NetEase: Once a favorite among Chinese concept stocks, now a neglected choice, has the “pig factory” really become a poor student?

$NetEase(NTES.US) The performance of NetEase in the second quarter was not very good, with its core gaming business falling short of market expectations. However, the issues encountered by the company in the second quarter were almost transparent, and in post-meeting discussions, management did not introduce many additional negative factors. Despite this, the decline continued to expand to over 10% after the opening, so what are investors panicking about? Dolphin Jun will discuss this with everyone based on some information exchanged between institutions and companies, as well as the most concerning issues in the market and recent adjustments made by NetEase.

Specifically:

1. All detailed revenues fell short of expectations: In the second quarter, the revenues of NetEase's gaming, Youdao, and Cloud Music were all mediocre, differing to varying degrees from market expectations. Since NetEase's performance and valuation mainly rely on gaming, Dolphin Jun will also focus on analyzing the gaming situation below.

2. More pressure in the second half of the year: Looking ahead to the third and fourth quarters, we expect NetEase's revenue growth pressure to be even greater, especially in gaming. Some changes in deferred revenue also indicate this, with a larger sequential decline in deferred revenue in the second quarter compared to seasonal declines in previous years:

1) On one hand, the high base from the strong performance of "Justice" and "Eggy Party" in the second half of last year makes it very challenging to maintain growth this year unless there are equally outstanding new games.

Despite the failure of "Wuxia" (the adjusted new version has not been released yet) and the uncertain delay of "Yanyun," even with a promising "Naraka Mobile" game, it is currently only anticipated, and the revenue pace of MMO and MOBA games is inconsistent, making it difficult to achieve short-term performance highlights in 1-2 quarters like "Justice" did last year.

2) On the other hand, due to public opinion, "Eggy Party" introduced an upgraded version of minor protection measures in April (increased facial recognition times + daily spending limits), affecting revenue. In addition, the "Fantasy Westward Journey" incident fermented in April of the second quarter and began to have an impact in May, reflecting only two months of revenue impact, so the drag on the third quarter may be more pronounced.

However, the good news is that these issues are being alleviated:

a. Management mentioned that the impact of "Fantasy Westward Journey" on revenue is gradually decreasing by the end of the third quarter, and the adjustment has now ended, indicating that the decline in the fourth quarter will slow down compared to the third quarter.

b. After cooling down in the second quarter, "Justice" rebounded month-on-month in July after the release of the one-year anniversary expansion at the end of June (but compared to last year's enthusiastic revenue, it will definitely decline), Dolphin Jun expects to maintain a steady revenue level in the future.

c. In the third quarter, the return of Blizzard will bring incremental revenue to the client games. However, the third quarter will mainly contribute one month of revenue from "Warcraft" (user data is good), and in the fourth quarter, with the return of "Hearthstone" and others, the repair and driving effects will be more pronounced

3. Is the counter-trend expansion due to product shortages?: In the pre-market quick review, Dolphin mentioned the signs of counter-trend personnel expansion at NetEase, specifically manifested in the year-on-year expansion of SBC expenses, especially in the R&D team.

Compared to the current revenue performance (Dolphin has already anticipated it and third-party flow has also indicated the issue in advance), Dolphin will pay more attention to the expenditure growth reflected in the financial report. Because this implies a weakening of short-term profit margins, especially in the third quarter when revenue is also under pressure.

Post-performance management explanations include annual incentive distribution (especially the incentive increment for "Justice" related personnel), and the increased R&D work on the anniversary expansion pack content of "Justice". But at the same time, it is also mentioned that the company is actively encouraging project initiation internally. Combining this wave of product cycles nearing completion ("Yanyun" actively postponed, mobile end will not be later than PC end, the remaining major releases this year are two Marvel IP games), Dolphin speculates that NetEase is about to enter a new investment cycle every 2-3 years.

4. Strict market value management, short-term repurchases are expected to increase: NetEase is not short of cash (as of 2Q, net cash on hand is RMB 116.1 billion, an increase of nearly RMB 3 billion quarter-on-quarter), nor is it short of USD needed for repurchases. In terms of shareholder returns, apart from stable dividends, repurchases are mainly based on market value changes, that is, increasing repurchases when the stock price is under pressure, and reducing repurchases in strong stock price periods.

In the second quarter, NetEase repurchased 3 million ADS, almost doubling from the first quarter. Total funds used amounted to USD 290 million, averaging USD 97 per ADS. In the current low market value, the company has indicated that it will continue to increase repurchase efforts.

At the same time, in the second quarter, it announced a dividend of USD 0.435 per ADS, with a dividend ratio of 26% (compared to non-gaap net profit), remaining stable quarter-on-quarter. However, generally speaking, NetEase will announce a special dividend in the fourth quarter to raise the overall dividend level for the year.

Overall, in previous years, NetEase management generally considers dividends and repurchases together for shareholder returns. Last year, with a strong stock price, repurchases were low, and dividends were increased to compensate. Therefore, with the stock price under pressure this year, it is expected that repurchases will significantly increase. The total dividend and repurchase combined are expected to be higher than last year (RMB 17.1 billion), if calculated at RMB 18 billion, the return rate corresponds to a market value of approximately RMB 53 billion is about 5% at the close on Thursday.

5. Performance indicators at a glance

Dolphin's Viewpoint

The second-quarter performance is indeed disappointing. Dolphin had already issued a precautionary statement in the previous quarter's review, but the market seems to have not adjusted expectations properly, especially for funds focusing on short-term speculative financial reports, resulting in a significant gap However, after the opening, the decline quickly expanded. The reason behind it is different from Tencent Music, Kuaishou, and Bilibili. The first three experienced more of an adjustment in the decline guidance, but NetEase's management did not provide much additional negative guidance during the post-meeting communication. Instead, they emphasized:

1) The adjustment period for Fantasy Westward Journey has ended and stability has begun;

2) Satisfaction with the performance of Naraka l users' data;

3) Revenue rebound after the release of the "Against the Flow" expansion pack; and

4) Plans to increase share repurchases in the short term. At least in the eyes of the Dolphin, these pieces of information actually alleviated some of our concerns.

So why is there such a great panic among investors?

(1) Firstly, the market's expectations for the second quarter's performance were slightly high. The top games of NetEase in the second quarter had higher revenue compared to the first quarter, but they all encountered issues of marginal slowdown (e.g. a 3-5 billion decrease in revenue for Against the Flow, minor protection adjustments in Eggy Party, a 20% week-on-week decline in public opinion for Fantasy Westward Journey PC game, etc.). However, the market's revenue expectations for the second quarter only reflected a decrease of less than 1 billion, which clearly fell short of expectations.

(2) Additionally, there are speculations that the capital flight is due to concerns about high pressure in the second half of the year. However, the pressure in the second half of the year is not new information. Game revenue is frequently disclosed by third-party data platforms, whether it's the performance of Naraka falling short of Against the Flow, or the revenue slowdown of Eggy Party, these are all public information. Therefore, the pressure in the second half of the year, especially the high base third-quarter growth, should have been anticipated.

The Dolphin believes that the current valuation (implicitly) can still plummet by more than 10%, which is more like a short-term capital game failure in "second-quarter performance exceeding expectations," escalating concerns about macro pressures under the thunderous guidance of other Chinese concept stocks, leading to an excessive reaction due to mass capital flight.

Returning to rationality, how does the Dolphin view NetEase at present?

Firstly, we believe that the current financial report is not without issues. From an incremental information perspective, the main concern is: as product reserves peak and enter a period of increased R&D investment, there is a potential weakening of short-term profit margins.

Secondly, the revenue pressure in the third quarter is within our expectations, and the recent descriptions of the top games by the management team have offset some of the potential weakening brought about by macro factors. Therefore, we believe that the sharp decline that evening was still somewhat exaggerated (after adjusting the performance expectations, we estimate that the current market value of $53 billion corresponds to less than 13x post-tax operating profit for 25 years, excluding net cash of $15.2 billion, corresponding to 10x).

However, we must acknowledge that NetEase currently needs to go through a period of poor performance and valuation pressure. During this period, the Dolphin hopes that the company will increase its "cash capability" by accelerating share repurchases. In the current environment of short-term speculative funds and a lack of long-term capital, like Tencent, NetEase should manage its own positions, get through the tough third quarter, and wait for a unified valuation recovery after interest rate cuts. In the medium to long term, we have confidence in NetEase's R&D and products, possessing the solid strength to match a valuation level of 15x-20x.

The following is a detailed interpretation of this financial report

I. Pressure Coming Early? Revenues Below Expectations In the second quarter, NetEase achieved a total revenue of 25.5 billion, a year-on-year increase of 6%. Apart from PC games, revenues from mobile games, cloud music, Youdao, and others all missed expectations.

In fact, the problems encountered by the company in the second quarter were almost transparent, but the market mostly continued to anticipate linearly, leading to significant deviations from expectations:

1) Can Eternal Return save the game in advance?

In the second quarter, overall gaming and value-added related revenues reached 19.27 billion, a year-on-year increase of 11.8%, lower than market expectations. Looking into details, apart from PC games, mobile games and CC live streaming all missed expectations.

Looking at deferred revenue, year-on-year growth in the second quarter was 5.2%, with a 8% decrease from the previous quarter. Roughly calculated, the current revenue was 18 billion, showing an 18% decrease from the previous quarter. The magnitude of the quarter-on-quarter decline exceeded that of the same period in previous years, highlighting a series of issues in the second quarter, which in turn raised market concerns.

a. Mobile Games: Achieved 14.7 billion in the second quarter, a 16% increase year-on-year, while the market expected 19.6%, basically following the growth rate of the first quarter linearly.

In the first quarter, "Eggy Party" set a new historical high, but in the second quarter, due to issues with underage players, the company upgraded the facial recognition system and introduced rules such as daily spending limits. Similarly, the peak revenue game "Justice" in the first quarter saw a decline in popularity in the second quarter (monthly revenue decreased by 300-500 million), and the annual expansion pack was only released on June 30, which did not contribute to the second quarter.

Therefore, the market only expected a 1.3 billion decline from the first quarter to the second quarter, which was clearly optimistic.

b. PC Games: Reached 4.55 billion in the second quarter, flat year-on-year, actually exceeding expectations.

During this period, due to issues such as changes in the "Fantasy Westward Journey" treasure trove rules, there was a significant impact on public opinion. After the public opinion fermented in April, weekly revenue decreased by 20%. However, the company took this matter seriously and made adjustments quickly. Coupled with other PC games filling the gap, the actual impact was relatively limited.

It is worth mentioning that the second quarter only reflected the impact of 2 months, which may be slightly more pronounced in the third quarter. However, management revealed that the adjustments to "Fantasy Westward Journey" have ended, and the revenue is stabilizing without further decline, although it cannot be compared to the peak of last year "Journey to the West" accounts for about 40% of NetEase's annual revenue of less than 20 billion yuan in PC game revenue. Since there is no channel split for PC games, the profit margin is higher. For a game like "Journey to the West" that has been in operation for 20 years, the profit margin is particularly high. Based on revenue of 8 billion yuan and an operating profit margin of 80%, which is 6.4 billion yuan in operating profit, "Journey to the West" contributes nearly 20% to the overall profit of the group.

Therefore, if this revenue segment cannot be stabilized, it will indeed have a significant impact on the company's performance in the medium to long term. The management's description of the recent situation of "Journey to the West" can be seen as reassuring.

In the third quarter, with the return of Blizzard, "World of Warcraft" was launched on August 1st, and the current user data has exceeded expectations, with nearly 40% being new users, indicating that top-quality games are always attractive. Next, "Hearthstone" is expected to be launched by the end of September, which can provide some support for the PC game revenue in the fourth quarter.

However, NetEase's profit margin from operating Blizzard games is not as good as self-developed games, mainly due to the high revenue share with Blizzard, so the incremental profit growth may be limited.

Overall, pressure on the game sector has started to show in the second quarter, but the industry's year-on-year growth is worse, so NetEase's market share for the current period should remain stable.

Looking ahead to the second half of the year, due to the sharp increase in industry supply during the summer, and NetEase's main mobile game products are only "Naraka Mobile" and "Marvel Ultimate Reversal", although the latter has an IP, combined with historical products, the uncertainty is high.

After the launch of "Once Human" in the PC game sector, it performed well, but to bring significant incremental growth, it will depend on the later development of the mobile game version. Although "Yanyun" is confirmed to be launched within the year, it is likely to be in the fourth quarter, so its short-term contribution is expected to be limited. Therefore, NetEase's market share in the second half of the year may decline accordingly.

2) Little Brother Cloud Music, Following in Big Brother's Footsteps

As the younger brother of Tencent Music, Cloud Music has undergone similar changes in logic over the past year - strong growth in subscription revenue, adjustments in live streaming, optimization of copyright content costs, and improvement in gross profit margin.

In the second quarter, subscription revenue increased by 27% year-on-year, accelerating on a quarter-on-quarter basis. However, compared to big brother Tencent Music, Cloud Music relies more on volume for membership growth due to its weaker competitive advantage, rather than price increases

3) Advertising drives Youdao to reduce losses faster

In the second quarter, Youdao's revenue growth still relies on advertising, with a high year-on-year growth rate of 68%. The decrease in revenue from learning courses year-on-year is mainly due to a high base, leading to an expanded decline. However, there hasn't been much improvement in smart hardware, with a 25% year-on-year decline.

However, market expectations are relatively conservative, so it still exceeded expectations in the end, and due to the increase in the proportion of high-margin advertising revenue, overall losses were further reduced. The market expects to achieve a turnaround from loss to profit in Non-GAAP operating profit for the full year.

4) NetEase Yanxuan not thriving in peak season

Although the second quarter is in the peak season for e-commerce, other innovative businesses mainly led by Yanxuan showed almost zero growth year-on-year compared to last year. This year's e-commerce market is intensifying, with low-price competition being the main theme, but Yanxuan does not have a price advantage, so it is not surprising that it is losing ground.

II. Significant increase in SBC, a signal of a new investment cycle?

In the second quarter, Non-IFRS net profit attributable to shareholders was 7.8 billion, a 13% year-on-year decrease, mainly due to fluctuations in exchange gains and losses. Excluding the impact of non-operating businesses, looking only at the core Non-IFRS operating profit, it increased by 18% year-on-year, with an accelerated growth rate on a quarterly basis.

However, a significant change in the second quarter was the substantial increase in general stable employee stock incentives (accounting for around 3% of revenue), which increased to 4.2% this quarter. Research and development (R&D) related SBC expenses increased by 50% year-on-year, and the growth rate of current R&D expenses continued to rise. In addition to the annual incentives from "Justice" bringing about an increase, it may also indicate that the R&D team is starting to expand.

Therefore, while eliminating noise, but retaining employee stock incentives that are also considered necessary to maintain the current business model, Dolphin Jun will also look at the core operating profit situation.

In the second quarter, the operating profit of the core main business was 7 billion, which is also lower than the market, mainly due to revenue gaps and increased R&D expenses. The gross profit margin actually exceeded expectations overall, thanks to the improved monetization efficiency of games and cloud music.

The transformation of channels is the main factor driving the increase in game gross profit margin. In the second quarter, Tencent challenged the Android channel with the DNFM mobile game, which was also a breakthrough point. Of course, NetEase has been quick in introducing official servers in the transformation, with about one-third of the revenue from some existing games coming from official servers.

However, apart from Evergreen games, most of NetEase's games, especially new games, still cannot abandon third-party channels. If the revenue sharing ratio of the Android channel can be reduced by 30%-50%, then there is still a lot of profit space for NetEase. Of course, this cannot be changed overnight, so we will wait and see.

In addition to games, the gross profit margin of cloud music has increased mainly due to the steady growth of subscription services and the industry trend of continuous optimization of copyright costs, leading to an increase in the comprehensive gross profit margin under changes in revenue structure.

In the second quarter, marketing expenses were 3.5 billion, slipping on a quarter-on-quarter basis, with a year-on-year growth returning to 7%. The commercial war with "Yuanmeng" at the beginning of the year is not the norm. With "Yuanmeng" lying flat, the counterattack of "Eggy Party" has also stopped. However, in the third quarter, with the launch of the "Naraka Mobile," marketing expenses are expected to increase.

Dolphin Research on "NetEase" Historical Articles:

Financial Report Season (Past Year)

May 27, 2024 Conference Call "NetEase: No Need to Worry About Short-Term Fluctuations Caused by Treasure Trove Adjustments (1Q24 Conference Call Summary)" Link 2024 年 5 月 24 日财报点评《 NetEase: It takes a little more time to return to the "good student"》

2024 年 2 月 29 日电话会《 NetEase: "Naraka" mobile game will be launched in the second quarter (4Q23 conference call minutes)》

2024 年 2 月 29 日财报点评《 NetEase's performance is scary? Don't worry, the product cycle is coming soon!》

2023 年 11 月 17 日电话会《 Next year's game reserves are still rich (NetEase 3Q23 conference call minutes)》

2023 年 11 月 17 日财报点评《 NetEase: Is the "money printing machine" going downhill? It's not scary if it's a pig factory》

2023 年 8 月 25 日电话会《 Domestic growth exceeds overseas this year (NetEase 2Q23 performance conference call)》

2023 年 8 月 24 日财报点评《 NetEase: Is the pig cycle facing a "Waterloo"? Don't be too pessimistic》

2023 年 5 月 25 日电话会《 New and old games are making efforts, overseas layout is accelerating (NetEase 23Q1 financial report conference call minutes)》

2023 年 5 月 25 日财报点评《 NetEase: Here comes the "pig" cycle again》

2023 年 2 月 23 日电话会《 [Management: "Believe in the ability of long-term operation" (NetEase 4Q22 performance conference call minutes)](https://longportapp.cn/zh-CN/topics/4303991? 2023 年 2 月 23 日财报点评《 NetEase: Can "Egg Party" Speed Up the New Cycle with a Continuous Flow of Licenses?》

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

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?》

In-depth

2021 年 6 月 25 日《 NetEase: The Super "Pig Cycle" of Pig Farms I Dolphin Research》

Hot Topic

2021 年 7 月 27 日《 NetEase Maintains a Long-Term Target Price of $115-141》

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