Can R&D change NetEase's "Destiny"?

Internet and gaming service provider NetEase-S (09999.HK) has just announced its performance for the second quarter of 2024. Following the performance announcement, the stock price of NetEase (NTES.US) in the US stock market plummeted by 11.17% to close at $82.25, but there was a slight rebound in after-hours trading, with a marginal increase of 0.18%. However, the Hong Kong stock market did not take into account the post-market trend of the US stock market, opening sharply lower by 10.6% today, and then continuing to decline, falling by as much as 14.8% at one point.

The sharp decline on this day directly wiped out NetEase's accumulated gains so far this year. Based on an H-share price of HKD 124.20, NetEase fell by 13.15% on the same day, with a cumulative decline of 10.21% year-to-date. In comparison, the world's top gaming company Tencent (00700.HK), if based on the current price of HKD 376.60, has seen a cumulative increase of 29.45% year-to-date.

"World of Warcraft" Revenue to be Recognized in the Second Half of the Year

In the second quarter of 2024, online gaming service revenue increased by 6.69% year-on-year to RMB 20.056 billion, which remains the main source of revenue, accounting for 78.69% of the total revenue. Based on the disclosed data, the quarterly net revenue from online games is estimated to be around RMB 19.3 billion, a 12% year-on-year increase, with mobile games accounting for around RMB 14.7 billion, a 16% year-on-year increase, and PC games generating around RMB 4.5 billion in quarterly revenue, a 0.1% year-on-year decrease.

In contrast, Tencent's domestic market gaming revenue in the second quarter of 2024 increased by 9% year-on-year to RMB 34.6 billion, mainly driven by the revenue growth of "Fearless Agreement" and the successful release of "Dungeon & Fighter: Origin"; international market gaming revenue also increased by 9% to RMB 13.9 billion. During the period, the gross profit margin of the gaming business increased by 2.6 percentage points year-on-year to 70.0%, mainly due to changes in product mix.

Youdao's quarterly net revenue was RMB 1.3 billion, a 9.5% year-on-year increase, with a gross profit margin improvement of 1.2 percentage points year-on-year to 48.2%, mainly due to the improvement in profits from online marketing services.

Cloud Music's revenue in the second quarter increased by 4.7% year-on-year to RMB 2 billion, with a gross profit margin improvement of 5.1 percentage points year-on-year to 32.1%, mainly benefiting from the increase in subscription revenue and cost improvements.

Revenue from innovation and other businesses in the quarter increased by 0.5% year-on-year to RMB 2.067 billion, with a gross profit margin increase of 4.5 percentage points year-on-year, mainly attributed to the profit improvement of the selection and other businesses.

The return of "World of Warcraft" in June, which everyone is concerned about, will only show its impact in the second half of the year. Management stated during the performance release conference that the current user response is enthusiastic. In addition, Blizzard's "Hearthstone" has also officially announced its return on September 25th The future will deepen cooperation with Blizzard.

Youdao will continue to prioritize digital content services, online marketing services, and AI-driven subscription services. In the second quarter, this business unit achieved a historical high in operating cash flow, and operating losses also significantly narrowed. Its digital content services achieved healthy revenue growth, mainly driven by AI-empowered products. Its AI-driven subscription services have achieved rapid sales expansion for six consecutive quarters, with a year-on-year growth of about 200% in the second quarter.

NetEase Cloud Music continues to cultivate communities and promote monetization. In order to further cultivate its content ecosystem, NetEase continues to expand the variety of content. In the second quarter, NetEase enhanced cooperation with multiple music artists and further deepened partnerships.

Significant Increase in R&D Expenses

NetEase's quarterly profit declined mainly due to a significant increase in operating expenses, which should also be an important reason for the post-results stock price decline.

In the second quarter of 2024, NetEase's marketing and market expenses increased by 7% year-on-year to 3.502 billion yuan, accounting for 13.74% of total revenue, up from 13.63% in the same period last year.

In the first half of the year, NetEase launched a marketing campaign for its highly anticipated mobile game "Endless Rebirth," and related expenses should have been included in its second-quarter marketing expenses. However, after the public beta in July, its marketing effect seemed to be overshadowed by "Black Myth: Wukong" on August 20th. The performance in the second half of the year remains to be seen.

However, the largest increase in operating expenses should be in research and development expenses. In the second quarter, NetEase's R&D expenses increased by 14% year-on-year to 4.456 billion yuan, accounting for 17.48% of total revenue, up from 16.28% in the same period last year, as shown in the chart below.

It is worth noting that these operating expenses should also include equity incentive expenses. In the second quarter, its equity incentive expenses reached 1.06 billion yuan, up 36.8% year-on-year. Including this expense, NetEase's non-GAAP net profit attributable to shareholders for the second quarter of 2024 was 7.819 billion yuan, down 13.3% year-on-year.

Conclusion

NetEase's management mentioned at the performance release conference that they will increase R&D expenses for content optimization and also invest in AI. They believe that if AI research and development are successful in improving operational efficiency, it should offset the impact of related costs.

However, the market seems more concerned about whether NetEase's significant investment in operating expenses can bring meaningful output and profit improvement, which is one of the reasons for the decline in its stock price Next, we need to pay attention to the performance of NetEase's important gaming products, especially the mobile version of "Endless of God" and upcoming games like "Firefly Assault" in the second half of the year, as well as whether the collaborative products with Blizzard can regain their past glory - according to management, the ratio of new to old players is approximately 4:6.

Even more crucial is whether NetEase's increasing marketing and R&D expenses can truly translate into higher quality revenue from optimized content