NTES - NetEase: Navigating The Path To Prosperity Amid Regulatory Challenges And Fierce Competition

2023-07-16 11:29:50 ET

Summary

• NetEase, a Chinese tech company, has promising future prospects in various sectors including gaming, e-commerce, and online education, but faces regulatory risks and intense competition from major players.
• The company has seen strong revenue and earnings per share growth, attributed to its diverse game portfolios, content innovation, user-generated content, and global expansion efforts.
• Despite its strong performance, the company's current valuation is relatively high, suggesting it may be prudent to wait for a lower valuation before investing.

Thesis:

The future prospects for NetEase (NTES) in the gaming, e-commerce, online advertising, cloud services, music streaming, and online education industries in China are promising, driven by advancements in technology and changing consumer behaviors. However, the company faces regulatory risks, and intense competition from major players, and its current valuation may be relatively high. Therefore, it would be prudent to wait for a lower valuation before considering an investment in NetEase.

What is NetEase?

NetEase, a prominent Chinese technology company, generates its revenue from a diverse range of sources across multiple business segments.

One of the primary sources of revenue for NetEase is its online gaming division. The company develops and publishes online games through self-developed titles and licensed partnerships. Revenue is generated through various avenues within the gaming sector, including in-game purchases, virtual item sales, subscriptions, and downloadable content ((DLC)). NetEase has produced popular games such as "Fantasy Westward Journey," "Justice Online," "World of Warcraft," and "Minecraft" in China.

NetEase also operates an e-commerce platform called NetEase Yanxuan. This platform offers a wide range of products, including apparel, accessories, home goods, and electronics. Revenue is generated through the sale of these products to customers in China and potentially other regions.

Online advertising represents another significant revenue stream for NetEase. The company monetizes its various platforms, including gaming, e-commerce, and web portals, by providing advertising space to brands and businesses.

Additionally, NetEase provides cloud computing services, catering to the growing demand for cloud infrastructure. Through its cloud services, which include infrastructure-as-a-service (IaaS), platform-as-a-service (PaaS), and software-as-a-service (SaaS) solutions, NetEase generates revenue through subscription fees and usage-based pricing models.

NetEase has also made strides in the music streaming industry with its platform, NetEase Cloud Music. Users can access a vast library of music, and revenue is generated through premium subscriptions and advertising on the platform.

Moreover, NetEase has expanded into the online education sector. It offers various educational products and services, such as online courses, tutoring services, and language learning platforms, which contribute to its overall revenue.

While the gaming sector remains a primary revenue driver for NetEase, the company has diversified its portfolio to include e-commerce, online advertising, cloud services, music streaming, and online education. This diversification strategy allows NetEase to tap into multiple revenue streams and adapt to evolving market trends in the technology and entertainment industries.

Market

The future of the gaming, e-commerce, online advertising, cloud services, music streaming, and online education industries in China holds several exciting prospects. Here's a glimpse into what the future may hold for each sector:

Gaming: The gaming industry in China is expected to continue its rapid growth. With advancements in technology such as virtual reality ((VR)), augmented reality ((AR)), and 5G connectivity, gaming experiences will become even more immersive and seamless. Chinese game developers will continue to create innovative and high-quality titles, attracting both domestic and international audiences. E-sports will further establish itself as a mainstream form of entertainment, with increased investments in professional teams, stadiums, and tournaments. Collaboration and cross-border partnerships between Chinese and international gaming companies will flourish, fostering global synergy and expanding the reach of Chinese games.

E-commerce: China's e-commerce sector will remain vibrant, driven by increased consumer spending and the continued expansion of online retail platforms. The growth of mobile shopping will continue to play a crucial role, with consumers increasingly relying on smartphones for their purchasing needs. The integration of social commerce and livestreaming will become more prominent, providing personalized shopping experiences and driving engagement. The rise of cross-border e-commerce will enable Chinese consumers to access a wider range of international products, fueling further growth in this sector.

Online Advertising: China's online advertising industry will evolve to leverage emerging technologies and new consumer behaviors. Personalized and targeted advertising will become more sophisticated, driven by advances in data analytics and artificial intelligence. With the growing popularity of short-video platforms and live streaming, advertisers will focus on creating engaging and interactive content to capture the attention of users. As the digital ecosystem continues to expand, collaborations between advertisers, content creators, and influencers will drive innovative advertising strategies.

Cloud Services: The demand for cloud services in China will continue to surge as businesses and individuals increasingly rely on cloud infrastructure for storage, computing power, and software solutions. The adoption of edge computing and Internet of Things (IoT) technologies will lead to further expansion of cloud services, enabling efficient data processing and real-time analytics. As the Chinese government emphasizes data security and sovereignty, domestic cloud service providers will gain prominence, resulting in increased competition and advancements in cloud technologies tailored to the Chinese market.

Music Streaming: China's music streaming industry will witness sustained growth, driven by the rising popularity of digital music consumption. With a focus on personalized recommendations and curated playlists, music streaming platforms will enhance user experiences and engagement. Integration with social media platforms will enable users to discover, share, and interact with music in new ways. Partnerships between music streaming platforms and artists will strengthen, leading to exclusive content releases and live-streamed concerts. Additionally, international collaborations and licensing agreements will facilitate the expansion of Chinese music streaming services to global audiences.

Online Education: Online education in China will continue to thrive, driven by the increasing demand for flexible and accessible learning options. The integration of artificial intelligence ((AI)) and machine learning will enable personalized learning experiences and adaptive tutoring systems. Blended learning models, combining online and offline education, will gain prominence, providing a comprehensive and interactive educational environment. Education technology (EdTech) startups will flourish, introducing innovative tools and platforms to enhance learning outcomes. Collaboration between educational institutions, corporations, and technology companies could drive the development of online education ecosystems.

Market Risk

A significant risk that NetEase faces across the industries it operates in is the regulatory environment in China . Government policies and regulations can have a profound impact on the company's operations and growth prospects. Let's delve deeper into this risk:

The regulatory landscape in China has been subject to changes and can pose challenges for companies operating in sectors such as gaming, e-commerce, online advertising, cloud services, music streaming, and online education. The Chinese government exercises strict control over content, data, and business practices to ensure social stability, cultural preservation, and cybersecurity.

For the gaming industry, regulatory measures include content censorship, age restrictions, and limitations on the release of new games. Government authorities conduct regular content inspections, which may result in game delays or rejections. These regulations aim to uphold social values, prevent addiction among young users, and maintain a healthy gaming environment.

In e-commerce, the Chinese government enforces regulations related to consumer protection, counterfeit products, taxation, and cross-border trade. Compliance with these regulations requires companies to invest in robust systems, processes, and resources to ensure legal and ethical operations. Changes in tax policies or cross-border trade regulations can impact the cost structure and profitability of e-commerce businesses.

Online advertising is subject to regulations related to content standards, privacy protection, and advertising practices. Advertisers must adhere to guidelines on content approval, user data privacy, and deceptive advertising. Failure to comply with these regulations may result in penalties or reputational damage.

Cloud services, including data storage and processing, face scrutiny regarding data security and compliance with local data protection laws. The Chinese government emphasizes the sovereignty and security of data, leading to the implementation of stringent regulations. Companies operating in the cloud services sector must navigate requirements related to data localization, cross-border data transfers, and cooperation with government investigations.

In music streaming, the Chinese government imposes content restrictions and copyright regulations. Platforms must obtain licenses for music distribution and comply with copyright laws to avoid legal disputes. Content censorship is also a consideration, requiring platforms to align with government guidelines on sensitive or politically sensitive content.

Online education is subject to government regulations regarding curriculum, teacher qualifications, and online education platforms. Compliance with these regulations ensures quality education and student safety. Additionally, changes in policies related to market access or licensing requirements can impact the operations and expansion plans of online education providers.

Competition

NetEase faces intense competition in the industries it operates. Let's take a closer look at the competition NetEase faces across its key sectors:

Gaming: In the gaming industry, NetEase competes with several major players in China, including Tencent, Alibaba, Perfect World, and Shanda Games. Tencent (TCEHY), in particular, is a formidable competitor and holds a dominant position in the Chinese gaming market. These companies have significant resources, strong game portfolios, and established user bases. Competition is fierce in both the PC and mobile gaming segments, with each company striving to develop compelling games, secure intellectual property rights, and attract and retain players.

E-commerce: NetEase competes with e-commerce giants such as Alibaba (BABA), which operates platforms like Taobao and Tmall, and JD.com (JD) in the Chinese e-commerce market. Alibaba, in particular, holds a significant market share and has a wide range of product offerings, strong logistics capabilities, and extensive consumer reach. JD.com, with its emphasis on quality and authenticity, as well as its strong logistics infrastructure, is also a formidable competitor. These companies engage in fierce competition, utilizing marketing campaigns, discounts, and user incentives to attract and retain customers.

Online Advertising: In the online advertising sector, NetEase faces competition from domestic digital advertising giants like Tencent, Alibaba, and Baidu ( BIDU ). These companies have vast user bases and diverse digital platforms that attract advertisers. Tencent's WeChat and Alibaba's platforms, including Taobao and Tmall, offer targeted advertising opportunities, leveraging user data and advanced algorithms. Baidu, known for its search engine dominance, also competes in the online advertising space with its advertising platforms and tools.

Cloud Services: In the cloud services sector, NetEase faces competition from prominent players such as Alibaba Cloud, Tencent Cloud, and Huawei Cloud. Alibaba Cloud holds the largest market share in China's cloud market, leveraging its extensive infrastructure and diverse service offerings. Tencent Cloud, backed by Tencent's ecosystem and strong gaming presence, has also gained significant traction. Huawei Cloud, with its focus on advanced technologies and enterprise solutions, is another notable competitor. These companies vie for enterprise customers, offering a range of cloud services, including computing, storage, and AI capabilities.

Music Streaming: In the music streaming industry, NetEase Cloud Music competes with Tencent Music Entertainment ( TME ), which operates platforms such as QQ Music, Kugou Music, and Kuwo Music. Tencent Music Entertainment enjoys a dominant market share in China and has exclusive partnerships with major record labels. Both NetEase Cloud Music and Tencent Music Entertainment engage in content acquisition, user engagement strategies, and partnerships with artists to attract and retain users in this highly competitive space.

Online Education: In the online education sector, NetEase faces competition from companies like Tencent Classroom, Yuanfudao, and VIPKid. Tencent Classroom, backed by Tencent's resources and extensive user base, offers online education services across various subjects and age groups. Yuanfudao, a leading online education platform, specializes in K-12 education and has gained significant popularity. VIPKid focuses on English language learning and connects Chinese students with foreign teachers. These companies compete to attract students, offering quality educational content, and leveraging technology to enhance the learning experience.

Performance

Source: Seeking Alpha (Retrieved on 07-15-2023)

As seen from the table above, both revenue and EPS (Earnings per share) growth have been outstanding in more recent times and in the longer time frame as well. I have been looking into what led to the growth numbers.

According to the most recent earnings call, NetEase's growth can be attributed to several key factors. The strong performance of NetEase's game portfolios, as discussed during the call, drove revenue and profit growth. The Fantasy Westward Journey Online series flagship titles continued to generate steady revenue, benefiting from sustained user connections and regular iterations to keep users engaged.

Newer titles like Eggy Party also made a significant impact. Eggy Party became China's most downloaded game on iOS in the first quarter, solidifying its leading position in the casual game arena. NetEase's content innovation and operational expertise, as highlighted during the call, played a crucial role in keeping players engaged through regular updates, new gameplay features, tournaments, and crossover events.

NetEase's focus on user-generated content (UGC) was another contributing factor. The earnings call mentioned that NetEase encouraged the user community to contribute to Eggy Party's content, resulting in over 1 million apps created per week. This UGC ecosystem and continuous content updates ensured a fresh and enjoyable experience for players.

The transcript also revealed that NetEase expanded globally by soft-launching Eggy Party in Southeast Asia, receiving valuable feedback. The company plans to bring Eggy Party to global audiences in the near future, anticipating a positive response. Furthermore, the earnings call mentioned NetEase's upcoming games, including Justice mobile game, Badlanders, Racing Master, and the highly-anticipated Harry Potter: Magic Awakened, which is set to make its international market debut.

Beyond the gaming sector, other business lines contributed to NetEase's growth. Youdao, despite the challenging pandemic environment, resumed its growth trajectory in STEAM courses and other key business lines. The introduction of the Champion Class and the growth of Youdao Fun Reading, a digital online reading service, played a significant role in driving net revenues.

Cloud Music achieved margin expansion by optimizing copyright cost structure and revenue-sharing strategies. The transcript highlighted NetEase's focus on expanding its music library through licensing agreements with renowned music labels and supporting independent artists, fostering a thriving music-centric ecosystem with high user engagement.

NetEase Yanxuan, the private-label consumer brand, saw significant sales growth in various categories. The brand's commitment to delivering quality products, deepening the supply chain model, and enhancing the user experience contributed to its success.

NetEase's ESG initiatives and achievements were also mentioned during the call. The company placed emphasis on corporate governance, reducing its carbon footprint, promoting diversity and inclusion, and talent development.

In summary, NetEase's growth was driven by the strong performance of its game portfolios, with both flagship and newer titles contributing to revenue and profit growth. The focus on user-generated content, global expansion plans, and a robust pipeline of upcoming games added to the company's success. Other business lines like Youdao, Cloud Music, and NetEase Yanxuan also made significant contributions. Finally, NetEase's commitment to ESG initiatives and achievements reinforced its position as a leading and sustainable company.

Furthermore, I believe that these statistics and events showcase the capability of the management of NetEase to maintain a strong user base and expand to other industries and countries and overall, to take advantage of investment opportunities. Thus, I expect the revenue and earnings to keep on growing in the future.

Valuation and Performance Comparison

Source: Seeking Alpha (Retrieved on 07-15-2023)

NetEase is pretty expensive compared to similar companies when looking at the P/S ratio. Using the P/E ratio, the company is roughly averagely valued. Its sales growth numbers aren’t out of the ordinary compared to the other players, same goes for the EPS growth rate. The combination of both, however (high revenue and EPS growth), is something that only NetEase and Tencent achieve.

Overall Conclusion

The future of these industries in China holds prospects for growth and innovation, driven by advancements in technology, changing consumer behaviors, and supportive government policies.

However, NetEase faces regulatory risks due to the strict control exercised by the Chinese government over content, data, and business practices. Changes in regulations can impact the company's operations and growth prospects.

NetEase competes with major players in each sector, including Tencent, Alibaba, Baidu, and Tencent Music Entertainment. The competition is intense, with companies striving to develop compelling products, attract and retain users, and expand their market share.

NetEase's performance has been impressive, with strong revenue and EPS growth. The company's success can be attributed to its strong game portfolios, content innovation, user-generated content, global expansion efforts, and diversified business lines.

In terms of valuation, NetEase is relatively expensive compared to similar companies when looking at the price-to-sales ratio. However, its sales growth and EPS growth rates are on par with its competitors.

In conclusion, I am still waiting for a lower valuation to buy NetEase. With the risks that come with the industry, I am not willing to pay the valuation that it has now.

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