribution was made.

Foreign Tax Credits. Subject to certain conditions and limitations, any foreign taxes paid on or withheld from distributions from us and not refundable to you may be credited against your U.S. federal income tax liability or, alternatively, may be deducted from your taxable income. This election is made on a year-by-year basis and applies to all foreign taxes paid by you or withheld from you that year.

Distributions will constitute foreign source income for foreign tax credit limitation purposes. The foreign tax credit limitation is calculated separately with respect to specific classes of income. For this purpose, distributions characterized as dividends distributed by us will generally constitute “passive category income” or, in the case of certain U.S. Holders, “general category income.” Special limitations may apply if a dividend is treated as QDI (as defined above).

Special rules may apply to individuals whose foreign source income during the taxable year consists entirely of “qualified passive income” and whose creditable foreign taxes paid or accrued during the taxable year do not exceed US$300 (US$600 in the case of a joint return).

Since the rules governing foreign tax credits are complex, you should consult your own tax advisor regarding the availability of foreign tax credits in your particular circumstances.

The U.S. Treasury has expressed concerns that parties to whom ADSs are pre-released may be taking actions that are inconsistent with the claiming of foreign tax credits by U.S. Holders of ADSs.

 

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Such actions would also be inconsistent with the claiming of the preferential tax rates applicable to QDI, as defined above. Accordingly, the creditability of foreign taxes and the availability of such preferential tax rates could be affected by future actions that may be taken by the U.S. Treasury or parties to whom ADSs are pre-released.

Dispositions of Ordinary Shares or ADSs

Subject to the discussion in “— Passive Foreign Investment Company” below, you generally will recognize taxable gain or loss realized on the sale or other taxable disposition of ordinary shares or ADSs equal to the difference between the U.S. dollar value of (i) the amount realized on the disposition (i.e., the amount of cash plus the fair market value of any property received), and (ii) your adjusted tax basis in the ordinary shares or ADSs. Such gain or loss will be capital gain or loss.

If you have held the ordinary shares or ADSs for more than one year at the time of disposition, such capital gain or loss will be long-term capital gain or loss. Preferential tax rates for long-term capital gain (currently, with a maximum rate of 15% for taxable years beginning before January 1, 2011) will apply to non-corporate U.S. Holders. If you have held the ordinary shares or ADSs for one year or less, such capital gain or loss will be short-term capital gain or loss taxable as ordinary income at your marginal income tax rate. The deductibility of capital losses is subject to limitations.

Generally, any gain or loss recognized will not give rise to foreign source income for U.S. foreign tax credit purposes.

You should consult your own tax advisor regarding the U.S. federal income tax consequences if you receive currency other than U.S. dollars upon the disposition of ordinary shares or ADSs.

Passive Foreign Investment Company

We generally will be a PFIC under Section 1297 of the Code if, for a taxable year, either (a) 75% or more of our gross income for such taxable year is passive income, or the income test, or (b) 50% or more of the average percentage, generally determined by fair market value, of our assets during such taxable year either produce passive income or are held for the production of passive income, or the asset test. “Passive income” includes, for example, dividends, interest, certain rents and royalties, certain gains from the sale of stock and securities, and certain gains from commodities transactions.

Certain “look through” rules apply for purposes of the income and asset tests described above. If we own, directly or indirectly, 25% or more of the total value of the outstanding shares of another corporation, we generally will be treated as if we (a) held directly a proportionate share of the other corporation’s assets, and (b) received directly a proportionate share of the other corporation’s income. In addition, passive income does not include any interest, dividends, rents, or royalties that are received or accrued by us from a “related person” (as defined in Section 954(d)(3) of the Code), to the extent such items are properly allocable to income of such related person that is not passive income.

Under the income and asset tests, whether or not we are a PFIC will be determined annually based upon the composition of our income and the composition and valuation of our assets, all of which are subject to change. In determining that we are not a PFIC, we are relying on our projected revenues and projected capital expenditures. If our actual revenues and capital expenditures do not match our projections, we may become a PFIC. For example, if we do not spend enough of the cash (a passive asset) we raise from any financing transactions we may undertake, the relative percentage of our passive assets will increase. In addition, our determination is based on a current valuation of our assets, including goodwill (generally an active asset). In calculating goodwill, we have valued our total assets based on our market capitalization, determined using the market price of our ordinary shares and ADSs.

 

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Such market price may fluctuate. If our market capitalization is less than anticipated or subsequently declines, this will decrease the value of our goodwill and we may become a PFIC. Furthermore, we have made a number of assumptions regarding the amount of value allocable to goodwill. We believe our valuation approach is reasonable. However, it is possible that the IRS will challenge the valuation of our assets, including goodwill, which may result in our being a PFIC.

We do not believe that we are currently a PFIC. However, because the PFIC determination is highly fact intensive and made at the end of each taxable year, there can be no assurance that we will not be a PFIC for the current or any future taxable year or that the IRS will not challenge our determination concerning our PFIC status.

Default PFIC Rules under Section 1291 of the Code. If we are treated as a PFIC with respect to a U.S. Holder, the U.S. federal income tax consequences to the U.S. Holder of the ownership and disposition of ordinary shares or ADSs will depend on whether such U.S. Holder makes an election to treat us as a qualified electing fund, or QEF, under Section 1295 of the Code, or QEF Election, or a mark-to-market election under Section 1296 of the Code, or Mark-to-Market Election. A U.S. Holder owning ordinary shares or ADSs while we were or are a PFIC that has not made either a QEF Election or a Mark-to-Market Election will be referred to in this summary as a “Non-Electing U.S. Holder.”

If you are a Non-Electing U.S. Holder, you will be subject to the default tax rules of Section 1291 of the Code with respect to:

 

   

any “excess distribution” paid on ordinary shares or ADSs, which means the excess (if any) of the total distributions received by you during the current taxable year over 125% of the average distributions received by you during the three preceding taxable years (or during the portion of your holding period for the ordinary shares or ADSs prior to the current taxable year, if shorter); and

 

   

any gain recognized on the sale or other taxable disposition (including a pledge) of ordinary shares or ADSs.

Under these default tax rules:

 

   

any excess distribution or gain will be allocated ratably over your holding period for the ordinary shares or ADSs;

 

   

the amount allocated to the current taxable year and any period prior to the first day of the first taxable year in which we were a PFIC will be treated as ordinary income in the current taxable year;

 

   

the amount allocated to each of the other years will be treated as ordinary income and taxed at the highest applicable tax rate in effect for that year; and

 

   

the resulting tax liability from any such prior years will be subject to the interest charge applicable to underpayments of tax.

In addition, notwithstanding any election you may make, dividends that you receive from us will not be eligible for the preferential tax rates applicable to QDI (as discussed above in “Distributions on Ordinary Shares or ADSs”) if we are a PFIC either in the taxable year of the distribution or the preceding taxable year, but will instead be taxable at rates applicable to ordinary income.

 

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Special rules for Non-Electing U.S. Holders will apply to determine U.S. foreign tax credits with respect to foreign taxes imposed on distributions on ordinary shares or ADSs.

If we are treated as a PFIC for any taxable year during which you hold ordinary shares or ADSs, we will continue to be treated as a PFIC with respect to you for all succeeding years during which you hold ordinary shares or ADSs, regardless of whether we actually continue to be a PFIC. You may terminate this deemed PFIC status by electing to recognize gain (which will be taxed under the default tax rules of Section 1291 of the Code discussed above) as if your ordinary shares or ADSs had been sold on the last day of the last taxable year for which we were a PFIC.

If we are a PFIC in any year with respect to you, you will be required to file an annual return on IRS Form 8621 regarding distributions received on ordinary shares or ADSs and any gain realized on the disposition of ordinary shares or ADSs.

QEF Election. If you own (or owned) ordinary shares or ADSs while we are (or were) a PFIC and you make a QEF Election, you generally will not be subject to the default rules of Section 1291 of the Code discussed above. Instead, you will be subject to current U.S. federal income tax on your pro rata share of our ordinary earnings and net capital gain, regardless of whether such amounts are actually distributed to you by us. However, you can make a QEF Election only if we agree to furnish you annually with certain tax information, and we currently do not intend to prepare or provide such information.

Mark-to-Market Election. U.S. Holders may make a Mark-to-Market Election, but only if our ordinary shares or ADSs are marketable stock. Our ordinary shares are not currently listed on any exchange, but our ADSs will be “marketable stock” as long as they remain listed on the NASDAQ Global Select Market and are regularly traded. Stock is “regularly traded” for any calendar year during which it is traded (other than in de minimis quantities) on at least 15 days during each calendar quarter. There can be no assurances, however, that our ADSs will be treated, or continue to be treated, as regularly traded.

If you own (or owned) ordinary shares or ADSs while we are (or were) a PFIC and you make a Mark-to-Market Election, you generally will not be subject to the default rules of Section 1291 of the Code discussed above. Rather, you generally will be required to recognize ordinary income for any increase in the fair market value of the ADSs for each taxable year that we are a PFIC. You will also be allowed to deduct as an ordinary loss any decrease in the fair market value to the extent of net marked-to-market gain previously included in prior years. Your adjusted tax basis in the ADSs will be adjusted to reflect the amount included or deducted.

The Mark-to-Market Election will be effective for the taxable year for which the election is made and all subsequent taxable years, unless our ADSs cease to be marketable stock or the IRS consents to the revocation of the election. You should consult your own tax advisor regarding the availability of, and procedure for making, a Mark-to-Market Election.

One or more of our subsidiaries may also be classified as PFICs now or in the future, and furthermore, we or one or more of our subsidiaries may invest in the equity of other foreign corporations that are PFICs. In such cases, U.S. Holders will be subject to the PFIC rules with respect to their indirect ownership interests in such PFICs. U.S. Holders will not be able to make a QEF Election or a Mark-to-Market Election with respect to any of our subsidiaries that are PFICs, and there can be no assurance that U.S. Holders will be able to make such elections with respect to any other PFICs in which we or one or more of our subsidiaries invests.

 

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Since the PFIC rules are complex, you should consult your own tax advisor regarding them and how they may affect the U.S. federal income tax consequences of the ownership and disposition of ordinary shares or ADSs.

Information Reporting and Backup Withholding

Generally, information reporting requirements will apply to distributions on ordinary shares or ADSs or proceeds from the disposition of ordinary shares or ADSs paid within the United States (and, in certain cases, outside the United States) to a U.S. Holder unless such U.S. Holder is an exempt recipient, such as a corporation. Furthermore, backup withholding (currently at 28%) may apply to such amounts unless such U.S. Holder (i) is an exempt recipient that, if required, establishes its right to an exemption, or (ii) provides its taxpayer identification number, certifies that it is not currently subject to backup withholding, and complies with other applicable requirements. A U.S. Holder may generally avoid backup withholding by furnishing a properly completed IRS Form W-9.

Backup withholding is not an additional tax. Rather, amounts withheld under the backup withholding rules may be credited against your U.S. federal income tax liability. Furthermore, you may obtain a refund of any excess amounts withheld by filing an appropriate claim for refund with the IRS and furnishing any required information in a timely manner.

TAXATION OF NON-U.S. HOLDERS

Distributions on Ordinary Shares or ADSs

Subject to the discussion in “Information Reporting and Backup Withholding” below, as a Non-U.S. Holder, you generally will not be subject to U.S. federal income tax, including withholding tax, on distributions received on ordinary shares or ADSs, unless the distributions are effectively connected with your conduct of a trade or business in the United States (and, if an applicable income tax treaty so requires, attributable to a permanent establishment that you maintain in the United States).

If distributions are effectively connected with a U.S. trade or business (and, if applicable, attributable to a U.S. permanent establishment), you generally will be subject to tax on such distributions in the same manner as a U.S. Holder, as described in “Taxation of U.S. Holders – Distributions on Ordinary Shares or ADSs” above. In addition, any such distributions received by a corporate Non-U.S. Holder may also, under certain circumstances, be subject to an additional “branch profits tax” at a 30% rate or such lower rate as may be specified by an applicable income tax treaty.

Dispositions of Ordinary Shares or ADSs

Subject to the discussion in “Information Reporting and Backup Withholding” below, as a Non-U.S. Holder, you generally will not be subject to U.S. federal income tax, including withholding tax, on any gain recognized on a sale or other taxable disposition of ordinary shares or ADSs, unless (i) the gain is effectively connected with your conduct of a trade or business in the United States (and, if an applicable income tax treaty so requires, attributable to a permanent establishment that you maintain in the United States), or (ii) you are an individual and are present in the United States for at least 183 days in the taxable year of the disposition, and certain other conditions are met.

If you meet the test in clause (i) above, you generally will be subject to tax on any gain that is effectively connected with your conduct of a trade or business in the United States in the same manner as a U.S. Holder, as described in “Taxation of U.S. Holders – Dispositions of Ordinary Shares or ADSs” above. Effectively connected gain realized by a corporate Non-U.S. Holder may also, under certain circumstances, be subject to an additional “branch profits tax” at a 30% rate or such lower rate as may be specified by an applicable income tax treaty.

 

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If you meet the test in clause (ii) above, you generally will be subject to tax at a 30% rate on the amount by which your U.S. source capital gain exceeds your U.S. source capital loss.

Information Reporting and Backup Withholding

Payments to Non-U.S. Holders of distributions on, or proceeds from the disposition of, ordinary shares or ADSs are generally exempt from information reporting and backup withholding. However, a Non-U.S. Holder may be required to establish that exemption by providing certification of non-U.S. status on an appropriate IRS Form W-8.

Backup withholding is not an additional tax. Rather, amounts withheld under the backup withholding rules may be credited against your U.S. federal income tax liability. Furthermore, you may obtain a refund of any excess amounts withheld by filing an appropriate claim for refund with the IRS and furnishing any required information in a timely manner.

Enforcement of Civil Liabilities

We are incorporated in the Cayman Islands because of the following benefits found there:

 

   

political and economic stability;

 

   

an effective judicial system;

 

   

a favorable tax system;

 

   

the absence of exchange control or currency restrictions; and

 

   

the availability of professional and support services.

However, certain disadvantages accompany incorporation in the Cayman Islands. These disadvantages include:

(1) the Cayman Islands has a less developed body of securities laws as compared to the United States and provides significantly less protection to investors; and

(2) Cayman Islands companies may not have standing to sue before the federal courts of the United States.

Our constituent documents do not contain provisions requiring that disputes, including those arising under the securities laws of the United States, between us, our officers, directors and shareholders be arbitrated.

A substantial portion of our current operations is conducted in China through our wholly-owned subsidiaries which are incorporated in China or the British Virgin Islands. All or most of our assets are located in China. We have appointed CT Corporation System, 111 Eighth Avenue, New York, NY 10011, as our agent upon whom process may be served in any action brought against us under the securities laws of the United States. A majority of our directors and officers are nationals or residents of jurisdictions other than the United States and a substantial portion of their assets are located outside the United States. As a result, it may be difficult for a shareholder to effect service of process within the United States upon these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

 

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Maples and Calder, our counsel as to Cayman Islands law, and King and Wood, our counsel as to Chinese law, have advised us that there is uncertainty as to whether the courts of the Cayman Islands or China would:

(1) recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States; or

(2) entertain original actions brought in the Cayman Islands or China against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.

Maples and Calder has further advised us that a final and conclusive judgment in the federal or state courts of the United States under which a sum of money is payable, other than a sum payable in respect of taxes, fines, penalties or similar charges or similar fiscal or revenue obligations and which was neither obtained in a manner nor is of a kind enforcement of which is contrary to natural justice or the public policy of the Cayman Islands, may be subject to enforcement proceedings as a debt in the courts of the Cayman Islands under the common law.

King and Wood has advised us further that the recognition and enforcement of foreign judgments are provided for under Chinese Civil Procedures Law. Chinese courts may recognize and enforce foreign judgments in accordance with the requirements of Chinese Civil Procedures Law based either on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions.

 

F. Dividends and Paying Agents

Not applicable.

 

G. Statement by Experts

Not applicable.

 

H. Documents on Display

We have previously filed with the SEC our registration statement on Form F-1 and prospectus under the Securities Act of 1933, as amended, with respect to our ADSs.

We are subject to the periodic reporting and other informational requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Under the Exchange Act, we are required to file reports and other information with the Securities and Exchange Commission. Specifically, we are required to file annually a Form 20-F no later than six months after the close of each fiscal year, which is December 31. Copies of reports and other information, when so filed, may be inspected without charge and may be obtained at prescribed rates at the public reference facilities maintained by the Securities and Exchange Commission at 100 F Street, N.E., Washington, D.C. 20549. You can request copies of these documents upon payment of a duplicating fee, by writing to the SEC. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference rooms. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information regarding registrants that make electronic filings with the SEC using its EDGAR system.

 

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As a foreign private issuer, we are exempt from the rules under the Exchange Act prescribing the furnishing and content of quarterly reports and proxy statements, and officers, directors and principal shareholders are exempt from the reporting and short-swing profit recovery provisions contained in Section 16 of the Exchange Act.

Our financial statements have been prepared in accordance with U.S. GAAP.

In accordance with NASDAQ Marketplace Rule 5250(d)(1), we will post this annual report on Form 20-F on our website at http://corp.163.com under the heading “Investor Info.” In addition, we will provide hardcopies of our annual report free of charge to shareholders and ADS holders upon request.

 

I. Subsidiary Information

Not applicable.

 

Item 11. Quantitative and Qualitative Disclosures About Market Risk

Please refer to Item 5.F. “Operating and Financial Review and Prospects—Quantitative and Qualitative Disclosures About Market Risk.”

 

Item 12. Description of Securities Other than Equity Securities

Not Applicable.

PART II

 

Item 13. Defaults, Dividend Arrearages and Delinquencies

None.

 

Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds

Use of Proceeds

The following “Use of Proceeds” information relates to the registration statement on Form F-1 (File No. 333-11724), or the Registration Statement, for our initial public offering of 4,500,000 ADSs, each representing 100 of our ordinary shares (without taking into account our ADR ratio change effected on March 27, 2006), for an aggregate offering price of US$69.75 million. Our Registration Statement was declared effective by the SEC on June 29, 2000.

We received net proceeds of approximately US$64.9 million from our initial public offering (taking into account underwriting discounts of US$4.88 million, but not taking into account transaction expenses of approximately US$2.7 million). None of the transaction expenses included payments to directors or officers of our company or their associates, persons owning 10% or more of our equity securities or our affiliates.

 

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From the effective date of the Registration Statement to July 6, 2000, we did not use any of the proceeds from our initial public offering. Net proceeds from the offering have been invested in highly liquid money market instruments, short-term time deposits and similar instruments. Since July 6, 2000, we have used the net proceeds from our initial public offering to satisfy past indebtedness and reduce our accounts payable and to fund expenses primarily for marketing, employee compensation, and capital expenditures. None of the net proceeds from the initial public offering were paid, directly or indirectly, to any of our directors or officers of our company or their associates, persons owning 10% or more of our equity securities or our affiliates.

Merrill Lynch Far East Limited, Merrill Lynch, Pierce, Fenner & Smith Incorporated, Deutsche Bank Securities Inc., Chase Securities Inc., Salomon Smith Barney Inc., and UBS Warburg LLC were the underwriters for our initial public offering.

 

Item 15. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

William Lei Ding, our Chief Executive Officer, and Onward Choi, our Acting Chief Financial Officer, have performed an evaluation of our disclosure controls and procedures, as that term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act, as of the end of the fiscal year covered by this annual report. They have concluded that such disclosure controls and procedures were effective to ensure that information required to be disclosed in our periodic reports filed under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the SEC’s rules and regulations.

Management’s Report on Internal Control over Financial Reporting and Attestation Report of the Registered Public Accounting Firm

Our management’s report on internal control over financial reporting and the related report of our independent registered public accounting firm are included in this annual report on pages F-1 and F-2, respectively.

Changes in Internal Controls

There were no changes in our internal controls over financial reporting identified in connection with the evaluation required by Rules 13a-15 or 15d-15 that occurred during the period covered by this annual report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Item 16. Reserved

 

Item 16A. Audit Committee Financial Expert

Our board of directors has determined that Mr. Joseph Tong qualifies as an Audit Committee Financial Expert as defined by the applicable rules of the SEC and that Mr. Tong is “independent” as that term is defined in NASDAQ Marketplace Rule 5605(c)(2)(A).

 

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Item 16B. Code of Ethics

We have adopted a Code of Business Conduct which applies to our employees, officers and non-employee directors, including our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. This code is intended to qualify as a “code of ethics” within the meaning of the applicable rules of the SEC.

 

Item 16C. Principal Accountant Fees and Services

Disclosure of Fees Charged by Independent Accountants

The following table summarizes the fees charged by PricewaterhouseCoopers Zhong Tian CPAs Limited Company for certain services rendered to our company during 2007 and 2008.

 

     For the year ended
December 31,
     (in thousands of U.S. dollars)
     2007(1)    2008(1)

Audit fees(2)

   $ 1,250    $ 1,348

Audit-related fees(3)

     —        —  

Tax fees(4)

     81      36
             

Total

   $ 1,331    $ 1,384
             

 

(1) The fees disclosed are exclusive of out-of-pocket expenses and taxes on the amounts paid, which totaled approximately US$142,000 and US$131,000 in 2007 and 2008, respectively.
(2) “Audit fees” means the aggregate fees billed in each of the fiscal years listed for professional services rendered by our principal auditors for the audit of our annual financial statements and our internal controls over financial reporting.
(3) “Audit-related fees” means the aggregate fees billed in each of the fiscal years listed for professional services rendered by our principal auditors related to the audit of our financial statements and our internal controls over financial reporting that are not reported under “Audit Fees” and consultation on accounting standards or transactions.
(4) “Tax fees” means the aggregate fees billed in each of the fiscal years listed for professional services rendered by our principal auditors for tax compliance and tax advice.

Audit Committee Pre-approval Policies and Procedures

Our audit committee has adopted procedures which set forth the manner in which the committee will review and approve all audit and non-audit services to be provided by PricewaterhouseCoopers Zhong Tian CPAs Limited Company before that firm is retained for such services. The pre-approval procedures are as follows:

 

   

Any audit or non-audit service to be provided to us by the independent accountant must be submitted to the audit committee for review and approval, with a description of the services to be performed and the fees to be charged.

 

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The audit committee in its sole discretion then approves or disapproves the proposed services and documents such approval, if given, through written resolutions or in the minutes of meetings, as the case may be.

 

Item 16D. Exemptions from the Listing Standards for Audit Committees

We have not sought an exemption from the applicable listing standards for the audit committee of our board of directors.

 

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Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

Period

   Total
Number of

ADSs
Purchased(1)
   Average
Price
Paid

Per ADS
   ADSs
Purchased

as Part of
Publicly

Announced
Plans

or
Programs
   Approximate
Dollar Value
of ADSs

that May Yet
Be

Purchased
Under

the
Programs
          US$         US$

January 1 through January 31, 2008

   155,535    17.8062    155,535    81,552,021

February 1 through February 28, 2008

   345,400    17.5079    500,935    75,504,789

March 1 through March 31, 2008

   111,380    17.3354    612,315    73,573,974

April 1 through April 30, 2008

   —      —      612,315    73,573,974

May 1 through May 31, 2008

   —      —      612,315    73,573,974

June 1 through June 30, 2008

   —      —      612,315    73,573,974

July 1 through July 31, 2008

   —      —      612,315    73,573,974

August 1 through August 31, 2008

   —      —      —      —  

September 1 through September 30, 2008(2)

   2,995    20.8715    2,995    99,937,490

October 1 through October 31, 2008

   522,200    19.6672    525,195    89,667,287

November 1 through November 30, 2008

   140,500    19.9146    665,695    86,869,283

December 1 through December 31, 2008

   —      —      665,695    86,869,283
             

Total

   1,278,010         
             

 

(1) Our ADS to ordinary share ratio is one ADS for every 25 ordinary shares.
(2) During 2008, we announced a share repurchase program authorized by our board of directors. We also announced a share repurchase program authorized by our board of directors in July 2007 which expired in July 2008. Details of these share repurchase programs are set forth below:

 

Share Repurchase Programs authorized on

   Amount
Authorized
   Expiration
Date
     (US$)     

September 12, 2008

   100,000,000    September 11, 2009

July 2, 2007

   120,000,000    July 1, 2008

 

Item 16F. Change in Registrant’s Certifying Accountants

Not applicable.

 

Item 16G. Corporate Governance

None.

 

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PART III

 

Item 17. Financial Statements

The company has elected to provide financial statements pursuant to Item 18.

 

Item 18. Financial Statements

The consolidated financial statements for NetEase.com, Inc. and its subsidiaries are included at the end of this annual report.

 

Item 19. Exhibits

 

Exhibit

Number

 

Document

  1.1

  Amended and Restated Memorandum of Association of NetEase.com, Inc. (incorporated by reference to Exhibit 3.1 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  1.2

  Amended and Restated Articles of Association of NetEase.com, Inc. (incorporated by reference to Exhibit 3.2 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  1.3

  Amendment to Amended and Restated Articles of Association of NetEase.com, Inc. dated as of June 6, 2003 (incorporated by reference to Exhibit 1.3 to the company’s Annual Report on Form 20-F for the year ended December 31, 2002 filed with the Securities and Exchange Commission on June 27, 2003)

  2.1

  Specimen American Depositary Receipt of NetEase.com, Inc. (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  2.2

  Specimen Stock Certificate of NetEase.com, Inc. (incorporated by reference to Exhibit 4.2 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  3.1

  Shareholder Voting Rights Trust Agreement dated May 12, 2000 among William Lei Ding, Bo Ding and NetEase Information Technology (Beijing) Co., Ltd. (incorporated by reference to Exhibit 10.40 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.1

  Amended and Restated 2000 Stock Incentive Plan and Form of Stock Option Agreement (including standard and non-standard form) (incorporated by reference to Exhibit 4.2 to the company’s Annual Report on Form 20-F for the year ended December 31, 2000 filed with the Securities and Exchange Commission on August 31, 2001)

 

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  4.2

  Employment Agreement dated August 13, 1999 between NetEase.com, Inc. and William Lei Ding (incorporated by reference to Exhibit 10.2 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on March 27, 2000)

  4.3

  Addendum to Employment Agreement between NetEase.com, Inc. and William Lei Ding dated November 25, 2005 (incorporated by reference to Exhibit 4.3 to the company’s Annual Report on Form 20-F for the year ended December 31, 2005 filed with the Securities and Exchange Commission on June 29, 2006)

  4.4

  Employment Agreement dated July 1, 2007 between NetEase.com Inc. and Onward Choi (incorporated by reference to Exhibit 4.4 to the company’s Annual Report on Form 20-F for the year ended December 31, 2007 filed with the Securities and Exchange Commission on June 26, 2008)

  4.5

  Employment Agreement dated May 17, 2006 between NetEase.com, Inc. and Zhonghui Zhan (incorporated by reference to Exhibit 4.6 to the company’s Annual Report on Form 20-F for the year ended December 31, 2005 filed with the Securities and Exchange Commission on June 29, 2006)

  4.6

  Domain Name License Agreement dated February 3, 2000 between NetEase.com, Inc. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.7 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on March 27, 2000)

  4.7

  Copyright License Agreement dated February 3, 2000 between NetEase Information Technology (Beijing) Co., Ltd. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.8 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on March 27, 2000)

  4.8

  Trademark License Agreement dated February 3, 2000 between NetEase Information Technology (Beijing) Co., Ltd. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.9 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on March 27, 2000)

  4.9

  Supplemental Agreement (to Copyright License Agreement and Domain Name License Agreement) dated April 27,2000 between NetEase Information Technology (Beijing) Co., Ltd. and Guangzhou NetEase Computer System Co., Ltd (incorporated by reference to Exhibit 10.10 to Amendment No.1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.10

  Notice of Renewal dated April 2, 2001 relating to the Copyright License Agreement and the Trademark License Agreement each dated February 3, 2000 and made between NetEase Information Technology (Beijing) Co., Ltd and Guangzhou NetEase Computer System Co., Ltd (incorporated by reference to Exhibit 4.14 to the company’s Annual Report on Form 20-F for the year ended December 31, 2000 filed with the Securities and Exchange Commission on August 31, 2001)

 

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  4.11

  Exclusive Advertising Agency Agreement dated February 3, 2000 between Guangzhou NetEase Computer System Co., Ltd. and NetEase.com, Inc. (incorporated by reference to Exhibit 10.13 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on March 27, 2000)

  4.12

  Notice of Renewal dated April 2, 2001 relating to the Exclusive Advertising Agency Agreement dated February 3, 2000 between Guangzhou NetEase Computer System Co., Ltd. and NetEase.com, Inc. (incorporated by reference to Exhibit 4.18 to the company’s Annual Report on Form 20-F for the year ended December 31, 2000 filed with the Securities and Exchange Commission on August 31, 2001)

  4.13

  Trademark Transfer Agreement dated March 29, 2000 between Guangzhou NetEase Computer System Co., Ltd. and NetEase Information Technology (Beijing) Co., Ltd. (incorporated by reference to Exhibit 10.14 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.14

  Online Advertising Agreement dated February 15, 2000 between Guangzhou NetEase Computer System Co., Ltd. and Beijing Guangyitong Advertising Co., Ltd. (incorporated by reference to Exhibit 10.15 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on March 27, 2000)

  4.15

  Notice of Renewal dated April 2, 2001 relating to the Online Advertising Agreement dated February 15, 2000 and made between Guangzhou NetEase Computer System Co., Ltd. and Beijing Guangyitong Advertising Co., Ltd. (incorporated by reference to Exhibit 4.21 to the company’s Annual Report on Form 20-F for the year ended December 31, 2000 filed with the Securities and Exchange Commission on August 31, 2001)

  4.16

  Supplemental Agreement dated May 15, 2000 (amending the Domain Name License Agreement) between NetEase.com, Inc. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.37 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.17

  Agreement dated May 12, 2000 between NetEase Information Technology (Beijing) Co., Ltd. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.41 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.18

  Operating Agreement dated May 10, 2000 among NetEase Information Technology (Beijing) Co., Ltd., Beijing Guangyitong Advertising Co., Ltd., Bo Ding and William Lei Ding (incorporated by reference to Exhibit 10.42 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.19

  Supplemental Agreement dated May 12, 2000 (supplementing the Online Advertising Agreement dated February 15, 2000) between Guangzhou NetEase Computer System Co., Ltd. and Beijing Guangyitong Advertising Co., Ltd. (incorporated by reference to Exhibit 10.47 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

 

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  4.20

  Supplemental Agreement dated May 15, 2000 (supplementing the Domain Name License Agreement dated February 3, 2000) between NetEase.com, Inc. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.48 to Amendment No. 1 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on May 15, 2000)

  4.21

  Letter of Agreement, dated June 6, 2000, among William Lei Ding, Bo Ding and NetEase.com, Inc. (incorporated by reference to Exhibit 10.49 to Amendment No. 2 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on June 15, 2000)

  4.22

  Supplemental Agreement dated June 15, 2000 (supplementing the Online Advertising Agreement dated February 15, 2000), between Beijing Guangyitong Advertising Co., Ltd. and Guangzhou NetEase Computer System Co., Ltd. (incorporated by reference to Exhibit 10.50 to Amendment No. 2 to the company’s Registration Statement on Form F-1 (file no. 333-11724) filed with the Securities and Exchange Commission on June 15, 2000)