NetEase: Marketing Expenses And New Games In The Spotlight
Summary
- NetEase's 4Q 2020 earnings fell short of market expectations, and this was largely attributable to higher-than-expected selling and marketing expenses and slower-than-expected revenue growth for its online game services business.
- NetEase's key new games that are expected to be launched in 2021 are largely licensed games targeting the overseas markets, which is negative in my opinion.
- NetEase trades at consensus forward FY 2021 and FY 2022 P/E multiples of 26.2 times and 22.6 times, respectively.
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Elevator Pitch
I have a Neutral rating for NetEase, Inc. (NASDAQ:NTES).
NetEase's 4Q 2020 earnings fell short of market expectations, and this was largely attributable to higher-than-expected selling & marketing expenses and slower-than-expected revenue growth for its online game services business. Also, NetEase's key new games that are expected to be launched in 2021 are largely licensed games targeting the overseas markets, which is negative in my opinion.
NetEase trades at consensus forward FY 2021 and FY 2022 P/E multiples of 26.2 times and 22.6 times, respectively, which represents a discount to its peer Tencent Holdings Limited (OTCPK:TCEHY) (OTCPK:TCTZF) [700:HK]. While NetEase does deserve to be valued at a discount to Tencent which is a giant in the Chinese internet sector, the valuation discount could possibly be narrowed over time as NetEase invests to grow its online education and other businesses.
I assign a Neutral rating to NetEase considering the above-mentioned factors.
Company Description
NetEase calls itself "a leading China-based internet technology company that develops and operates some of China's most popular online PC and mobile games" which also "offers other innovative services, including online education, music streaming and a private label e-commerce platform" in the company's investor presentation slides. NetEase was established in 1997 and listed on Nasdaq in 2000.
An Overview Of NetEase's Business Segments
Source: NetEase's 4Q 2020 Results Presentation Slides
The core online game services business contributed 74% and 89% of NetEase's revenue and gross profit, respectively for FY 2020. The company derived the remaining 22% and 4% of its FY 2020 top line from its innovative businesses & others and Youdao (DAO) (Chinese online education company) business segments, respectively.
Higher-Than-Expected Selling & Marketing Expenses Were A Drag On 4Q 2020 Results
NetEase reported its 4Q 2020 financial results on February 25, 2021, and the company's earnings in the fourth quarter of last year were below consensus estimates.
The company's 4Q 2020 revenue grew by +25.6% YoY from RMB15,735 million in 4Q 2019 to RMB19,762 million in 4Q 2020. In USD terms, NetEase's top line was $3,029 million in 4Q 2020, which fell short of sell-side analysts' forecasts by approximately $20 million. NetEase's innovative businesses & others and Youdao business segments did well in the fourth quarter of FY 2020 in terms of revenue growth, but the company's online game services business was a slight disappointment.
Revenue for the innovative businesses & others segment expanded by +34.7% QoQ and +41.3% YoY to RMB5,255 million in 4Q 2020, while Youdao's top line increased by +23.5% QoQ and +169.7% YoY to RMB1,107 million over the same period. In contrast, NetEase's online game services business saw a -3.3% QoQ decline and a +15.5% YoY increase in revenue in the most recent quarter.
More importantly, NetEase's net profit attributable to shareholders fell by -67.4% QoQ and -68.0% YoY to RMB976 million in 4Q 2020. The company's diluted earnings per share dropped by -67.3% QoQ and -69.4% YoY to RMB1.43 or $0.22 in the most recent quarter. Market consensus was expecting NetEase to deliver diluted earnings per share of $0.30 in 4Q 2020. Foreign exchange losses and higher-than-expected selling & marketing expenses were the key reasons for NetEase's weaker-than-expected bottom line.
NetEase suffered from net foreign exchange losses amounting to RMB1.8 billion or $276 million in 4Q 2020, which the company attributed to "higher unrealized exchange losses arising from the company's U.S. dollar-denominated bank deposits and short-term loan balances as the exchange rate of the U.S. dollar against the RMB fluctuated over the periods" in its 4Q 2020 earnings release.
Considering that the foreign exchange losses were largely unrealized and could potentially reverse in subsequent quarters depending on foreign exchange movements, the greater concern lies with NetEase higher-than-expected selling & marketing expenses.
NetEase's selling & marketing expenses rose by +43.4% YoY from RMB17,353 million in 4Q 2019 to RMB24,892 million in 4Q 2020, as compared to the company's +25.6% YoY revenue growth over the same period. The selling & marketing expenses-to-revenue ratio increased from 13.7% in 4Q 2019 to 15.6% in 4Q 2020.
At the company's 4Q 2020 earnings call on February 25, 2021, NetEase noted that "despite intense market-wide competition for user acquisition during the summer, Youdao's advertising strategy promoted healthy results and was ROI (Return On Investment) driven." The company also highlighted that "excluding Youdao, our selling and marketing expenses as a percentage of net revenues were 12.2% compared with 12.9% in the prior quarter, which is relatively stable."
In other words, the sharp increase in selling & marketing expenses for the company was mainly due to Youdao, so the strong revenue growth for Youdao (as highlighted above) in 4Q 2020 came at the expense of significantly higher marketing spend and lower profitability.
Looking ahead, selling & marketing expenses for NetEase and Youdao could remain elevated going forward. Youdao stressed at the company's FY 2020 results briefing on February 25, 2021 that "the key metrics to drive growth of our business is now the sales and marketing" and "we will expect, still, a large-scale kind of customer acquisition activities, kind of high-level of that in the marketplace."
All Eyes On New Games And Sales Mix For Online Game Services Business
As mentioned in the preceding section, NetEase's online game services business did not perform as well as expected in the last quarter of FY 2020, so this puts the company's new games and sales mix in the spotlight.
NetEase's new games pipeline includes "Infinite Lagrange, Harry Potter: Magic Awakened, The Lord of the Rings: Rise to War, Elysium of Legends, Nightmare Breaker, Ghost World Chronicle, Diablo® Immortal™ and Pokémon Quest" as per the company's 4Q 2020 results presentation slides.
The company emphasized at its 4Q 2020 results briefing in late-February 2021 that "we are very confident and excited about our (new games) lineups for 2021" and it noted specifically that "Harry Porter, Diablo Immortal and Pokémon now all have already received their license approvals (in China)" and they "are developed with the intention for a global launch."
This draws attention to NetEase's sales mix for its online game services business. The company's key new games that are expected to be launched in 2021 are largely licensed games targeting the overseas markets, which is negative in my opinion. It's safe to assume that NetEase's licensed games are less profitable for the company as compared to its self-developed games, taking into account licensing costs. Also, in general, NetEase's foreign licensed games that it introduces to the domestic market are likely to be less popular in China vis-a-vis its self-developed games targeting the domestic market.
Separately, NetEase also has significant exposure to the PC games market, which is perceived to have inferior growth prospects as compared to the mobile games market. In the fourth quarter of FY 2020, revenue for NetEase's PC games only increased by approximately +8% YoY, as compared to a +19% YoY revenue growth for mobile games in the same quarter. In the past two years, NetEase typically derived more than a quarter of its online game services revenue from mobile games.
Notably, NetEase highlighted at its recent 4Q 2020 results briefing that "PC will continue to be an important part of our game strategy" considering the "unique specifications that the PC games can have and the user experience that PC games can deliver to our gamers."
Valuation And Risk Factors
The market values NetEase at consensus forward FY 2021 and FY 2022 P/E multiples (according to normalized earnings as estimated by sell-side analysts) of 26.2 times and 22.6 times, respectively based on its share price of $108.26 as of March 5, 2021. As a comparison, NetEase's peer Tencent Holdings Limited trades at 34.4 times consensus forward FY 2021 P/E and 30.0 times consensus forward FY 2022 P/E.
All the sell-side estimates used in this article are obtained from S&P Capital IQ.
NetEase's key risk factors are higher-than-expected selling & marketing expenses going forward that do not translate to revenue growth or market share gains, and new games launched in 2021 and beyond failing to meet market expectations.
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