NetEase: It will take a little more time to return to the "Three Good Students"

After the Hong Kong stock market closed on May 23rd Beijing time, NetEase released its financial report for the first quarter of 2024. The performance in the first quarter had its ups and downs, but overall met expectations. The highlights were the strong performance of mobile game revenue exceeding expectations, continued optimization of gross profit margin (shifting revenue from old games to self-operated channels + improvement in cloud music gross profit margin), and deferred revenue exceeding expectations. The underperforming aspects were PC game revenue, lack of new games, and higher marketing expenses due to the clash between "Egg Party" and "Star of Elements" during the Spring Festival.

However, compared to the Q1 financial report, the market is actually more concerned about some recent issues the company has faced and its future outlook. These include:

How the public opinion incident on the PC side has affected player retention.

2) The launch schedule for key upcoming new games. Especially for the mobile versions of "Sixteen Sounds of Yan Yun," "Eternal Interstice" (expected in the summer), "Mission Zero," etc. The recent 520 game conference did not mention a specific launch time for these games, while the company previously indicated a beta test in the second quarter. The market currently expects revenue contributions from these three new games.

2) The impact of recent adjustments to top old games (Fantasy, Justice, Swordsman) (restrictions on spending, restrictions on game item trading) on revenue, and whether the collective adjustments imply a return of regulatory risks?

In addition, competition is also a significant factor. This year, major games in the industry are launching in the second and third quarters, which undoubtedly increases the difficulty for NetEase Games to maintain its advantage. Especially with the failure of "The Legend of the Condor Heroes," the market has shifted from confidence to doubt about the performance of "Yan Yun" and "Eternal Interstice" after their launch.

In summary, the delayed new product cycle (revenue, launch time) + potential regulatory impact + competition have made NetEase's recent stock performance a "laggard" among Chinese concept stocks. The lackluster shareholder returns in the first quarter (no increase in buybacks, decreased dividend ratio) also lag significantly behind peers, failing to provide price support beyond performance.

However, after experiencing a half-month correction, the valuation has gradually entered a position worth focusing on, with the current market value implying a forward P/Non-gaap NP of 14x (assuming a 10% decrease in profit, excluding the current $157 net cash on hand), located in the lower area of historical averages and lower than most global gaming peers' valuations. Of course, if major new games are delayed this year or unexpectedly decline like "The Legend of the Condor Heroes," this valuation is not necessarily cheap. So from a safety perspective, one can also wait for a more attractive price.

Nevertheless, based on the current testing results of "Sixteen Sounds of Yan Yun" and "Eternal Interstice," the likelihood of bugs in these two games is low. Considering the late launch (contributing revenue for at most half a year) and the revenue gap due to adjustments in old game content, achieving double-digit revenue growth this year may be challenging Starting next year, with the gradual release of new products by overseas studios and the full-year revenue contribution from new games and Blizzard, the growth rate is expected to be significantly boosted. For a more accurate outlook and expectations for future performance, it is recommended to mainly refer to the relevant statements of the management in the conference call.

Specifically, focusing on the financial report highlights:

1. Mixed Revenue Performance: The overall revenue in the first quarter was 26.9 billion, a year-on-year increase of 7%. Apart from the underperformance of PC games, the revenue from mobile games, Youdao, and Cloud Music all exceeded expectations.

2. Mobile Games Shine: Nearly 80% of NetEase's overall revenue comes from gaming, with 80% of that being from mobile games. However, due to the significant contribution of revenue from official game channels within NetEase (which can reach up to 1/3 in older games) and cannot be publicly monitored, the revenue data disclosed by third-party platforms is inaccurate, leading to expectation gaps.

Nevertheless, the performance of mobile games in the first quarter was still good. Looking at deferred revenue, Q1 saw a 15% year-on-year growth despite a high base, and a 12% increase quarter-on-quarter, mainly driven by "Egg Party" and "Justice".

3. Sharp Decline in PC Games, Blizzard to Fill the Gap: PC game revenue in the first quarter declined by 15% year-on-year, exceeding market expectations. Apart from the base effect caused by the previous separation from Blizzard, we expect that the revenue in the first quarter was also affected by the public opinion incident surrounding "Dream". According to previous research, during the public opinion period at the end of March, the average daily active users of "Dream" dropped by 20%, with an estimated revenue impact of 5-10%. Similarly, it was also affected at the beginning of the second quarter.

In the third quarter, Blizzard's domestic service will re-collaborate with NetEase, which is expected to restore revenue from PC games. Additionally, after the previous breakdown in negotiations when Blizzard wanted to increase revenue share but failed, and with no one else taking over, it is expected that the revenue sharing agreement between NetEase and Blizzard will be more reasonable, with NetEase potentially obtaining a more favorable revenue share ratio.

4. Cloud Music and Youdao Slightly Exceed Expectations: In the first quarter, Cloud Music has gradually recovered from the impact of live broadcast adjustments, with revenue returning to positive growth; Youdao mainly saw a 126% year-on-year growth in advertising driving overall revenue, while the drag from smart hardware is also easing.

5. Continued Improvement in Gross Margin: In the first quarter, the gross margin further improved by 1.4 percentage points to 63.4%, mainly reflected in the increase in gross margin of games and Cloud Music.

(1) The increase in game gross margin is related to the higher proportion of self-developed games (with low IP licensing fees), guiding official website payments to reduce channel revenue sharing, and the increased monetization of low-cost casual game "Egg Party". Additionally, in seasons with fewer new games, there are not many additional costs, and the marginal costs of old games are very low, which also contributes to the improvement in gross margin.

(2) The improvement in Cloud Music's gross margin has been ongoing, benefiting from the increase in membership revenue while copyright costs are decreasing. In the first quarter, the gross margin has also increased to 38%, approaching the 40% gross margin level of Tencent Music. This may be due to Cloud Music's procurement of copyrights mainly from small and independent music labels or individual musicians, making it easier to negotiate cooperation based on revenue sharing models 6. The "Business Battle" of Egg Baby: In the first quarter, operating expenses increased by 24% year-on-year, mainly due to the increase in marketing expenses. In addition to the promotional expenses required for the launch of new games "Beyond the World" and "The Legend of the Condor Heroes", Egg Baby once again ignited during the Spring Festival, with a peak DAU reaching a new high of 40 million. Therefore, with active investment in marketing, the operating profit of the core business reached 7.6 billion, a year-on-year increase of 5.6%, slightly lower than the market's expected 7.7 billion.

7. Cash King, but Shortcomings in Repurchase and Dividends: NetEase has always had a large amount of cash on hand from several games that generate passive income. The cash held is generally used for shareholder feedback (dividends and repurchases) and long-term investments related to business. As of the end of the first quarter, the company still had a net cash balance of 113.4 billion RMB/15.7 billion USD (cash and cash equivalents, deposits, restricted cash, and short-term investments, net of short-term and long-term borrowings), which continued to increase compared to the previous quarter.

However, the dividend in the first quarter was only 0.495 USD per ADS, with a dividend ratio of 25%, significantly lower than the fourth quarter of last year. In terms of repurchases, in the first quarter, 170 million ADS were repurchased for 167 million USD, at an average of 98 USD per ADS. As of now, although the pace of this round of repurchases (50 billion USD over 36 months) accelerated compared to Q1, it is still relatively slow overall. One-third of the 3-year cycle has passed, but the repurchase amount is still less than one-fifth. Therefore, without an extension, the pace of repurchases may accelerate in the future.

8. Performance Indicators Overview

The following is a detailed interpretation of this financial report

I. Mixed Performance in Revenue

In the first quarter, NetEase achieved a total revenue of 26.9 billion, a year-on-year increase of 7%. Apart from PC games, mobile games, cloud music, and Youdao all performed better than expected to varying degrees:

Mobile games were a highlight, with a 19% year-on-year growth, exceeding the market's expectation of 14%.

PC games, in addition to the industry trend issues, were also affected by the separation of Blizzard, leading to a 15% year-on-year decline. In addition, the public opinion incident of "Fantasy" in the first quarter also dragged down revenue.

Cloud music has gradually emerged from the impact of live broadcast adjustments, with revenue returning to positive growth at a 4% year-on-year increase.

Youdao mainly saw a 126% year-on-year growth in advertising driving overall revenue, while the drag from smart hardware is easing, with a total revenue growth rate of 20%.

Other innovative businesses of NetEase, such as Yanxuan, were in the off-season of e-commerce, and the intense competition during the Spring Festival may have increased the impact on Yanxuan, causing the year-on-year growth to slow to 6%, slightly below market expectations.

2. Game: Can the product cycle still come as expected with the failure of "The Legend of the Condor Heroes"?

In the first quarter, the overall game and value-added related revenue reached 21.5 billion, a year-on-year growth of 7.4%, which basically met expectations. Among them, CC live streaming and PC games performed poorly, but looking at mobile game revenue alone, it reached 16.1 billion, a year-on-year growth of 19%, exceeding market expectations.

Due to the significant proportion of revenue from NetEase's official channels (up to 1/3 in old games), which cannot be publicly monitored, the revenue data disclosed by third-party platforms is inaccurate, leading to expectation gaps.

Of course, the performance of mobile games in the first quarter was not bad. In terms of deferred revenue, Q1 still achieved a year-on-year growth of 15% and a quarter-on-quarter growth of 12% under a high base, mainly contributed by "Egg Party" and "Justice".

In the first quarter, deferred revenue reached 14.9 billion, a net increase of 12% quarter-on-quarter, exceeding the highest performance during the period when "Justice" was launched and became popular in the third quarter of last year. Dolphin Jun estimated roughly that game revenue is expected to reach 22 billion, with a 15% year-on-year increase under a high base, maintaining a strong momentum.

However, on Pipeline, after the unexpected failure of "The Legend of the Condor Heroes", the other two heavyweight mobile games, "Eternal" and "Sixteen Songs of Yan Yun", currently do not have a clear public testing time. "Mission Zero" hasn't even appeared at the 520 conference. Combining the relevant statements from the management conference call, Dolphin Jun predicts that "Eternal" may go live during the summer vacation, while "Sixteen Songs of Yan Yun" may be in Q4.

The delayed and weakened product cycle effect will undoubtedly affect the market's expectations for NetEase's revenue growth this year. But at the same time, the growth pressure in 2025 will also be correspondingly reduced, with Blizzard returning to stability, and overseas studios starting to release new products one after another, which is expected to accelerate the growth rate in 2025 compared to this year.

3. Cloud Music and Youdao: Gradually overcoming growing pains, reaching a new high in profit level

Cloud Music and Youdao are still discussed together this quarter. Both businesses are currently at the end of the business adjustment period - Cloud Music's total revenue is returning to positive growth, and Youdao's intelligent hardware decline is narrowing.

1. Cloud Music: Contraction of live streaming business continues to impact, overall gross profit margin improves

Cloud Music mainly relies on the increase in subscription revenue. At the same time, similar to Tencent Music, it proactively contracted the live streaming part, resulting in a decline in revenue. The gross profit margin reached a new high of 38% due to the increase in subscription revenue and optimization of copyright costs (adjusting the revenue sharing ratio), approaching Tencent Music's 40% gross profit margin level. This may be due to Cloud Music's procurement of copyrights mainly from small and medium-sized music labels or independent musicians, making it easier to negotiate cooperation based on revenue sharing models

2. Youdao: Intelligent hardware has gone through the worst period, explosive growth in advertising

In the Youdao business, due to continuous channel optimization to improve the overall business ROI. Similar to the previous quarter, apart from advertising revenue, intelligent hardware and online courses are still in a negative growth phase, but the decline has significantly narrowed.

Advertising revenue continues to grow rapidly year-on-year, reaching 125%, with the company attributing this to the improved conversion efficiency of performance advertising driven by AI.

3. Other innovative businesses: Growth shows seasonal characteristics in e-commerce

Other innovative businesses include strict selection, mailbox, news and other products, with a first-quarter revenue of 1.97 billion, a year-on-year growth of 6%, mainly due to revenue coming from the strict selection business, which is more inclined to the fluctuations brought by the seasonal nature of e-commerce.

4. High marketing expenses stem from the "business war" of "Danzai"

In the first quarter, Non-IFRS net profit attributable to the parent company was 8.5 billion, a year-on-year increase of 12.5%, slightly higher than the market's expected 8.3 billion.

Non-GAAP net profit only excludes changes in employee stock incentives, and Netease's stock incentives as a proportion of revenue (around 3%) often do not fluctuate much. However, the impact on other indicators such as investment gains and losses, interest, exchange gains and losses from fluctuations is not excluded. Therefore, in order to eliminate noise, Dolphin will also choose to exclude the fluctuations brought by these non-core gains and losses, and focus only on the core operating profit situation.

The operating profit of the core main business in the first quarter was 7.6 billion, slightly lower than market expectations, mainly due to marketing expenses.

The gross profit margin actually exceeded expectations slightly overall, driven by the monetization efficiency improvement in games and cloud music Channel transformation is the main factor driving the increase in game gross profit margin. Even though the game gross profit margin has reached 70%, we expect there are still opportunities for further optimization in the future. Tencent also mentioned about optimizing the profitability of mobile games through channel transformation in the first quarter performance conference call.

In addition to games, the gross profit margin of cloud music has increased mainly due to the steady growth of subscription business. At the same time, in the industry trend of continuous optimization of copyright costs, the comprehensive gross profit margin has increased under the change in revenue structure.

Looking at the breakdown of expenses, marketing expenses continued to grow significantly in the first quarter, while the growth rate of research and development expenses slowed down, and management expenses increased slightly.

In the first quarter, in addition to the promotion expenses for new games "The Legend of the Condor Heroes" and "Beyond the World", the Spring Festival period also saw another round of promotion for "Egg Baby", reaching a peak DAU of 40 million. This led to a surge of 38% in marketing expenses in the first quarter, reaching 4 billion RMB, but with a slight slowdown compared to the previous quarter due to seasonal factors.

In terms of other expenses, research and development expenses continued to grow steadily, mainly due to the ongoing increase in internal research and development personnel, especially in overseas game studios. However, as the output of overseas studios will take some time, the first wave of product output peak is expected to be mainly distributed in 2025-2026. Therefore, research and development expenses are expected to continue to grow steadily in the next two years. During off-seasons or periods of poor performance of new products, the research and development expense ratio will also continue to increase

Dolphin Research on "NetEase" Historical Articles:

Financial Reports (Past Year)

February 29, 2024 Conference Call "NetEase: "Endless Journey" Mobile Game to Launch in Q2 2023 (4Q23 Conference Call Summary)"

February 29, 2024 Financial Report Review "NetEase Performance Scare? Don't Worry, Product Cycle is Coming Soon!"

November 17, 2023 Conference Call "Abundant Game Reserves for Next Year (NetEase 3Q23 Conference Call Summary)"

November 17, 2023 Financial Report Review "NetEase: Is the "Money Printing Machine" Going Downhill? Pig Farm Not Scary"

August 25, 2023 Conference Call "Domestic Growth Outpacing Overseas This Year (NetEase 2Q23 Performance Conference Call)"

August 24, 2023 Financial Report Review "NetEase: Pig Cycle Facing "Waterloo"? Don't Be Too Pessimistic"

May 25, 2023 Conference Call "New and Old Games Strengthening, Overseas Expansion Accelerating (NetEase 1Q23 Financial Report Conference Call Summary)"

May 25, 2023 Financial Report Review "NetEase: Here Comes the "Pig" Cycle Again"

February 23, 2023 Conference Call "Management: "Believe in the Ability of Long-term Operation" (NetEase 4Q22 Performance Conference Call Summary)"2023 年 2 月 23 日财报点评"NetEase: Can 'Egg Party' Speed Up the New Cycle with a Constant Stream of Licenses?"

2022 年 11 月 17 日电话会"NetEase: 'Fearless of Cycles, Stay Steady' (3Q22 Conference Call Minutes)"

2022 年 11 月 17 日财报点评"NetEase: Sailing Through Growth with Product Cycles, Where Does the Confidence to Break Up with Blizzard Come From?"

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2021 年 6 月 25 日"NetEase: The Super 'Pig Cycle' of Pig Factory I Dolphin Research"

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2021 年 7 月 27 日"NetEase Maintains Long-term Target Price of $115-141"

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