NetEase, Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

NetEase, Inc. is a Chinese technology company focused on online gaming, music streaming, e-commerce, and education, as well as innovative online services. It’s also the second-largest video game publisher in China, making them a gaming powerhouse with their huge influence in the industry.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

NetEase, Inc. operates across diverse yet interconnected business segments. Let’s look at the company’s major sources of revenue:

  • Online Game Services: This segment is the core of NetEase’s business, where it generates revenue from self-developed and licensed online and mobile games. Games like Fantasy Westward Journey, Onmyoji, and Naraka: Bladepoint are their biggest titles.

NetEase is the second-largest gaming company in China, behind Tencent, and is known for creating blockbuster games, including a few internationally acclaimed ones.

  • Youdao: Youdao is NetEase’s intelligent learning subsidiary. It is a technology firm focused on education technology that provides online learning services such as intelligent learning platform, learning content, digital tools and products, and learning hardware.
  • Cloud Music: NetEase Cloud Music is the company’s popular music streaming platform, which offers online music, live streaming and various social entertainment functionalities. It has become a major player in the music streaming industry in China.
  • Yanxuan: Yanxuan is NetEase’s private-label e-commerce platform, which sells products in a variety of categories, including home furnishings, appliances, food, clothing, and other merchandise.

Revenue Distribution

The revenue stream shows the breakdown of how the company is performing in their several divisions. For the year ended December 31st 2022:

  • Games and related value-added services made up RMB74.2 billion, with net revenues up by 9.6% yoy.
  • Youdao contributed RMB5 billion in revenues, up 15.5% yoy.
  • Cloud Music net revenues were up 30% yoy to RMB8.9 billion, although there was a net loss.
  • Innovative businesses and others segment contributed RMB4.6 billion, up by 13.5% yoy.

Overall, NetEase’s total net revenues increased by 10.2% year-over-year in 2022, reaching RMB94.3 billion. However, as discussed, a significant portion of it (roughly two-thirds) comes from their gaming division. This reliance on the gaming sector makes the company’s total revenue vulnerable to trends and changes in the industry.

The gaming industry in China has seen rapid growth, but it’s also highly competitive and heavily regulated by the government.

Government policies regarding online gaming time and content in China have caused uncertainty in their market share. However, Chinese regulators have resumed approving game licenses, which indicates a degree of normalization.

  • Competition: Tencent, NetEase’s main rival, also focuses on gaming. Other competitors include various domestic and international gaming companies. The need to compete for audience share requires large investments in content creation and marketing, increasing costs for all the participants. Also, companies in the space are constantly competing for market share. A game that was successful today, may become irrelevant the next year, because the players may have moved to other games that has new mechanics. There are also several competitors focused in one or more specific genres, and there are new games and genres coming into the space constantly, making their profits volatile.
  • Music Streaming: The music-streaming space is also competitive, with players like Tencent Music and other global streaming services in China. The market has a lot of regulations and are changing at a high rate.
  • E-commerce: Online retail is well developed in China, but a competitive landscape makes it hard to find a loyal customer base.
  • Education: The online education market is also heavily regulated, therefore, it is an industry with unique risks.

NetEase’s edge lies in a combination of unique titles, a huge user base, strong development skills in the gaming division, and an expansive ecosystem. In addition, the company has been investing heavily in online gaming and digital content, which may strengthen its position in these sectors over the long run.

Financials

NetEase’s financials provide valuable insights into its performance. Let’s analyze them.

Income Statement:

  • Revenue Growth:
    • The company has consistently shown strong and solid revenue growth, particularly in the gaming sector.
    • However, in 2022 the total revenue growth was at 10.2%, down from almost 15% in 2021 and 25% in 2020. This may be a cause for concern.
    • Revenues from online game services increased by 9.6% yoy in 2022, while music streaming went up by 30%.
  • Profitability:
    • The gross margin has remained relatively stable and is high throughout the years.
    • However, Operating profit margins have dipped drastically, down from 23% in 2021 to 12.9% in 2022. There has also been a dip in net income.

Net income was impacted by write-offs and impairments that aren’t a good sign for their future profitability in the core gaming sector.

  • Operating Expenses:
    • Sales and marketing expenses are a large portion of total operating expenses.
    • The increase in R&D and G&A have also affected operating margins negatively.

Balance Sheet

  • Strong Cash Position: As of December 31, 2022, NetEase has significant cash and short-term investment balances (RMB94 billion or $13.6 billion USD).
  • This indicates a strong financial footing, which can be used for expansion and future opportunities, and provides a cushion in case of a crisis.
  • Relatively Low Debt: NetEase has a relatively low level of debt, which is impressive.
  • Good Liquidity: The company’s balance sheet has strong liquidity, providing it with financial resilience against market uncertainty.

While the balance sheet demonstrates positive characteristics like strong cash balance and low debt, there is a high portion of other assets that is difficult to identify. This may be something that the investor has to research further to understand. The overall balance sheet indicates a healthy company with good fundamentals.

Moat Analysis

Based on the above analysis, here is a moat assessment for NetEase:

  • Brand: NetEase has a strong brand image, especially in China’s gaming and music industries, and it has produced some very successful games.
  • Switching Costs: There are some switching costs for their games, music streaming services and other products due to data accumulation, personalized profiles, the learning curve, and habituated users. While other companies can offer similar software, most will stick with their preferred software because of the huge learning curve in setting up their profiles, their data, their configuration and so on. For users on its learning platform, switching costs are high because they have already built their history and are committed to the teachers that teach on the platform.
  • Network Effects: It does have network effects in some areas of its business, primarily the music streaming, cloud gaming, and online gaming industry. However, it is more limited to other non-networking effects than to having a large network effect that dominates the industry.
  • Cost Advantages: Some areas of the business have cost advantages, especially those where the company does most of its development, and operations, such as mobile games.

Therefore, a moat rating is 3 out of 5. The presence of some economic moats provide the company with a competitive advantage, but factors such as the volatility of game tastes, competition from new entrants and new games, and regulatory uncertainty could limit this. As such, it is not a wide and enduring moat. The company still has a relatively short track record and has only recently started to expand internationally. Therefore, time will tell if these moats can really be wide and enduring.

Risks and Business Resilience

  • Regulatory Risk: Gaming regulations in China can drastically affect NetEase’s performance.

Regulatory actions (both current and potential) may impose restrictions on game content, playing time, or monetization models, and that is a major risk that is difficult to predict.

  • Though, recently the Chinese regulators resumed approving video games which can signal the end of regulations in the industry.
  • Intensified Competition: With companies like Tencent and many other global gaming companies in competition, profits can be easily eroded, leading to lower revenue and margins for the company.
  • Changing User Preferences: The preferences of customers are known to change frequently, and that can cause a significant damage to the company.
  • Economic Downturn: A major economic downturn could drastically effect the company’s profitability, causing users to spend less on discretionary items.
  • Diversification Issues: Over-dependence on video games.

Despite these risks, the business has a few traits which point to a level of resilience:

  • Diverse Revenue Streams: While the main stream is online gaming, the company’s other revenue streams in music, education and e-commerce offer diversification against gaming business volatility.
  • Cash Reserves: The huge cash balance of the company also provides safety against major turmoil.
  • Reputation for Quality: NetEase has generally been known to produce high quality games, which give them brand and user recognition.
  • Technological Superiority: In the company’s R&D and new technologies gives a chance to stay ahead of its competition.

Understandability

The business is fairly diverse, and has quite a few moving parts. Understanding it may not be extremely easy for a new investor. Therefore, it gets a rating of 3 out of 5 in understandability. The core business in gaming, which makes up two-thirds of total revenue, is easy to understand, however, when considering newer sectors like Youdao, and other innovative ventures, it is difficult to know the long-term trajectory of each, and what the potential business could look like.

As such, while the company’s operations are diverse, it requires some work to understand each of the revenue streams and how they all intertwine together.

Balance Sheet Health

The company has a solid balance sheet with tons of cash, reasonable levels of debt, and a generally strong financial state. Its various businesses also generate good revenues over time. Therefore, giving a rating of 4/5 to the company’s balance sheet.

However, investors should be aware of the high number of intangible assets and other long-term assets, which may affect their liquidity, if things go badly for the company.

Latest Developments

  • The most recent Q4 2022 earnings report by NetEase showed a 4% YoY increase, compared to a growth of 9.6% for the whole year. The dip may be attributed to increased regulations in the gaming sector, and may signal a slow down of the core business.
  • The company continues to grow its other divisions, especially cloud music. However, profits from these areas are still lagging.
  • The company has also given guidance on lower YoY growth for Q1 2023.