EUR 850.00 For Business Accounts Only

Morningstar | NetEase’s Margin Will Likely Normalize in the Rest of the Year as New Games Are Launched

Narrow-moat NetEase is currently fairly valued with a fair value estimate of USD 283. Net revenue in the first quarter was CNY 18.4 billion, growing 30% year over year, versus our full-year estimate of 28%. It was driven by 35% growth in online games revenue (versus negative 1% at Tencent) resulting from launches of games such as Knives Out in Japan, Identity V, Justice and Night Falls: Survival. The sequential increase of 8% in online games revenue (versus positive 18% at Tencent) was due to steady performance of certain legacy titles. Gross margin was up 210 basis points year over year helped by higher online game revenue, higher sales and improved procurement and operation in the e-commerce segment, offset by weakness in the advertising segment and lower gross margin for innovative businesses and others. Operating profit was up 183% year over year with margin improving from 8.5% to 18.6%, a level that is unsustainable given the lack of new game launches which require sales and marketing expenses in the quarter. We assume 10% operating margin for the full year as we expect new game launches in the rest of the year. Net profit was up 217% year over year to CNY 2.4 billion, helped by a CNY 330 million reduction in exchange losses.

In the quarter, NetEase optimized its structure by focusing on core businesses. Gross margin for innovative businesses and others was negative 13.1% versus negative 9.9% in the first quarter of last year, mainly due to terminating operations of noncore businesses, some of which have relatively higher gross margin but are losing making at the operating level. Cloud Music’s gross profit margin improved year-over-year due to the scale effect.

To further NetEase’s international expansion after some success in Japan, NetEase will publish more games into major markets such as Japan, the U.S., and the mainstream western market. In Japan, Knives Out was number one in the grossing chart a few times in March and May; Identity V became one of the top five games in the iOS grossing chart in April; Night Falls: Survival and Cyber Hunter reached number one in the download chart after their launches in April. Management noted that in many mature western mainstream game markets, PC and console games are more dominant unlike China, meaning mobile game markets in the western mainstream markets have the most upside potential.