NetEase, Inc. 2013 Form 20-F Summary
Business context and reporting period
NetEase, Inc. filed an annual report on Form 20-F for the fiscal year ended December 31, 2013. The filing presents audited consolidated results for 2011–2013 under U.S. GAAP. It is not a quarterly filing and does not provide a clear standalone fourth-quarter 2013 income statement or cash-flow statement.
NetEase operates primarily in China through subsidiaries and variable interest entities. Its principal businesses are online games, Internet advertising, and e-mail, wireless value-added, e-commerce and other services. American Depositary Shares trade on Nasdaq under the symbol NTES; each ADS represents 25 ordinary shares.
Financial performance and liquidity
| Metric | 2013 | 2012 | Change |
|---|---|---|---|
| Total revenues | RMB9,771.3 million | RMB8,380.0 million | +16.6% |
| Net revenues | RMB9,196.2 million | RMB8,201.0 million | +12.1% |
| Gross profit | RMB6,717.7 million | RMB5,622.9 million | +19.5% |
| Gross margin | 73.0% | 68.6% | +4.4 percentage points |
| Operating profit | RMB4,352.6 million | RMB3,711.6 million | +17.3% |
| Operating margin on net revenues | 47.3% | 45.3% | Improved |
| Net income attributable to shareholders | RMB4,443.9 million | RMB3,637.5 million | +22.2% |
| Net margin on net revenues | 48.3% | 44.4% | Improved |
| Operating cash flow | RMB5,235.9 million | RMB4,224.3 million | +23.9% |
| Capital expenditures | RMB218.9 million | RMB178.7 million | +22.5% |
Revenue mix shifted toward diversification. Online game services represented 85.5% of net revenues, compared with 87.8% in 2012; advertising represented 10.8%, compared with 9.4%; and e-mail, wireless value-added services and others represented 3.7%, compared with 2.8%.
At December 31, 2013, cash and cash equivalents were RMB1,458.3 million, time deposits were RMB17,125.5 million including current and non-current deposits, restricted cash was RMB2,136.7 million, and short-term investments were RMB901.2 million. Short-term borrowings were RMB975.5 million. Working capital was RMB18,564.6 million. Management stated that cash, operating cash flow and short-term investments should satisfy anticipated needs for at least the next 12 months.
Total assets were RMB24,546.3 million and total liabilities were RMB4,378.1 million at year-end. The company had no material long-term debt disclosed beyond other long-term payables of RMB144.9 million and its short-term loan.
Material changes versus the prior comparable period
- Self-developed games drove growth, particularly Fantasy Westward Journey II, New Westward Journey Online II, Kung Fu Master, Heroes of Tang Dynasty II and Ghost II. Comprehensive upgrades, expansion packs and promotional activity supported user engagement.
- Online game net revenues increased 9.2% to RMB7,864.5 million, despite lower revenue from Blizzard-licensed games, including World of Warcraft, as its latest expansion moved further through its life cycle.
- Advertising net revenues increased 28.7% to RMB987.5 million. Average revenue per traditional advertiser increased to approximately RMB1.3 million, while the number of traditional advertisers declined to 662 from 682. The top ten advertisers accounted for 27.2% of advertising revenue, up from 19.3%.
- E-mail, wireless value-added services and others increased 47.8% to RMB344.2 million, helped by e-commerce, e-mail services and game-related accessories. The segment generated a gross loss of RMB23.2 million because of investment in mobile and other services.
- Cost of revenues declined 3.9% to RMB2,478.5 million. Lower sales taxes, Blizzard-related royalties and amortization contributed to the decline, while staff and content costs increased.
- Operating expenses increased 23.7% to RMB2,365.1 million. Selling and marketing expenses rose 20.6%, general and administrative expenses rose 22.2%, and research and development expenses rose 28.3% to RMB921.6 million.
- The effective income tax rate declined to 10.7% from 16.2%, primarily because certain subsidiaries received Key Software Enterprise status and related preferential tax treatment. The filing recognized RMB818.1 million of income tax exemptions and rate reductions for 2013.
- Net cash provided by investing activities remained negative at RMB5,453.3 million, mainly reflecting time-deposit placements and transfers to restricted cash. Financing cash flow was positive RMB86.8 million after a RMB1,005.7 million short-term loan, RMB815.4 million of dividends and RMB106.8 million of share repurchases.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide quantitative revenue or earnings guidance. Management expects online games to remain the primary revenue source, while pursuing mobile games, advertising growth, e-commerce and other mobile Internet initiatives. In 2013, NetEase invested RMB200.0 million for a 27% voting interest in Hangzhou Yixin Technology, the China Telecom joint venture operating YiChat.
- Blizzard commitments: Outstanding commitments under the StarCraft II, World of Warcraft and Hearthstone license agreements totaled RMB670.0 million at December 31, 2013, including RMB557.4 million due in 2014. NetEase guarantees these obligations to the extent Shanghai EaseNet lacks funds. The company also expects approximately RMB375.9 million of commitments after the commercial launch of Heroes of the Storm, plus potential hardware expenditures of up to approximately RMB209.9 million.
- Revenue concentration: Several major internally developed and licensed games generated 90.6% of total net game revenues in 2013. Continued popularity, successful upgrades and new-game launches are critical.
- VIE structure: Substantially all revenues are generated directly or indirectly through consolidated VIEs, including Guangzhou NetEase, Guangyitong Advertising and Shanghai EaseNet. The filing warns that PRC authorities could challenge the structure, restrict operations, revoke licenses, block websites, restrict revenue collection or require restructuring.
- Regulation: Online games, Internet content, advertising, payment services, virtual currency, data protection and online lottery-related services are subject to extensive and evolving PRC regulation and licensing requirements.
- Liquidity restrictions: PRC statutory reserves and other restrictions limited the ability to transfer approximately RMB3.1 billion, or 15% of consolidated net assets, from PRC subsidiaries and VIEs to the company. NetEase accrued RMB344.7 million of withholding tax liabilities for planned offshore distributions and intended to reinvest remaining undistributed PRC earnings.
- Tax and accounting items: Share-based compensation increased to RMB306.3 million from RMB203.0 million. Unrecognized RSU compensation cost was RMB515.4 million at year-end, with a weighted-average remaining vesting period of 3.23 years.
- Shareholder returns: The board adopted a policy targeting annual cash dividends of 20%–25% of anticipated current-year net income, subject to board discretion and legal and liquidity constraints. A fiscal 2013 dividend of US$183.3 million was paid in March 2014. A new US$100 million repurchase program was authorized in February 2014.
- Controls and audit: Management and PricewaterhouseCoopers Zhong Tian LLP concluded that internal control over financial reporting was effective as of December 31, 2013. The filing also highlights that the PRC-based auditor was not subject to PCAOB inspection at the time.
Most important facts for investors to verify
- Confirm the absence of standalone fourth-quarter 2013 financial statements; the filing reports full-year results only.
- Reconcile reported net revenues with total revenues and the substantially higher 2013 sales-tax expense.
- Assess sustainability of growth from upgraded self-developed games as Blizzard-licensed game revenue declines.
- Review the RMB670.0 million Blizzard commitment and guarantee exposure, including the Heroes of the Storm contingent commitment.
- Evaluate the legal, cash-transfer and consolidation risks associated with the PRC VIE structure.
- Determine how much of the RMB18.6 billion cash, deposits and short-term investments was held by PRC subsidiaries or VIEs and therefore subject to transfer restrictions.
- Assess the sustainability of the 10.7% effective tax rate and the renewal of preferential tax statuses.
- Monitor advertising concentration, mobile and YiChat investment performance, share-based compensation dilution and future repurchases.