NetEase, Inc. 2011 Form 20-F Summary
Reporting period: Fiscal year ended December 31, 2011. The filing is an annual Form 20-F and does not provide a clear standalone fourth-quarter 2011 income statement or cash-flow schedule. Financial statements are audited and prepared under U.S. GAAP. NetEase operates primarily in China through subsidiaries and variable interest entities, or VIEs.
Business Context
NetEase provides online games, Internet portal and advertising services, wireless value-added services, e-mail, search, payment and emerging e-commerce services. Online games remained the core business, representing approximately 88.4% of 2011 net revenue. Major titles included Fantasy Westward Journey, Westward Journey Online II, Tianxia III, Ghost, Heroes of Tang Dynasty and Blizzard-licensed World of Warcraft and StarCraft II.
NetEase consolidated several VIEs because management concluded that it controlled their significant activities and received substantially all related economic benefits. Substantially all revenue was generated in China.
Financial Performance and Liquidity
| Metric | 2011 | 2010 | Change |
|---|---|---|---|
| Total revenue | RMB7,472.8 million | RMB5,659.8 million | +32.0% |
| Net revenue | RMB7,290.7 million | RMB5,507.7 million | +32.4% |
| Online game net revenue | RMB6,448.6 million | RMB4,854.5 million | +32.8% |
| Advertising net revenue | RMB720.1 million | RMB572.7 million | +25.7% |
| Wireless value-added services and other net revenue | RMB122.0 million | RMB80.5 million | +51.5% |
| Gross profit | RMB4,918.4 million | RMB3,708.8 million | +32.6% |
| Gross margin | 67.5% | 67.3% | +0.2 percentage points |
| Operating profit | RMB3,323.4 million | RMB2,544.3 million | +30.6% |
| Operating margin | 44.5% | 45.0% | Down 0.5 percentage points |
| Net income attributable to shareholders | RMB3,234.3 million | RMB2,235.8 million | +44.7% |
| Net margin on net revenue | 44.4% | 40.6% | Improved |
| Operating cash flow | RMB4,072.9 million | RMB2,855.0 million | +42.6% |
| Capital expenditures | RMB410.1 million | RMB298.0 million | +37.6% |
Basic and diluted earnings were RMB0.99 per ordinary share and RMB24.76 and RMB24.68 per ADS, respectively. One ADS represents 25 ordinary shares.
At December 31, 2011, cash and cash equivalents were RMB2,214.6 million, time deposits were RMB9,704.8 million, and held-to-maturity investments were RMB993.6 million. Total current assets were RMB14,474.2 million against current liabilities of RMB2,282.6 million. Total liabilities were RMB2,346.5 million and total shareholders’ equity was RMB13,098.5 million. The filing reports no interest expense in 2010 or 2011 and no material debt securities or bank borrowings.
Management stated that cash, operating cash flow and short-term investments were sufficient to meet anticipated cash needs for at least the following 12 months. However, approximately RMB2.4 billion, or 18% of consolidated net assets, was restricted from transfer by PRC statutory reserve and other regulatory requirements. Approximately 97.4% of cash and cash equivalents and time deposits were held by PRC subsidiaries and VIEs.
Material Changes Versus 2010
- Growth was led by self-developed games and continued expansion of World of Warcraft, together with the April 2011 launch of StarCraft II in China.
- Online game costs increased 34.9%, driven by higher Blizzard royalties and consultancy fees, server custody costs, staffing, depreciation and amortization.
- Total operating expenses increased 37.0%. Selling and marketing expense rose 29.3%, general and administrative expense rose 47.8%, and research and development expense rose 46.4%.
- Advertising margin improved to 47.2% from 45.4%, while online game margin remained broadly stable at 71.2% versus 71.6%. Wireless value-added and other services remained loss-making at the gross-profit level, although the gross loss narrowed to RMB10.9 million from RMB27.4 million.
- Net profit benefited from a lower effective tax rate of 10.9% versus 13.4% in 2010, including a reported RMB47.1 million tax benefit associated with Key Software Enterprise recognition.
- NetEase recorded a one-time RMB50.3 million impairment charge for the StarCraft II license rights. The impairment reduced future amortization expense.
- Cash and cash equivalents increased 72.3% to RMB2,214.6 million, while total cash, cash equivalents and time deposits increased 25.3% to approximately RMB11.9 billion.
- Research and development spending increased to RMB465.5 million from RMB317.9 million, and full-time employees increased to 6,160 from 5,254.
Guidance, Outlook, Risks and Unusual Items
The filing does not provide quantitative revenue or earnings guidance. Management expected online games to remain the primary revenue source and planned continued investment in new games, expansion packs, item-based games, advertising, e-mail, search and e-commerce.
- Blizzard commitments: Outstanding commitments under the World of Warcraft and StarCraft II license agreements were RMB576.9 million at year-end. NetEase guaranteed payments if Shanghai EaseNet lacked sufficient funds. In March 2012, the World of Warcraft license was extended for three years, with expected additional commitments of approximately RMB1.3 billion.
- Game concentration: Several major titles, including Blizzard-licensed games, generated approximately 83.6% of total net revenue in 2011. Loss of player interest, unsuccessful launches, game cannibalization or licensing disruption could materially affect results.
- Regulatory exposure: The business depends on PRC licenses, content approvals, real-name and anti-addiction requirements, virtual-currency rules and contractual VIE arrangements. Authorities could restrict operations, challenge the VIE structure, revoke licenses or require restructuring.
- Payment platform: Wangyibao was still applying for a Payment Service Permit from the People’s Bank of China. Failure to obtain the permit could adversely affect the payment platform and related operations.
- Liquidity and guarantees: The company had RMB318.7 million of restricted cash, including deposits related to Blizzard royalties and marketing. It also had RMB277.7 million of non-Blizzard contractual commitments and RMB77.6 million of 2012 capital commitments.
- Foreign exchange: NetEase recorded a RMB79.1 million foreign-exchange loss in 2011. It held material Euro- and U.S.-dollar-denominated cash and deposits and did not use hedging instruments.
- Tax incentives: Preferential PRC tax rates and exemptions reduced 2011 taxes by an aggregate reported RMB559.0 million. These benefits are subject to renewal and government review.
- Other unusual items: Share-based compensation was RMB122.0 million in 2011. The filing also reports RMB89.8 million of unconditional government incentives and RMB13.1 million of investment income from held-to-maturity investments.
- Legal and operational risks: The filing reports no material pending legal proceedings, but identifies risks involving intellectual property, cybersecurity, service interruptions, data protection, content censorship, competition and dependence on telecommunications providers.
Investor Verification Priorities
- Verify the annual rather than quarterly scope of the filing; the supplied text does not provide clear standalone 2011 Q4 results.
- Reconcile reported total revenue, business tax, net revenue and segment revenue, particularly the distinction between total and net online game revenue.
- Assess sustainability of growth and margins after the 2011 launch cycle, marketing spending and the StarCraft II impairment.
- Review the concentration of revenue in key games and the economics, renewal terms, guarantees and future commitments associated with Blizzard licenses.
- Evaluate the ability to upstream cash from PRC subsidiaries and VIEs, including the RMB2.4 billion restricted-net-assets balance and the concentration of cash within China.
- Monitor renewal of preferential tax statuses and potential PRC withholding or resident-enterprise tax exposure.
- Review the legal enforceability and regulatory status of the VIE structure and Wangyibao’s payment-service authorization.
- Confirm future share-based compensation, RSU settlement obligations and dilution; unrecognized RSU compensation was RMB253.0 million at year-end.
- Consider the absence of dividends, the expiration of the US$50 million repurchase authorization without purchases, and the influence of founder and CEO William Lei Ding, who beneficially owned approximately 44.5% of ordinary shares.