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Morningstar | Narrow-Moat NetEase's 4Q Results Beat Our Expectations on Operating Leverage

Fourth-quarter non-GAAP operating income at narrow-moat NetEase was 14% higher than our estimate. Non-GAAP research and development, sales and marketing, and general and administrative expenses as a percentage of sales all came down sequentially as a result of operating leverage, in our view. We believe NetEase remains undervalued as its growth in overseas markets and businesses such as cloud music and cross-border e-commerce, both leading in their respective industries, is not priced into the stock. NetEase has a proven record of longevity in its games, strong research and development capacity, and innovative games, leading to our confidence in its international expansion in its gaming business. We maintain our fair value estimate at $283 per share.

Revenue in the fourth quarter was up 36% year over year, sustaining the momentum of the third quarter; sequentially it was up 18%. Sequentially, total gaming revenue and mobile gaming revenue were up 7% and 9%, respectively, helped by the higher contribution from mobile games Night Falls: Survival and Ancient Nocturne. E-commerce revenue's year-over-year growth slowed to 44% from 67% in the third quarter due to a higher base. Innovative businesses and others registered year-over-year growth of only 14% versus 32% in the prior quarter. Deferred revenue in the quarter was up 8% sequentially, indicating that first-quarter revenue could be higher on a sequential basis.

Gross margin for the online game segment was down to 62.8% from 65.1% in the third quarter due to a higher contribution from lower-margin mobile games and licensed games. While it is normal for e-commerce businesses in China to see lower margin sequentially in the fourth quarter due to promotions, gross margin for the e-commerce segment reached a new low of 4.5% versus 7.4% in the same period last year due to a larger-scale promotion and discounts to clear inventory. Management expects that the overall e-commerce segment in 2019 and forward will have a relatively stable gross profit margin similar to 2018’s 8% level.

Management said the primary focus in 2019 would be e-commerce, music, and online education. NetEase’s purchase of intangible assets and licensed copyrights of music content increased 100% year over year in 2018, and we expect to see strong growth in such expenses. The expansion in these loss-making businesses is expected to push the effective tax rate in 2019 to the high 20s in the next two years by our estimate.

After bringing Rules of Survival, Identity V, and QwQ to Asian markets, NetEase plans to tap the mainstream Western market and will launch Night Falls: Survival in Japan and the U.S. in the first half of 2019. A successful launch of new games overseas will diversify overseas gaming revenue away from Knives Out’s contribution in Japan. More than 10 titles are in the regulator approval pipeline in China, but NetEase can launch games overseas while waiting for approval in China. Upcoming titles include Fantasy Westward Journey 3D (Fantasy Westward Journey is a flagship title), Xuanyuan Sword, Ages of Isle, and Pokemon Quest. Also, management said the development of mobile game Diablo Immortal, jointly developed with Blizzard, is near completion. We expect Diablo Immortal to be launched globally this year. We view the game pipeline this year to be strong.