NetEase, Inc. Form 20-F Summary
Business context and reporting period
This is NetEase’s annual report on Form 20-F for the fiscal year ended December 31, 2019, prepared under U.S. GAAP. The filing does not provide a separate standalone 2019 fourth-quarter income statement; the figures below are primarily full-year results. NetEase operates online games, Youdao intelligent-learning services, NetEase Cloud Music, advertising, live streaming, e-commerce and other internet services, primarily in China. Its online businesses are conducted partly through contractual arrangements with PRC variable interest entities.
In September 2019, NetEase sold Kaola to Alibaba for approximately US$1.9 billion. Kaola was deconsolidated and reported as discontinued operations. Youdao completed an IPO in October 2019, while NetEase retained control and continued to consolidate it.
Financial performance and key metrics
| RMB millions, except percentages | 2018 | 2019 | Change |
|---|---|---|---|
| Total net revenue | 51,178.6 | 59,241.1 | 15.8% |
| Gross profit | 27,346.1 | 31,555.3 | 15.4% |
| Gross margin | 53.4% | 53.3% | Down 0.1 pp |
| Operating profit | 9,977.3 | 13,790.7 | 38.2% |
| Net income from continuing operations | 8,616.1 | 13,468.6 | 56.3% |
| Net income attributable to NetEase shareholders | 6,152.4 | 21,237.5 | 245.2% |
| Continuing-operations margin | 16.8% | 22.7% | Up 5.9 pp |
| Operating cash flow from continuing operations | 14,659.8 | 16,911.0 | 15.4% |
| Capital expenditures | 2,169.4 | 1,209.5 | Down 44.3% |
2019 revenue was approximately US$8.51 billion and continuing-operations net income was approximately US$1.93 billion using the filing’s RMB6.9618 per US$1 exchange rate. Online games generated RMB46,422.6 million, or 78.4% of revenue; Youdao generated RMB1,304.9 million; and innovative businesses and others generated RMB11,513.6 million.
- Online-game revenue increased 15.5%, led by mobile games. Mobile games represented 71.4% of online-game revenue versus 71.0% in 2018.
- Youdao revenue increased 78.4%, primarily from learning services and products.
- Innovative businesses and others revenue increased 12.3%, driven mainly by NetEase Cloud Music, NetEase CC live streaming and Yanxuan.
- Research and development expense increased 14.0% to RMB8,413.2 million, while selling and marketing expense decreased 10.0% to RMB6,221.1 million.
- Investment income improved to RMB1,306.3 million from a RMB22.4 million investment loss in 2018. The 2019 figure included fair-value gains on investments and short-term-investment income.
- Basic and diluted earnings per share were RMB6.59 and RMB6.53, respectively; basic and diluted earnings per ADS were RMB164.86 and RMB163.37, respectively. Each ADS represented 25 ordinary shares.
Liquidity, debt and capital resources
- At December 31, 2019, NetEase held RMB3,246.4 million in cash and cash equivalents, RMB55,847.1 million in current and non-current time deposits, RMB15,312.6 million in short-term investments and RMB3,150.4 million in restricted cash.
- Short-term loans were RMB16,828.2 million. The filing states that current cash, operating cash flow and short-term investments should fund anticipated needs for at least the next 12 months.
- Net cash provided by continuing operating activities was RMB16,911.0 million, compared with RMB21,304.5 million of cash used in continuing investing activities, including RMB1,209.5 million of property, equipment and software purchases.
- NetEase had a US$500 million revolving facility, of which US$300 million was undrawn at year-end, plus US$1,015.7 million of unused uncommitted credit facilities.
- Contractual commitments totaled approximately RMB11,196.1 million, including RMB1,472.6 million of capital commitments and RMB8,092.7 million for royalties and licensed content.
- PRC subsidiaries and VIEs had RMB14.1 billion of restricted net assets, approximately 23% of consolidated net assets, limiting transfers to the Cayman Islands holding company.
Material changes versus the prior comparable period
- Revenue growth accelerated across the principal continuing businesses, and operating profit recovered from the 2018 decline.
- Continuing-operations profitability improved substantially because revenue growth exceeded operating-expense growth and investment income increased.
- Net income attributable to shareholders was significantly increased by the Kaola disposal. Discontinued operations contributed RMB7,962.5 million of net income in 2019, including an approximately US$1.257 billion one-time net gain on disposal, versus a RMB2,138.7 million loss in 2018.
- Gross margin was broadly stable overall, but Youdao’s margin declined to 28.4% from 29.6%, while innovative businesses and others remained a lower-margin segment at 15.1%.
- NetEase issued approximately RMB6,941.0 million of redeemable and noncontrolling interests, primarily associated with subsidiary financing, and paid RMB8,840.6 million of dividends.
- NetEase Cloud Music completed additional financing while NetEase retained control; external investors held approximately 37.4% of NetEase Cloud Music at year-end.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide quantitative revenue, earnings or margin guidance. Management emphasizes continued investment in new online games, mobile-game development, international expansion, Youdao technology and other innovative businesses.
- Key operating risks include rapid changes in player preferences, dependence on successful new games, mobile-app-store revenue sharing, licensed-game relationships, game-approval delays and restrictions on minors’ gaming activity.
- Revenue is concentrated in online games, with the top five games accounting for 36.8% of total revenue in 2019. Mobile-game margins are generally lower than PC-game margins because of platform revenue sharing.
- PRC regulatory, licensing, content-censorship, data-security, foreign-investment and VIE-structure risks could restrict operations or impair NetEase’s ability to consolidate VIE results.
- Youdao disclosed potential uncertainty regarding permits, filings and regulatory compliance for online education services and educational applications.
- COVID-19 emerged after the 2019 reporting period. The company reported higher game-player traffic and server-capacity complaints during the outbreak and stated that, as of the filing date, it was not aware of a material adverse financial-statement impact; future effects remained uncertain.
- Revenue recognition for in-game virtual items depends on estimates of paying players’ average playing periods and churn. This estimate was identified as a critical audit matter.
- PricewaterhouseCoopers Zhong Tian LLP gave an unqualified opinion and concluded that internal control over financial reporting was effective as of December 31, 2019.
Most important facts for investors to verify
- Separate recurring continuing-operations earnings from the nonrecurring Kaola disposal gain.
- Confirm the sustainability of mobile-game growth, player concentration and the effect of app-store revenue sharing on margins.
- Review cash accessibility, VIE-level liquidity, PRC dividend restrictions and the RMB14.1 billion of restricted net assets.
- Assess short-term borrowings, subsidiary guarantees, contractual commitments and the maturity profile of licensed-content obligations.
- Monitor PRC regulation of games, online education, data security, foreign investment and VIE contractual arrangements.
- Evaluate Youdao’s path to profitability and NetEase Cloud Music’s financing, ownership dilution and funding requirements.
- Review the assumptions supporting deferred game revenue and the estimated average playing period of paying players.
- Check subsequent developments related to COVID-19, the PUBG litigation and any changes affecting U.S.-listed China-based issuers and auditor oversight.