EUR 850.00 For Business Accounts Only

Morningstar | NetEase's FVE Maintained at USD 283 after Adjusting Estimates of New Businesses, Tax and Ad Segment

We maintain narrow-moat NetEase’s fair value estimate at USD 283 after some adjustments following a discussion with the company. We made changes to our assumptions in the revenue and margin for the innovative businesses and others segment and advertising business, and effective tax rate while holding other assumptions largely intact.

We now expect the innovative businesses and others segment to see decline in revenue growth to 14% in 2019 and 2020, same as the growth in the fourth quarter of 2018, as the company exits noncore operations in this segment. We expect revenue growth to pick up to 23% by 2023 due to higher contribution from fast-growing new businesses such as cloud music. The penetration of online music among netizens in China reached 71% in July 2018 as per Questmobile with a high paying willingness ratio of roughly 60%. NetEase cloud music’s monthly active users ranked number four at 116 million in July 2018, just behind the top three music apps owned by Tencent, according to Questmobile. NetEase cloud music is a differentiated product with a focus on users that are younger, trendy and like comics. The gross margin of this segment is expected to be negative 6% from 2019 to 2022, same as 2018, and we expect it to rise to 17.8% by 2028. While this may appear to be aggressive, we note that Tencent Music generated a gross profit margin of 35% in 2017.We expect this segment to contribute 5% of gross profit by 2028. Management plans to cease operations of certain noncore operations that are high in gross margin but loss-making at the bottom line, which will put pressure on the gross margin in the near term. New businesses such as cloud music and education are not profit generating and long-term investments into these businesses will be needed to gain sufficient scale. The purchase of music copyrights would be a large part of the cost of revenue of this segment.

We forecast effective tax rate to be 35% from 2019 to 2021, attributed to increasing scale of loss making businesses such as e-commerce. This is in line with our expanding negative gross margin of 6% for the innovative businesses and others segment until 2021. After that, effective tax rate will trend down gradually to 19% by 2028 versus 28% in 2018 and 11% to 17% from 2013 to 2017.

Advertising revenue was weak in 2018, and we expect to see slow growth of only 3% per year as a result of the weak macroeconomics, Sino-U.S. trade spat, and challenges in different industries in China. Internet services, automobile and real estate sectors, NetEase’s top performing verticals, are facing challenges. We expect revenue growth to stay flat at 3% in the long run as portal advertising is a mature business. We expect the gross margin for the advertising business to decline to 61.4% by 2021 due to higher content expenses and potentially lower pricing. We then expect gross margin to stay flat in outer years.