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Morningstar | NetEase’s Strong 2Q In Line; FVE Maintained at USD 344 per ADR

NetEase’s decent second-quarter results revealed strong growth momentum following two consecutive weak quarters, which is in line with our expectations and reaffirms our positive outlook on the company’s long-term growth. Net revenue rose 21.7% year over year, or 14.9% sequentially, with solid growth across all business segments. Fast-growing e-commerce continues to lead revenue growth, while online games also offer a bright spot, with revenue rising 15% sequentially--the strongest growth since first-quarter 2017. We expect NetEast to extend its growth trajectory in the second half, with new game releases and promising upgrades of existing games. We maintain both our earnings forecasts and our fair value estimate of USD 344 per ADR. We think NetEase shares are undervalued at the current trading level, with long-term prudent growth being supported by multiple drivers from its strong intellectual property in online games, well-established e-commerce platforms, and various incubated businesses in areas such as online education, music, and so on.

Revenue from online games came in at CNY 10 billion in the second quarter, representing 7% year-over-year growth, or 15% from the preceding quarter. This is the strongest quarter since first-quarter 2017, thanks to the launches of several successful new games in non-MMORPG categories, including Shadowverse, Identity V, and QwQ. Each of these titles quickly climbed to the top of the download chart in China. Nevertheless, legacy titles, such as Fantasy Westward Journey, Westward Journey Online, Onmyoji, and Invincible continue to post steady growth. In addition, NetEase launched an exciting PC game, Justice, on June 29, which took the company five years to develop and features state-of-the-art technology and stunning graphics. The new game immediately attracted millions of fans and reset expectations for PC games.

While we don’t expect immediate monetization of Justice, we think the game will likely further expand its user base and become another valuable IP for NetEase. We still believe NetEase’s intellectual property and its past successful experience will continue to support the company and make it a long-term winner in the area of online gaming.

NetEast’s e-commerce business maintained a fast-growing trajectory in the second quarter, with revenue rising 75% year over year, or 17% sequentially. It’s also worth highlighting that the gross margin from e-commerce improved to 10.1% from 9.5% in the preceding quarter, despite the big promotional season around June 18. While the e-commerce segment is still loss-making at this stage, management is confident that it can achieve a sustainable profit margin through continuous optimization of product mix, supply-chain upgrades, and economies of scale. We expect NetEase’s e-commerce to maintain leading revenue growth, which is positioned well through satisfying Chinese consumers' increased demand for good-quality merchandise.

Other businesses, including advertising, email, and others, also posted sound growth in the second quarter, rising 28% year over year, or 11% sequentially. NetEast’s advertising segment maintains stable revenue growth and stable margins in the second quarter, with revenue rising 6% year over year and stable gross margin of 67%, while the Cloud Music and live broadcasting business saw rapid growth. However, the high copyright costs and investments in these incubated businesses dampened the margin, despite a small improvement to negative 7% from negative 10% in the first quarter.