2023-05-15 11:58:20 ET
Summary
- The market expects NetEase to deliver topline growth acceleration in Q1, but NetEase's operating income is projected to expand at a slower rate than its revenue.
- The normalization of new game approvals in China is a key tailwind for NetEase this year, but foreign markets expansion will be a drag on NetEase's operating profitability.
- Investors need to be patient as NetEase executes on its overseas growth plans, so a Hold rating for NetEase is appropriate.
Elevator Pitch
I have a Hold investment rating for NetEase, Inc. ( NTES ) (9999:HK) stock.
With my earlier February 21, 2023 write-up for NetEase, I predicted that NTES's actual Q4 2022 earnings would fall short of the sell-side's expectations, and I was proven to be right. NetEase's fourth quarter normalized earnings per ADS (American Depositary Share) in USD terms came in -7% lower than what the analysts had forecasted. NTES suffered from share price declines of -3.7% and -5.1% on the day of the Q4 results announcement (February 23) and the subsequent day, respectively.
My attention turns to the market's expectations of NetEase's upcoming Q1 2023 results announcement and the likelihood of major positive or negative surprises emerging from NTES's first quarter results release in this latest update.
My analysis leads me to suggest that NetEase's Q1 2023 results are highly likely to be in line with the current consensus financial projections for the company. This implies that NTES's Q1 results disclosure isn't going to be a re-rating catalyst for the stock in the short term. Instead, patience is required when one considers NTES as a potential investment candidate. Overseas market expansion will reduce NTES's geographical concentration risks, but this will come at the expense of an increase in investments in the near term. As such, I think that a Hold rating for NetEase is fair.
The Market Has A Mixed View Of NTES's First Quarter Financial Performance
NetEase disclosed earlier on May 4, 2023, that its earnings for the first quarter of the current year will be released on Thursday, May 25 morning before the market opens.
The sell-side analysts see NTES witnessing revenue growth acceleration in Q1 2023, but they expect NetEase's operating earnings expansion to be relatively muted.
Based on the market's consensus financial projections for NetEase sourced from S&P Capital IQ , NTES's topline growth in local currency terms on a YoY basis is expected to improve from +4.0% for the fourth quarter of 2022 to +5.2% in the first quarter of 2023. On the flip side, the sell-side is expecting NTES's EBITDA and EBIT in RMB terms to increase marginally by +1.3% YoY and +1.5% YoY, respectively for Q1 2023.
In the next section, I discuss what I think about the analysts' consensus Q1 2023 financial estimates for NetEase.
I Expect NetEase To Announce In-Line Q1 2023 Results
My opinion is that NTES's financial performance for the first quarter of 2023 should meet the market's expectations. NetEase's revenue outlook has improved, but the company is still in investment mode. This implies that the sell-side's expectations of faster topline expansion and muted operating income growth are pretty realistic.
Gaming research firm Niko has forecasted that new domestic game licenses granted by regulatory authorities in China could potentially more than double from 468 last year to over 1,000 in 2023. Niko's estimates are consistent with the company's disclosures at its most recent quarterly results briefing. Earlier, NetEase emphasized at its Q4 2022 earnings call in late February 2023 that "the process of license (approval in China) has started to normalize" with "Justice mobile games, Racing Master and Badlanders" being the company's new games which received approvals from regulators in the early part of this year.
NetEase's revenue growth in RMB terms slowed from +24.4% in FY 2020 to +18.9% in FY 2021, before decelerating further to +10.1% for FY 2022. Referring to Niko's research highlighted above, the number of new local game license approvals in Mainland China dropped from 1,314 in 2020 to 679 and 468 in 2021 and 2022, respectively. In other words, the moderation in NTES's topline acceleration for the past two years is mainly attributable to a decline in the number of new game approvals. With expectations that Chinese regulators will grant significantly more new game licenses this year, it is reasonable to see NTES growing its topline at a faster pace in Q1 2023 and full-year 2023.
On the flip side, there are good reasons why the analysts have forecasted that NTES's EBITDA (+1.3%) and EBIT (+1.5%) growth for Q1 2023 will be much slower than its revenue expansion (+5.2%) during the same time period.
At its Q4 2022 earnings briefing, NetEase stressed that the company will "continue to place equal emphasis on both the China market and the global market" and it also acknowledged that the "overseas (gaming) studios" are "in the investment phase." Specifically, NTES expects 2025 to be the earliest that one can expect new game launches from the overseas studios. Late last month, NetEase announced the formation of a new foreign gaming studio known as "Anchor Point Studios" which will have a presence in both "Barcelona, Spain, and Seattle, United States."
In other words, NetEase will have to bear with higher expenses associated with investments made for foreign markets expansion in the near term, before successfully achieving geographic diversification in the future.
In a nutshell, I don't expect NTES's Q1 2023 results to excite or disappoint investors in a big way.
Closing Thoughts
Regulatory headwinds remain the key downside risk factor for Chinese gaming companies, despite the fact that the number of new gaming license approvals in Mainland China is expected to rise this year. Therefore, it makes sense that NetEase, Inc. is continuing with its expansion plans in international markets outside of China. It is inevitable that there will be "short-term pain" involved with such geographical diversification efforts, as NetEase has to invest significantly ahead of new game launches by its overseas gaming studios. I continue to rate NetEase, Inc. as a Hold, considering that NTES is still in investment mode.
For further details see:
NetEase: Patience Is Needed