NetEase Earnings Scare? Fear Not, the Product Cycle is Just Around the Corner!

On February 29th, after the Hong Kong stock market closed, Netease.US released its fourth-quarter 2023 financial report. As a shining star among Chinese concept stocks, Netease's Q4 performance fell significantly short of expectations, leading to a significant drop in pre-market stock prices, which was a normal reaction.

However, Dolphin Jun believes that this financial report may not necessarily indicate that Netease itself is performing poorly, but rather that it reflects some unexpected factors affecting expectations. Looking at the marginal trends for the next year (pipeline, cost optimization), short-term pressure appears to be not too significant of an issue.

Specifically, the highlights of the financial report are as follows:

• Overall performance fell short of expectations:

Total revenue was 27.1 billion, a year-on-year increase of 7%, with revenues from games, Youdao, and Cloud Music all weaker than expected. Nearly 80% of Netease's overall revenue comes from gaming, with 80% of that from mobile games. Market expectations were high given third-party turnover data showing a 30%+ year-on-year increase in domestic mobile game turnover for Netease in the fourth quarter, hence the high expectations (mobile game revenue +33%), but the actual growth was 29%.

Dolphin Jun speculates that this difference may be related to the timing of actual user consumption confirmation (calculated based on deferred revenue gaming turnover Q4 growth of 16%, accelerating from Q3), and overseas revenue may also be affected by the depreciation of the Renminbi during the same period, affecting the scale of revenue recognition. However, the specific situation will still need to be observed in the earnings call.

Cloud Music and Youdao both slightly underperformed expectations, with Cloud Music currently undergoing revenue decline due to adjustments in the live streaming business, and Youdao's fourth quarter was mainly impacted by poor sales of smart hardware.

• Continued trend of improving gross margin:

The gross margin remained at 62% in the fourth quarter, without showing a seasonal decline despite the slowdown in revenue growth. Within specific business segments, the increase in gross margin was mainly reflected in gaming and Cloud Music.

(1) The increase in gaming gross margin is attributed to a higher proportion of self-developed games (lower IP copyright fees), reduced revenue sharing through directing payments on official websites, and increased monetization of low-cost casual games such as "Egg Puff".

(2) Although Cloud Music has been adjusting its revenue due to the contraction of the live streaming business, resulting in revenue pressure, the fourth-quarter gross margin has also increased to 30% due to simultaneous increases in subscriber volume and price, and optimization of copyright sharing ratios.

• Large increase in marketing expenses, operating profit miss:

Marketing expenses in the fourth quarter increased by 24% year-on-year in the absence of significant new game launches. This was mainly due to increased spending on marketing efforts for "Egg Puff" to counter the launch of "Yuanmeng", resulting in operating profit of 6.9 billion, a year-on-year increase of 55%, lower than the market's expected 7.6 billion.

However, since the beginning of the year, "Egg Puff" has surprisingly maintained stability in competition with "Yuanmeng" and has achieved explosive turnover during the Spring Festival period, ensuring that this large-scale marketing effort did not go to waste. Moreover, a wave of layoffs at the end of 2023 is expected to see improved operating efficiency in 2024, as well as a trend of improvement in gross margin, so Dolphin Jun believes that short-term pressure is not a major issue.

• Eternal Handheld Game License Issued, Pipeline Injects Vitality:

Entering 2024, a new wave of product cycles for Netease is about to arrive. First up is "The Legend of the Condor Heroes" at the end of March, followed by "The Sixteen Songs of Yan Yun".

Moreover, the license for "Naraka: Bladepoint Mobile" was issued earlier than expected, and it is not ruled out that the launch process for "Naraka Mobile" may be accelerated compared to originally planned (e.g., before the summer vacation). The performance of this game on the PC side has been remarkable, and with optimistic expectations, Dolphin Jun believes that the first TTM (trailing twelve months) may bring in over 5 billion in revenue.

• Still "Money Printing Machine" and "Cash King":

Netease has long had a lot of cash on hand from a few games that generate passive income. The cash held is generally mainly used for shareholder feedback (dividends and repurchases) and long-term investments related to business. Dividends were $1.08 per ADS in the fourth quarter, while $56.2 million was spent on purchasing 600,000 ADS, averaging $94 per ADS.

As of the end of the fourth quarter, the company still had 110.9 billion/15.6 billion US dollars in net cash (cash and cash equivalents, deposits, restricted cash, and short-term investments, net of short-term and long-term borrowings), an increase of 6.5 billion RMB from the previous quarter, a solid cash cow.

• Summary of performance indicators

Dolphin Jun's Perspective:

The performance in the fourth quarter was indeed mediocre, especially compared to the market's high expectations. Even games clearly missed this quarter. This issue was also mentioned in Dolphin Jun's comments in the previous quarter, where it was noted that Netease, fueled by occasional hype around new game releases, can easily be pushed into higher expectations. With high expectations, any slight miss in core business performance may face double punishment from the market.

However, regarding this financial report, although the miss was significant, Dolphin Jun is not too worried:

On one hand, "Egg Puff" withstood the fierce competition from "Yuanmeng" and performed exceptionally well during the Spring Festival period, further proving Netease's gaming operation capabilities and the quality of its products. On the other hand, the next round of product cycles is closer, and the issuance of the license for "Naraka: Bladepoint Mobile" increases the certainty of this year's product peak.