NetEase Stuns Naysayers, But YY Sees More Pain

by: Chinese Internet Weekly

Amid the economic jitters, market players were less inclined to place their bets on the Chinese internet sector. Gains at NetEase and Tencent Music Entertainment helped ameliorate losses.

YY is facing challenges from multiple fronts. Increasing investments into its competitors as well as new forms of entertainment could dim the outlook for YY further.

NetEase reported a sterling set of second-quarter 2019 results amidst headwinds in its gaming division. In addition, there were many things to like from the earnings call.

This week would be an interesting one for those watching the Chinese internet sector due to the raft of earnings reports.

By ALT Perspective

Last week can appear to be ho-hum as the S&P 500 (SPY) moved down just 0.5 percent. However, that small change glosses over a week that saw the steepest plunge of the year for the S&P 500 offset by its best day in months.

Traders and investors alike were relieved on Thursday when China adjusted its daily reference rate for the Chinese yuan at a stronger level than the consensus forecast. Chinese trade data that surprised on the upside and bargain hunting further supported gains. Market players turned bearish on Friday after President Trump conceded that a meeting on trade with China next month might not materialize. The Chinese, while facing a slowdown in the economy, certainly did not want to appear eager to negotiate after being so humiliatingly slapped with more tariffs. Doing otherwise would be falling right into the playbook of the Trump administration, making them look desperate and weakening their hands.

Amid the economic jitters, market players were less inclined to place their bets on the Chinese internet sector (CQQQ)(FXI). In particular, the sector representative ETF, the KraneShares CSI China Internet ETF (KWEB) fell 3.16 percent for the week, with the majority of its holdings in the red. Gains at NetEase (NTES) and Tencent Music Entertainment Group (TME) helped ameliorate the sector losses. As explained in a past issue of the Chinese Internet Weekly, I found this ETF holding the most representative stocks in the sector. An overview of the week's share price movements of the top few holdings of KWEB as compared with the ETF itself is provided as follows for convenient references in the subsequent sections.

Chart Data by YCharts

YY: Facing challenges from multiple fronts

Live broadcasting player YY (YY) had an ignominious double-digit percentage fall last week, extending a losing streak from mid-July. YY is not alone in experiencing a bearish patch. Its peers Momo (MOMO), Huya (HUYA), and newly-listed DouYu (DOYU) are also struggling to find investor favor. Besides intensifying rivalry among themselves and rising costs, the industry faces competition from 'outsiders' including Alibaba (BABA) and Tencent (OTCPK:TCEHY) which have been pushing their in-house versions.

Chart Data by YCharts

The greater threat, however, is coming from the competition for users' time. In a previous Chinese Internet Weekly, I gave a personal anecdote whereby I noticed the habit of my Chinese associates to launch their Douyin app (or Kuaishou) whenever we would go on the road for trips lasting an hour or more. Douyin is TikTok's Chinese equivalent, both operated by ByteDance (BDNCE). There are also up and coming alternative apps to watching short videos from Baidu (BIDU) and Tencent (OTCPK:TCEHY), all quick to capitalize on the latest form of binge-watching.

Source: QuestMobile/SCMP-Abacus

Even as Tencent's Weishi and Yoo apps are seeing impressive year-on-year growth in monthly active users ('MAU'), albeit with "the support of half of the company," the social media and gaming titan is intent on spreading its eggs in more baskets. Reputable local media Beijing News reported Tencent is close to acquiring a 30-40 percent stake in Kuaishou. The latest round of funding could bring Kuaishou’s valuation to at least $25 billion. It wouldn't be the first monetary injection into Kuaishou for Tencent, having participated in three of Kuaishou’s eight rounds of fundraising previously, but it would certainly be the largest.

Tencent could have found the move into gaming by Kuaishou promising and complementary to its own core gaming business. While it gained prominence as a video-sharing and live-streaming app, Kuaishou recognized the importance of 'locking-in' users and branched into enabling them to play games within the app in 2018. Its first game, Tiao Tiao Qiu, was a platform-jumping game similar to a 'mini-game' found within the ubiquitous messaging app of Tencent. Given there was no protest by Tencent, the move into gaming by Kuaishou could be taken as being 'approved' by the former.

Kuaishou's revenue generation ability could also have attracted Tencent. Despite having fewer MAUs than TikTok, at 316 million MAUs versus 503 million MAUs, Kuaishou garnered nearly $78 million in gross revenue in the second quarter, a 57 percent increase over the prior-year period, compared with just $27.2 million in the same period at TikTok. Google's (GOOG)(GOOGL) YouTube has more than five times the MAUs compared with Kuaishou but it only generated less than double the revenue the latter did in the second quarter.

We all have 24 hours each day. There are only so many things we can do in a day. The more people spend on doing something, another activity would inevitably experience lower participation. YY and its peers are in the latter predicament. Multi-tasking can result in some overlapping but that is more relevant in the scenario where the consumer leaves the television switched on playing dramas from iQIYI (IQ) (typically slower pace and you can re-watch at a later time) and watching short-videos on the phone - not viewing short-videos from Kuaishou/TikTok and live-streaming from YY simultaneously, both fast-paced formats.

Despite the precipitous fall in its share price since April, the consensus price target has yet to be revised correspondingly. Hopefully, the analysts still have high conviction on their calls. Otherwise, we should be expecting more downside pressure when analysts issue perhaps overdue downgrades or downward revisions in target price. Increasing investments into its competitors as well as new forms of entertainment could dim the outlook for YY further. As such, even if YY reports a good set of Q2 2019 results scheduled for Tuesday, the market might not be too confident and buy into the name.

Chart Data by YCharts

NetEase stuns naysayers with its Q2 2019 results

NetEase reported its second quarter 2019 results on Wednesday after normal trading closed. Investors were naturally delighted with a huge beat by $1.45 on its Q2 GAAP EPS of $3.44. Non-GAAP EPS of $4.09 was also a more-than-decent beat by $1.40. It should be noted that the gaming, edutech, and e-commerce titan had already surpassed consensus analyst expectations in the prior three quarters. With the nearly 40 percent earnings surprise most recently in the first quarter, we would have expected analysts to be more aggressive in their forecast to avoid another embarrassing far-off estimation. That makes the latest beat, with an even higher percentage surprise, all the more impressive.

NetEase NTES earnings surprise from Seeking Alpha Essentials

Source: Seeking Alpha Essential

It wasn't all rosy. NetEase actually missed by $20 million on its Q2 2019 revenue of $2.73 billion. That small discrepancy, of course, pales in comparison with the earnings beat. Not forgetting the Q2 revenue was a comfortable 15.3 percentage increase year-on-year despite the gaming sector still undergoing significant regulatory headwinds.

The lower revenue compared with expectations could also be a result of a greater emphasis on protecting margins at its e-commerce division albeit at the expense of slower year-on-year growth. E-commerce gross margin in Q2 2019 rose to 10.9 percent compared to 10.1 percent the same period a year ago and was the highest in seven quarters.

NetEase Q2 2019 results presentation, e-commerce net revenue and gross margins

Source: NetEase Q2 2019 results presentation

There were many things to like from the earnings call. I highlight some of the key ones as follows.

First, the management spoke of the company's success in keeping users engaged through regular updates and expansion packs for its game titles. Such incremental revisions would be much easier to push through compared to new titles that draw in regulatory scrutiny. At the same time, the older titles are proven and still attracting loyal players. For instance, NetEase continues to see promise in its 15-year-old Fantasy Westward Journey Online. It has introduced close to 30 major expansion packs thus far, amounting to an average of around two major expansion packs per year with "many smaller-scale updates along the way".

Second, even with old games keeping their shine, NetEase has seen success with fresh titles both in China as well as overseas, topping download charts and garnering favorable recommendations. Its three new games introduced in Japan - LifeAfter, Cyber Hunter, and Super Mecha Champions, a mecha anime shooting game which was just released in July - topped Japan’s iOS downloads chart shortly after their launches. Overseas games revenue accounted for more than 10 percent of NetEase total games net revenue in Q2 2019.

"BuildTopia is a real-time creative shooting game topping the iOS download chart within a day of its launch, and Sky is an adventure game bringing users a heartwarming experience and receiving multiple recommendations from the Apple store. We also launched an updated version of Tom and Jerry, which proved instantly popular among younger players, taking the game to the top of the iOS downloads chart shortly after its launch and continues to trend well with a growing user base." - Charles Yang, Chief Financial Officer, NetEase

Third, there has been concrete progress in NetEase efforts to improve operational efficiency in its e-commerce businesses. Its self-built bonded warehouse in Ningbo, meant for Kaola, began trial operation in June. It has also managed to strengthen its partnerships, signing strategic agreements with additional international brands such as L’Oreal and Maybelline.

Fourth, NetEase Cloud Music app has seen a 50 percent expansion in user base from last year to over 800 million users. Subscriber numbers, arguably the more important metric compared to advertising dollars from free users, are growing even faster at 135 percent year-over-year.

Fifth, the management shared that a cafe and shop NetEase had opened in July has been doing well. The theme is based on a game created by NetEase, with popular characters from the game featured throughout the cafe and shop. Such online-to-offline initiatives reflect well on NetEase's ability to catch up on its internet peers including Alibaba and which have long showcased their own 'O2O' developments.

The favorable initial reception to the cafe and shop provided NetEase with the confidence to expand on the concept and extract greater value from its existing gaming intellectual property at a time when new titles are getting tougher to come to the market. Furthermore, with the manufacturing sector facing serious headwinds and services rising to the occasion, the wading of NetEase into consumerism bodes well for the company.

Finally, Natalie Wu, an analyst from China International Capital Corporation, one of China's leading investment banking firms, took the opportunity to get the management to provide an update and greater clarity on the collaboration with Disney's (DIS) Marvel announced in May. While the replies were lacking in details, it was revealed that there would be "several games across different genres" coming with different schedule and timetable as NetEase works with Marvel. More importantly, the partnership will go "beyond games."

Marvel and NetEase collaboration

Source: Marvel

While the management updated at length on the numbers for its edutech subsidiary Youdao and spoke on the new products, nothing was mentioned regarding the rumored listing. The online education arm was just weeks ago reported by some outlets to be seeking a valuation of about $2.0 billion. Interestingly, no analyst questioned the management on this, an indication that the rumor might not be substantiated.

Quant traders would also be excited with the 'Very Bullish' rating for NetEase that has a very high score of 4.77 out of 5. Superior earnings revisions and profitability continue to drive a stronger rating for NetEase even as its momentum and value trail behind its peers. Subscribers of Seeking Alpha Essential will be able to dive deep into the various components that derive the rating for each quant category.

NetEase NTES quant rating from Seeking Alpha Essentials

Source: Seeking Alpha Essential

Earnings watch this week

This week would be an interesting one for those watching the Chinese internet sector due to the raft of earnings reports. We have (JD) and newly-listed Douyu taking the lead, reporting the financial results for the second quarter before the U.S. markets open on Tuesday. YY and Huya will do so after the markets close.

On Wednesday, internet behemoth Tencent will publish its quarterly results before the U.S. markets open. Tencent and e-commerce player Vipshop (VIPS) is scheduled to report after the markets close. Hot on the heels would be Alibaba which will report its unaudited financial results for the quarter and fiscal year ended March 31 before U.S. trading begins. Share with fellow readers your expectations before the result releases and your thoughts thereafter!

Disclosure: I am/we are long BABA, BIDU, NTES, JD, TCEHY, DIS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.