CLOUD MUSIC: "Pig" cycle is back

Hello everyone, I'm Dolphin Analyst!

After the Hong Kong stock market closed on May 25th Beijing time, $NetEase.US released its Q1 2023 financial report. Although CLOUD MUSIC is just a game company, it has always had the style of a mature large group company. Its regulation of business strategy and consideration of investor interests make it a relatively reassuring Chinese company.

I remember that the sudden drop in game gross profit margin in the previous quarter caused the market to panic. After a good financial report was released, the stock fell 10% on the same day. In fact, CLOUD MUSIC was very clear in subsequent communications that the source of the gross profit margin decline came from the minimum copyright guarantee fee for Blizzard games it represented. Since the two officially broke up and stopped service on January 24th (the actual recharge channel had been closed since November), in order to solve the problem once and for all, CLOUD MUSIC chose to confirm this copyright guarantee fee in the fourth quarter, so it will only affect Q4 this quarter.

In the last communication, CLOUD MUSIC also gave detailed answers to the current popular large models, AIGC, and the game going global issue that has always been of concern. Its thinking angle of mature regulation of business strategy and consideration of all investor interests impressed me (see "CLOUD MUSIC financial report review after the big drop"). Therefore, I completely cannot understand the panic selling caused by the one-time accounting impact, and the investment value of a company should be considered from a medium- to long-term perspective, focusing on its core competitiveness and business development prospects.

Perhaps it can only be explained that the market's confidence in Chinese concept assets is still fragile, and there were doubts about the sustainability of the egg tart craze and the recovery of the domestic game market at that time. But after a quarter of verification, "Egg Tart Party" has proven itself to be not a flash in the pan hit, but a long-term product through continuous operation. And the intensive launch of multiple popular games such as "Nishuihan", "Peak Speed" and "Harry Potter (overseas service)" in the second quarter also indicates that CLOUD MUSIC's new product cycle will also begin.

At the new level of profitability, when CLOUD MUSIC's revenue growth accelerates again, the entire group will also release profit growth that is higher than market expectations. In addition, the net cash in hand, which accounts for 26% of the current market value, will also highlight the current valuation attractiveness.

Back to Q1 Financial Report:

1. Revenue basically meets expectations. Among them, games performed better than expected, while CLOUD MUSIC and Youdao performed worse. However, as games are the main source of profit and valuation for CLOUD MUSIC, their performance determines the overall performance of the CLOUD MUSIC group.

1. Games: Sufficient Reserves

In the first quarter, games and related value-added services (CC live broadcast, etc.) achieved 20.1 billion yuan, a year-on-year increase of 7.6%. Among them, the net income of games was 18.6 billion yuan, a year-on-year increase of 7.7%. The growth rate has shown signs of accelerating recovery. Compared with the Q3 financial report of last year, Dolphin Analyst expects to start a new product cycle in the second half of this year. The unexpected success of "Egg Party" has accelerated the arrival of the cycle.

Can the follow-up games maintain the trend of accelerated growth and enter a new cycle?

At the end of the first quarter, the group's deferred revenue was 13 billion yuan, a year-on-year increase of 7.9% and a quarter-on-quarter increase of 3.8%. Although the quarter-on-quarter improvement is obvious, combined with the popularity of "Egg Party", this data is not impressive. The calculated current period revenue increased by 11% year-on-year, but the absolute value did not exceed the revenue of "Diablo Immortal" just released in Q3 2022. Therefore, it must be admitted that although "Egg Party" is very popular, the short-term revenue of large DAU games is still not as good as MMORPG.

The main new game in the first quarter is "Egg Party". According to Qimai data, although the popularity of Egg Party has declined, it tends to slow down naturally in the game, which is healthier than the previous "Harry Potter" and "Diablo Immortal".

As for CLOUD MUSIC, they hope to maintain the long-term operation of this highly popular competitive game. If they can achieve this, it will be an important supplement to the category support of CLOUD MUSIC's game revenue. Moreover, since "Egg Party" itself has a high profit margin, if the subsequent revenue contribution continues to increase, it will also be beneficial to the overall profit margin improvement.

Just a few days ago on May 20th, CLOUD MUSIC just held this year's game conference. From the updated pipeline, the end of the second quarter and the third quarter will be a period of intensive product launches. Heavyweights such as "Nishuihan" mobile game, and those with certain popularity such as "Peak Speed" and "All-Star Streetball Party".

In the third quarter, "Harry Potter" will also be launched in overseas regions, and "Shuatu Zhabin" (Europe, Southeast Asia) and "Egg Party" which have already been proven successful will also be launched in overseas regions as soon as possible.

As the issuance of game licenses gradually becomes normalized, CLOUD MUSIC management expressed a more positive expectation for the game business in the previous quarter, such as increasing the annual issuance from a high single-digit number to a double-digit number. Therefore, based on CLOUD MUSIC's existing reserves of licenses and launch plans, as well as the reserves expected to obtain licenses, Dolphin Analyst is confident in CLOUD MUSIC's game business this year.

2. CLOUD MUSIC and Youdao: Difficult to increase revenue, focus on profit

CLOUD MUSIC and Youdao will be briefly discussed together this quarter. First of all, the revenue of both businesses is not very good this quarter.

1) CLOUD MUSIC has the impact of proactive adjustments, deliberately reducing the exposure of live content and reducing the proportion of anchor and guild splits to increase gross profit margin, but social and entertainment revenue has certainly decreased.

2) Youdao business, the demand for adult training courses has declined more this quarter, and it is not clear whether it is due to the collective decline in industry demand or the weakening of its own competitiveness.However, if we compare New Oriental's 3Q23FY performance from December last year to February this year, the decline in adult training business is very obvious, so Dolphin Analyst is more inclined to think that it is an industry problem. We can wait and see how it is explained on the conference call later.

3) Other innovative businesses, such as strict selection and advertising, generated revenue of 1.86 billion yuan, which has been repaired year-on-year, and the decline in gross profit margin is mainly due to seasonal effects, which is basically in line with expectations.

4. Profit greatly exceeds expectations: getting rid of the burden of Blizzard

As we mentioned earlier, the main source of the first quarter's profit exceeding expectations is the gross profit margin and promotion expenses, which are better than market expectations.

Among them, the operating profit of 7.2 billion yuan exceeded the market by 2 billion yuan, of which the gross profit contributed 1.2 billion yuan, the promotion expenses were restrained by 500 million yuan compared to expectations, and the management and research and development expenses were both more than 100 million yuan less than the market expected. The reduction in expenses may be related to the small optimization and adjustment of the team that CLOUD MUSIC has been continuously doing.

Finally, the GAAP operating profit margin reached 28.8%, almost reaching a historical high, and the operating profit was 7.2 billion yuan, a year-on-year increase of 31%.

After getting rid of the burden of Blizzard, which dragged down the overall profitability of CLOUD MUSIC, this quarter can actually reflect the true gross profit margin level of CLOUD MUSIC's self-developed games, which is close to 70% (the overall gross profit margin of games and related value-added services is 67%, and it is estimated to be 70% after excluding the low gross profit margin of CC live broadcast business), which is an absolute new high compared to the historical level with Blizzard agency.The profit margin of games like "Egg Party" with high DAU and low cost will be higher than that of heavy MMORPG mobile games that underperform.

Although in the short term, the revenue cost confirmation of heavy MMORPG mobile game "Nishuihan" in the third quarter may also lower the comprehensive gross profit margin. However, in the medium and long term, if the subsequent "Egg Party" can continue to operate for a long time and improve performance contribution, and similar products explode, AIGC's cost optimization role in game creation, and CLOUD MUSIC's game gross profit margin still have the motivation to maintain or even increase.

5. Repurchase and Cash: Blizzard refunds affect, cash still abundant, repurchase in progress

As of the end of the fourth quarter, CLOUD MUSIC had about RMB 123.5 billion in short-term cash assets (cash, short-term investments, and short-term deposits), and net cash after deducting short- and long-term borrowings was RMB 95.1 billion (accounting for 24% of the current market value), a decrease of RMB 500 million from the previous quarter. Among them, the net cash flow from operating activities in the fourth quarter was RMB 6 billion, a year-on-year increase but a quarter-on-quarter decrease.

Although the profit was outstanding this quarter, there was an outflow of cash due to refunds from Blizzard game users, so the quarterly cash flow did not bring much new cash. However, the net cash of RMB 95.1 billion (USD 13.9 billion) still accounts for 26% of the current market value.

The 36-month period USD 5 billion repurchase plan approved in November 2022 repurchased 3.1 million American depositary shares in the first quarter, totaling USD 267 million, with an average price of USD 86 per share.

Dolphin "CLOUD MUSIC" Historical Articles:

Financial Report Season

February 23, 2023 Telephone Conference Call "Management: "Believe in the Ability of Long-term Operation" (CLOUD MUSIC 4Q22 Performance Conference Call Summary)"

February 23, 2023 Financial Report Review "CLOUD MUSIC: Can "Egg Party" Speed Up the New Cycle with the Sweet Rain of Version Numbers?"

November 17, 2022 Telephone Conference Call "CLOUD MUSIC: "Fearless Cycle, Maintain Steadiness" (3Q22 Conference Call Summary)"

November 17, 2022 Financial Report Review "CLOUD MUSIC: Product Cycle Escorts Growth, Where is the Confidence to Break Up with Blizzard?"