NetEase: A "money-printing machine" on a downhill slope? If it's a pig factory, it's not scary

After the Hong Kong stock market closed on November 16th, Beijing time, NetEase.US released its third-quarter earnings report for 2023.

Looking at the Q3 performance alone, overall it is still quite good, with better-than-expected results mainly reflected in profits. However, there are flaws in the revenue, with all categories except mobile games missing expectations. It is only because mobile game revenue accounts for more than 70% of total revenue that the overall revenue did not fall significantly behind.

Although game revenue is still decent, a key forward-looking indicator, "contract liabilities," is disappointing. The year-on-year growth rate in the third quarter continued to slow down, which differs from the market's general perception. Since June, NetEase has released five new games, including "Justice" and "Peak Speed," which have performed well. Therefore, the market had high expectations for sustained high revenue. Originally, it was hoped that the fourth quarter could continue to perform strongly.

Last quarter, Dolphin Research mentioned that based on the current pipeline, the third quarter was a small peak of this product cycle, and the next climax may have to wait until the second quarter of next year for "Yanyun Sixteen Sounds" and the second half of the year for "The Legend of the Condor Heroes," "Mission Zero," and "Endless Journey Mobile Game" to be released. In addition, "Egg Party," which started to gain popularity in the fourth quarter of last year, also brings growth pressure due to the high base.

However, from another perspective, this is also a normal product cycle fluctuation for NetEase. Past experience has shown that NetEase has the long-term operational ability to revitalize old games. Coupled with the next small peak not being far away, it is best to remain cautious and calm.

Specifically, let's focus on the key points of the earnings report:

1. Mobile games are the "highlight": Although NetEase's overall revenue in the third quarter basically met market expectations, apart from mobile games, which saw a year-on-year growth of 33% slightly exceeding expectations, other categories such as PC games, cloud music, Youdao, and innovative businesses all missed expectations. The overall revenue growth of nearly 12% was maintained solely by the incremental revenue from a few new mobile games.

2. Deferred revenue weakness, focus on the performance of new games: The disappointing aspect of the third quarter was the deferred revenue, or contract liabilities, which fell nearly 1 billion yuan short of expectations. Looking at the year-on-year trend, the third quarter also continued to slow down.

3. Gross margin improvement, profit explosion: Since the launch of "Egg Party" earlier this year, NetEase's quarterly profits have been continuously surging. In terms of core operating profit, the third quarter showed an accelerating growth trend with a year-on-year increase of 59%.

There are several reasons for the improvement in gross margin. NetEase has divested low-margin Blizzard agent games and adjusted the high revenue-sharing direct broadcasting business of cloud music. In addition, a key factor in the significant increase in game gross margin is that the company deliberately reduced the distribution of new games through the Android channel and guided users to download from the official website and enter the community management, thereby reducing the cost of channel sharing.

4. Stable expenses, focus on marketing ROI: In the third quarter, NetEase's expenditure on operating expenses remained stable overall. However, the sales expenses were nearly 400 million lower than expected. Despite the intensive release of new games in Q3, the absolute value of promotional expenses actually decreased. This was mainly due to the company's adoption of higher ROI promotional strategies and channels, such as Douyin and content marketing copy.

**5. Adjusted net profit excluding SBC reached 8.65 billion in the third quarter, with a significantly slower YoY growth rate of 16% (compared to +66.7% in the previous quarter) due to the high base. However, this fluctuation was not caused by operational factors but rather by factors such as investment income that are not closely related to the fundamentals, so it should not be a major concern.

6. Still a "money-making machine" and "cash king": NetEase has always had a large amount of cash from a few games that generate passive income. The cash held is generally used for business investments or to reward shareholders (dividends and buybacks). In the third quarter, a dividend of $0.4950 per ADS was paid out, and $24 million was used to purchase 500,000 ADS at an average price of $103 per ADS.

As of the end of the third quarter, the company had a net cash balance of 104.4 billion (cash and cash equivalents, deposits, restricted cash, and short-term investments, net of short-term and long-term borrowings), an increase of 4.8 billion from the previous quarter. It is indeed a cash cow.

7. Personnel changes: Group CFO Yang Zhaoxuan resigned for personal reasons. There is no need to speculate too much here. It is simply a personal decision. Yang Zhaoxuan will serve as a company advisor until June next year.

8. A little gossip: After failing to find a successor as the Chinese agent, Blizzard has been secretly sending signals of interest to NetEase again. Although the embarrassing breakup happened just a year ago, NetEase expressed an open and embracing attitude during the phone call. Dolphin Research has previously made bold speculations that due to the performance of the game itself, issues related to game licenses, and other factors, Blizzard is finding it difficult to find another suitable agent in China. Therefore, with the deep cooperation between Blizzard and Microsoft, leveraging the relationship with NetEase, it is highly likely that they will join hands again. Currently, both parties seem to have loosened their stance, and we will wait and see.

Dolphin Research's viewpoint

The market, which panicked and sold off due to the missed revenue from PC games last quarter, seems to be relatively calm about the drag from PC games this time, as well as the underperformance of Cloud Music and Youdao, especially the issue of deferred revenue. The stock only dropped by 2% last night and rebounded by one point after hours.

As we mentioned in our quick performance review last night, as long as the core mobile game business is not affected, there is no need to panic because NetEase is still in a relatively advantageous product cycle.

In the past two years, NetEase has had a relatively high success rate in its product cycle, and its old games occasionally shine again due to operational efforts. Therefore, among a group of Chinese concept stocks that have significantly underperformed the market, NetEase's stock price performance can be said to be outstanding. Of course, this has its pros and cons. With high expectations, if there is a slight miss in the core business, it may face double punishment from the market. But unlike other small and medium-sized game companies with highly volatile fundamentals, we cannot underestimate NetEase's product matrix advantage and long-term operational capabilities. If we extend the time perspective, Dolphin Research believes that NetEase has the potential to achieve a compound revenue growth rate of around 10%, but profitability is still in a period of rapid release, so the profit growth performance in the next three years will be better than the revenue side.

Finally, looking at the valuation, if we adjust the earnings for 2024 to 32 billion yuan, give it a PE ratio of 15x, and add the net cash of 104.4 billion yuan, the total value would be 80 billion US dollars, which is a relatively reasonable and neutral expectation.

Compared to the current growth potential of about 10%, considering the safety cushion and the cycle of explosive points in the pipeline, we can also pay attention to better prices or turning points.

The following is a detailed interpretation of this earnings report:

1. Revenue: Only mobile games are the "cash cow"

In the third quarter, NetEase achieved a total revenue of 27.3 billion yuan, a year-on-year increase of 11.6%, which is basically in line with expectations. However, there are significant differences in the performance of different segments:

Among them, mobile games are undoubtedly the "cash cow", with a year-on-year growth rate of 33%.

But other businesses don't look so good. PC games continue to decline more than expected, and the adjustments in the live streaming of cloud music, as well as the streamlining of channels for Youdao's smart hardware, have also dragged down their respective growth performances.

(1) The next small peak will be in Q2 next year.

In the third quarter, gaming and related value-added services (such as CC live streaming) achieved 21.8 billion yuan, a year-on-year increase of 16.5%. Among them, gaming net revenue was 20.4 billion yuan, a year-on-year increase of 17.5%, mainly benefiting from the strong performance of several new mobile games such as "Justice", "Dunk City Dynasty", and "Racing Master".

Based on calculations, Dolphin Research estimates that the gaming revenue in the third quarter is expected to be 21.7 billion yuan, a year-on-year increase of 14.2%, which is a significant increase and an all-time high for NetEase in absolute value.

So, how about the sustainability of the gaming revenue in the third quarter?

First, Looking at financial indicators - deferred revenue: the growth rate has slowed down and is lower than expected.

At the end of Q3, the overall deferred revenue of the group reached 14.2 billion, with a YoY growth of only 2.1%, continuing to slow down. On a MoM basis, due to the seasonal effect of the summer peak season, it only increased by 9.6%, which is obviously lower than previous years.

The main revenue in Q3 mainly came from "Nishuihan", followed by "All-Star Street Basketball Party" and "Peak Speed". Recently, NetEase Games has had a high hit rate, even for relatively niche products, their performance is outstanding.

Looking at the revenue calculated from deferred revenue, the current growth is significant. However, when combined with the deferred revenue itself, it indicates that the proportion of purchasing and consuming in the current period is still relatively high. This may bring some pressure on the growth of revenue confirmation in the next quarter.

2) Looking at the Performance of Core Game Revenue and Pipeline: A New Peak in Q2 Next Year

By the end of Q3, NetEase has few new games planned to be launched in Q4 and Q1 next year, especially for popular ones such as "Yanyun Sixteen Tones", "Shediao", and "Eternal Requiem Mobile Game". It is expected that they will be launched in Q2 next year and the second half of the year, so we still need to wait for two quarters of the off-peak period.

In addition, the fourth quarter will also face the problem of a high base. Last year, "Egg Party" started to become popular and significantly boosted financial indicators, so there is also pressure from the high base.

In terms of PC games, the peak season in Q3 was not prosperous, continuing to decline by 16% beyond expectations. After "Eternal Requiem" became free-to-play, the number of players reached a new high, resulting in more in-game purchases. However, overall, the revenue scale of "Eternal Requiem" is relatively stable.

Other old PC games also have basically no significant fluctuations. Therefore, to quickly overcome the counter-cyclical period, it still relies on new PC games to drive growth. However, among the current reserve projects, mobile games still dominate. Coupled with industry issues, the pressure on PC games cannot be resolved in a short period of time.

Looking at the subsequent pipeline, Q4 and Q1 next year may both encounter the impact of weak revenue from new games and the high base. However, as long as NetEase does not have a long-term shortage of game reserves or visible intense competition (declining gross profit margin, significant increase in sales expense ratio), short-term fluctuations can be partially ignored. In the case where NetEase's R&D innovation and operating model have not undergone significant changes, during the period of weak alternation between multiple product cycles (another small peak is expected in Q2 next year), it is actually a good time to buy on dips when the market panics.

Of course, we will also closely monitor the updates of the launch plan, especially for products with high expectations in several markets and the company. It is not ruled out that NetEase may accelerate the launch progress of some games due to growth pressure. (Please pay attention to the conference call for more details)

（2) Cloud Music and Youdao: Growth Contraction, Profit Optimization

Cloud Music and Youdao are still discussed together this quarter. Both businesses are facing the same issue - in order to improve operational efficiency and profitability at the group level, adjustments have been made to certain aspects of Cloud Music and Youdao's operations. Cloud Music has mainly adjusted its live streaming business, while Youdao has reduced its channel partnerships for smart devices, which in turn has affected the sales of its own smart hardware.

1) Cloud Music:

Cloud Music's main source of revenue growth comes from subscriptions. However, due to regulatory factors and proactive optimization of the live streaming segment, revenue has declined. The gross profit margin follows the same logic as the previous quarter, as live streaming itself has a low gross profit margin. The adjustments made have actually helped improve the gross profit margin.

2) Youdao:

In Youdao's business, due to channel streamlining and improving the overall ROI of the company, the performance of smart devices and online courses has been lackluster, apart from advertising revenue.

3) Other Innovative Businesses

This includes products such as Yanxuan, Mailbox, and News. In the third quarter, the revenue was 1.98 billion yuan, which remained flat compared to the same period last year. However, there is no clear medium to long-term trend, and the short-term fluctuations may be mainly due to the seasonal impact of Yanxuan's business. As the third quarter is the off-season for e-commerce, the growth rate has declined. The gross profit margin has also fluctuated and declined mainly due to changes in some Yanxuan products and seasonal factors.

2. Increase in Gross Profit Margin, Continued Improvement in Customer Acquisition Efficiency

The non-IFRS net profit attributable to shareholders in the third quarter has exceeded expectations, with an actual gross profit of 8.65 billion yuan, while the market expectation was only 7.1 billion yuan. The difference in expectations mainly comes from the increase in gross profit margin and the impact of changes in investment gains and losses.

So, in order to eliminate noise, Dolphin Research also chooses to exclude the fluctuations caused by non-core operating income and only focus on the core operating profit. The third quarter also exceeded market expectations by nearly 1 billion, with cost optimization exceeding expectations by 700 million and marketing expenses saving 300 million more than market expectations. Therefore, the main factor is the gross profit margin, which is the result of optimizing the business model.

The business model of the gaming industry has become relatively mature, and NetEase has mainly focused on optimizing the distribution channel. Generally speaking, on the Android platform, distribution channels such as app stores charge a 30% share of the revenue, known as the "Apple tax" on iOS. However, NetEase has reduced this share by guiding more users to download from its official website/TapTap and introducing them into its own community for management, thereby increasing its gross profit margin.

For example, the new game "Dunk City Dynasty" was not released on the Android app store as usual, further increasing the game's gross profit margin compared to the previous period.

In addition, the gross profit margins of Cloud Music and Youdao have also continued to improve, which is related to their own business adjustments.

Cloud Music mainly adjusted its live streaming business. Similar to Tencent Music, in an industry trend of continuously optimizing copyright costs, the subscription model has a higher gross profit margin than the live streaming revenue sharing model. Therefore, by actively adjusting the live streaming business, the comprehensive gross profit margin has increased under the change in revenue structure.

Youdao mainly streamlined some high-cost channel platforms, but it had a certain impact on the revenue scale of its smart hardware business.

In terms of expense breakdown, the main control in the third quarter is still marketing expenses, while research and development expenses have steadily increased, and management expenses have incurred one-time impairment and bad debt expenses due to business adjustments:

On the one hand, although there are new games such as "Justice" and "Racing Master" in the third quarter, most of the promotion expenses will be invested and confirmed in June, so Q3 sales expenses will not show a significant peak at the same time.

On the other hand, NetEase has also improved customer acquisition efficiency by seeking higher ROI marketing channels (such as Douyin) and marketing methods (such as content marketing). Youdao's business, which has always had a high sales expense ratio, has also been optimized quarter by quarter since the closure of its K12 business.

In the end, the operating profit in the third quarter reached 7.56 billion yuan, a year-on-year increase of 59%, and the operating profit margin was 27.7%, an increase of 2.5 percentage points compared to the previous period.

In terms of other expenses, research and development (R&D) expenses continue to grow, mainly due to the ongoing increase in internal R&D personnel, especially the establishment and acquisition of overseas game studios. For example, two studios have been newly established so far this year. However, since it will take some time for the output of overseas studios to materialize, Dolphin Research expects that the first wave of product output peak will mainly occur in 2025-2026. Therefore, R&D expenses are expected to continue to grow steadily in the next two years. During the off-season or periods of poor performance of new products, the R&D expense ratio will also continue to increase.

3. Steady increase in net cash, ongoing share repurchase

No wonder they say the gaming business is a money-making machine. As of the end of the third quarter, NetEase had approximately 116 billion yuan in short-term cash assets (cash, short-term investments, short-term and long-term deposits), and a net cash of 104.4 billion yuan (accounting for 20% of the current market value) after deducting short-term and long-term borrowings. Compared to the previous quarter, net cash increased by 4.8 billion yuan. In the fourth quarter, net cash flow from operating activities was 9.8 billion yuan, showing a significant increase both year-on-year and quarter-on-quarter.

In November 2022, a 36-month, $5 billion share repurchase plan was approved. In the third quarter, due to the continuous increase in market value, the pace of share repurchase slowed down to some extent. In the third quarter, 500,000 American Depositary Shares were repurchased, consuming $53 million, with an average price per share of $103.

Dolphin Research "NetEase" historical articles:

Earnings Season

August 25, 2023, conference call: "Domestic Growth Outpaces Overseas (NetEase 2Q23 Earnings Conference Call)"

August 24, 2023, earnings report review: "NetEase: Is the Pig Cycle Facing a Waterloo? Don't Be Too Pessimistic"

May 25, 2023, conference call: "Simultaneous Efforts in New and Old Games, Accelerating Overseas Expansion (NetEase 23Q1 Earnings Conference Call Summary)" May 25, 2023 Earnings Report Review: "NetEase: The 'Pig' Cycle is Back"

On February 23, 2023, a conference call was held: "Management: Believing in the Ability of Long-term Operation" (NetEase 4Q22 Performance Conference Call Summary)

Earnings Report Review on February 23, 2023: "NetEase: Continuous Approval for Game Licenses, Can 'Egg Party' Accelerate the New Cycle?"

On November 17, 2022, a conference call was held: "NetEase: Fearless of Cycles, Maintaining Stability" (3Q22 Conference Call Summary)

Earnings Report Review on November 17, 2022: "NetEase: Product Cycle Safeguards Growth, Where Does the Confidence to Break Up with Blizzard Come From?"

On August 18, 2022, a conference call was held: "NetEase: Focusing on Overseas Markets is a Necessary Strategic Choice" (2Q22 Conference Call Summary)

Earnings Report Review on August 18, 2022: "NetEase Opens with a Frown? It's Really Not About Performance"

On May 25, 2022, a conference call was held: "No Obvious Benefit from Epidemic Control, Record-breaking Revenue from Old PC Games (NetEase Conference Call Summary)"

Earnings Report Review on May 25, 2022: "The 'Pig' Cycle Continues, NetEase Once Again Achieves 'Steady Happiness'"

On February 24, 2022, a conference call was held: "NetEase's Future Focus: Overseas Markets, Overseas Talent, and Collaboration with Overseas Teams (Conference Call Summary)"

Earnings Report Review on February 24, 2022: "Surviving the Winter, How Long Can NetEase's Spring Last?" Phone Conference on November 16, 2021: "Metaverse? Management: No need to say more, NetEase will appear with confidence"

Earnings Report Review on November 16, 2021: "After the 'Harry Potter' explosion, what other cards does NetEase have?"

Phone Conference on August 31, 2021: "Summary of NetEase's Q2 Conference Call: Revenue from minors accounts for less than 1%, looking forward to 'Harry Potter'"

Earnings Report Review on August 31, 2021: "Will regulatory measures affect the 'super pig cycle' of NetEase's pig farms?"

Earnings Report Review on May 18, 2021: "NetEase Games finally outperforms the market, and Youdao Online Education is also on the rise?"

Phone Conference on February 26, 2021: "Transcript of NetEase's Conference Call: 'Onmyoji' IP valued at $10 billion"

Earnings Report Review on February 25, 2021: "Dolphin Research: Established game giants remain resilient, NetEase Education shows rapid growth in the track"

In-depth Analysis on June 25, 2021: "NetEase: The Super 'Pig Cycle' of Pig Farms"

Hot Topic on July 27, 2021: "NetEase maintains a long-term target price of $115-141"

Risk Disclosure and Statement for this Article: "Dolphin Research Disclaimer and General Disclosure"