TME - NetEase: Cautiously Positive Prospects Fairly Valued

2023-08-30 04:04:00 ET

Summary

• New smash hit games and Cloud Music paying user growth support medium-term prospects.
• Competitive risks are significant in both growth opportunities.
• Valuation seems fair.

New smash hit game titles and growing Cloud Music paying users supports medium term prospects for China's second-biggest video game developer NetEase ( NTES ). Competitive risks are significant. Valuation appears fair.

Company Overview

NetEase, a technology company is widely known as China’s second biggest game developer. The company generates revenues from four primary business segments:

• Games and related value-added services which offer video games and related services accounts for over three quarters of revenues. It is also NetEase’s most profitable segment with segment gross margins of over 60%.

• Youdao, which is NetEase’s education business, offers STEM courses, and smart learning devices (such as dictionary pens). The segment accounts for around 5% of total revenues. This is the company’s second-most profitable business with segment gross margins of around 50%.

• Cloud Music is NetEase’s music streaming platform. The segment accounts for around 9% of revenues. This is NetEase’s least profitable segment with segment gross margins of under 15%.

• Innovative businesses and others comprise its online retail business which sells products from its private label consumer lifestyle brand Yanxuan. The segment accounts for 8% of revenues. Segment gross margins are around 25%.

Background: Q2 2023 growth helped by existing and new games, Youdao and Yanxuan, offsetting weakness at Cloud Music

For Q2 2023, NetEase’s revenues rose 3.7% YoY to CNY 24 billion bringing 1H 2023 revenue growth to 5% YoY.

• Games related value-added services revenues rose 3.6% YoY to CNY 18.8 billion primarily driven by increased revenue contribution from mobile games, including their strong legacy titles such as Fantasy Westward Journey series and newer games such as Eggy Party.

• Youdao revenues rose 26.2% YoY to CNY 1.2 billion, driven by increased revenue contribution from learning services and online marketing services.

• Cloud Music revenues declined 11% YoY (a sharper decline from the previous quarter when revenues dropped 5% YoY) to CNY 1.9 billion despite a strong 13% YoY growth in revenues from paying music subscribers. The decline was attributed to falling revenues from social entertainment services.

• Innovative businesses and others revenues rose 10% YoY to CNY 2.1 billion.

Near term, gaming revenue growth could be supported by their new game launches; Eggy Party which was launched in China last year to tremendous success is now being rolled out internationally. Harry Potter: Magic Awakened, again, hugely popular in China is also being expanded to international markets. Justice Mobile launched on June 30th is already a commercial hit , and could drive growth as user numbers gain momentum over the coming quarters.

Cloud Music revenues may continue to come under pressure near term due to falling social entertainment revenues (down 23.8% in Q2 2023, mirroring Tencent whose social entertainment services revenues were down 24.6%) which the company has not specifically described but is likely partly composed of online gambling activities which the Chinese government recently cracked down on . Tencent Music ( TME ) warned of further declines ahead, and NetEase Music is likely to see similar declines.

Games and related VAS services: new smash hits Eggy Party and Justice Mobile could drive medium term growth

Justice Mobile is NetEase’s answer to Tencent’s ( OTCPK:TCEHY ) Honor of Kings or miHoYo’s Genshin Impact. The company has pledged to support the game for 10 years, and if the success of Honor of Kings (launched in China around eight years ago) is anything to go by, Justice Mobile could support revenue growth at least over the next few years.

Eggy Party, NetEase’s answer to the highly successful Fall Guys game (developed by Epic Games which is part owned by Tencent) could find success overseas as Fall Guys is currently not available on mobile, and may not be available for some time considering ongoing legal disputes between Epic Games and Apple. NetEase’s opportunistic move to capitalize on the gap could yield dividends medium term. NetEase has historically focused on hardcore games typically geared towards PCs, but the success of Eggy Party (a friendly and playful game of squishy eggs) gives the company a foothold in the casual mobile games market, currently dominated by gaming heavyweight Tencent in China. Casual games have a wider audience, and their newfound success expands their addressable market and therefore revenue potential as well (China's casual games market is valued at around $4 billion ). In their Q1 2023 earnings call, management made clear their intention to support, innovate and expand the game over the next two to three years.

Paying music subscribers could support non-games growth medium term

Paying users have been the growth engine for Cloud Music and likely to remain so. NetEase has roughly 41.8 million paying users, about 20% of their 207 million MAUs, a far cry from Tencent Music who has double the number at 99.4 million paying users with 594 million MAU at the end of 1H 2023. NetEase Cloud Music’s MAUs have been growing at a robust pace up 14% YoY in Q2 2023 compared with 5% for Tencent Music. A few factors in NetEase’s favor could support continued MAU growth for the foreseeable future; Chinese regulatory changes a few years ago barring Tencent’s advantage of exclusive distribution deals with record labels, and sub-licensing content to competitors like NetEase (for as much as two to three times what it originally paid) made for a more level playing field among competitors. In addition, following the new rules, indie artists became a point of differentiation for music streaming platforms, an area NetEase has long focused on and is currently far ahead with more than 611,000 indie artists compared with 390,000 for Tencent Music.

Margins

Games and related value-added services gross profits have increased to 67% in 1H 2023, compared with 62.7% in FY2022, driven by the termination of lower margin licensed games. This may be offset by an increasing revenue share from their growing mobile games business which generally tend to carry lower margins than P C games (as a portion of mobile gaming revenues are shared with app stores).

Cloud Music, which has long been in the red, turned profitable for the first time in 1H 2023 on the back of growing paying subscribers and cost optimization efforts. Medium term, continued growth in premium subscribers may support the business’s profitability.

Risks

Stiff competition

Games:

Competition in China is increasing. NetEase’s biggest gaming rival used to be Tencent but now the company has to contend with new players notably miHoYo whose new game Genshin Impact became the fastest app to surpass $1 billion revenue. Stiff competition could increase game development costs as gamers become more demanding and discerning over game quality. Genshin Impact with its $100 million budget was considered high at the time but as competition intensifies such numbers could become the norm; NetEase’s Justice Mobile also had a $100 million budget.

In addition, stiff competition in China is prompting developers to venture overseas, notably in North America where most game developers are focused on PC or console games rather than mobile games giving Chinese game companies an edge. However, North America is a costlier market to enter, which suggests higher development costs. With acquisitions making up a major part of NetEase’s international expansion strategy, acquisition risks are significant, and the possibility of paying prices at inflated valuations cannot be ruled out considering the ongoing consolidation wave in the industry. NetEase is aiming to increase international revenues to 40%-50% of revenues but no timeline has been provided and it would be at least 2025 for their international operations to deliver any ‘positive surprises’.

Music:

Tencent Music’s recent shift in focus towards indie artists is a competitive threat to Cloud Music. It remains to be seen if NetEase Cloud Music is surpassed by its bigger rival. NetEase has a far longer history and market standing as an indie-focused music streaming platform but Tencent has bigger pockets (to incentivize and support indie artists), the advantage of a larger ecosystem due to its WeChat messaging app as well as arguably a bigger international reach (enabling them to offer better tools and services such as international distribution services for indie artists).

Short video rival ByteDance’s entry into the music streaming space in direct competition with NetEase further increases competitive pressures. ByteDance’s algorithm has been credited with helping new, undiscovered songs go viral, and the app is fast emerging as a platform to discover new music. NetEase’s lack of a comparable social media platform is arguably a weakness ByteDance is well positioned to exploit and thus ByteDance’s entry would present a formidable competitive force in the battle for indie artists.

Conclusion

NetEase has a buy analyst consensus rating.

Conservatively assuming a revenue growth rate of 9.5% this year, 11% for the next two years and 3% thereafter, a net margin of roughly around 23% rising to 24%, CAPEX of 2%, and a discount rate of 9%, suggests the company is worth around CNY 467 billion or around $64 billion, on par with the $64 billion market value today. The company could be viewed as a hold.

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