NetEase, Inc. 2014 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, 2014. The filing presents audited consolidated financial statements for 2012–2014 under U.S. GAAP. NetEase operates primarily in China through subsidiaries and variable interest entities, providing online games, advertising, e-mail, e-commerce, online payment, mobile Internet and other services. Its ADSs trade on Nasdaq under the symbol NTES; each ADS represents 25 ordinary shares.
The filing is annual rather than a standalone fourth-quarter filing. All reported amounts below are in RMB unless otherwise stated; U.S. dollar translations use RMB6.2046 per US$1.00.
Key financial metrics
| Metric | 2013 | 2014 | Change |
|---|---|---|---|
| Total revenues | 9,771.3 million | 12,480.4 million | 27.7% increase |
| Net revenues after sales tax | 9,196.2 million | 11,712.8 million | 27.4% increase |
| Gross profit | 6,717.7 million | 8,451.3 million | 25.8% increase |
| Gross margin | 73.0% | 72.2% | Down 0.8 percentage points |
| Operating profit | 4,352.6 million | 4,765.1 million | 9.5% increase |
| Operating margin | 47.3% of net revenue | 40.7% of net revenue | Lower year over year |
| Net income attributable to NetEase shareholders | 4,443.9 million | 4,756.6 million | 7.0% increase |
| Net margin attributable to shareholders | 48.3% of net revenue | 40.6% of net revenue | Lower year over year |
| Operating cash flow | 5,235.9 million | 5,873.0 million | 12.2% increase |
| Capital expenditures | 218.9 million | 537.4 million | 145.4% increase |
Revenue mix shifted toward diversification. In 2014, online game services generated RMB9,266.2 million of net revenue, advertising generated RMB1,397.1 million, and e-mail, e-commerce and other services generated RMB1,049.6 million. These represented 79.1%, 11.9% and 9.0% of net revenue, respectively, compared with 85.5%, 10.8% and 3.7% in 2013.
Online games remained the core business, but their share declined as advertising and e-commerce expanded. Game revenue growth was supported by Fantasy Westward Journey II, New Westward Journey Online II, mobile games and the January 2014 launch of Hearthstone: Heroes of Warcraft in China. Advertising revenue benefited from stronger demand, greater mobile-news monetization and 2014 FIFA World Cup-related content. E-mail, e-commerce and other revenue more than tripled, primarily due to third-party lottery and insurance services.
Liquidity, debt and balance sheet
- Cash and cash equivalents were RMB2,021.5 million at December 31, 2014, compared with RMB1,458.3 million in 2013.
- Time deposits totaled RMB19,169.6 million, including current and non-current balances; cash, cash equivalents and time deposits totaled approximately RMB21.2 billion.
- Restricted cash was RMB2,628.8 million, including customer deposits, Blizzard-related deposits and collateral for borrowings.
- Short-term investments increased to RMB2,058.6 million from RMB901.2 million.
- Short-term loans totaled RMB2,049.9 million at year-end; the filing reports no material long-term debt.
- Total liabilities were RMB6,862.9 million and shareholders’ equity was RMB23,358.2 million.
- Management stated that cash, operating cash flow and short-term investments should be sufficient for anticipated needs for at least the next 12 months.
- Working capital was RMB20,976.1 million, calculated as current assets less current liabilities.
Material changes versus 2013
- Net revenue increased 27.4%, but operating profit increased only 9.5% because operating expenses rose 55.9%.
- Selling and marketing expense increased 73.3% to RMB1,895.0 million, driven by game, e-commerce, advertising and World Cup-related promotion.
- Research and development expense increased 43.6% to RMB1,323.5 million, reflecting higher game-development headcount, compensation and content-design costs.
- Online game gross margin declined from 79.0% to 77.2%, primarily because mobile and licensed games carry lower margins than internally developed games.
- Advertising gross margin improved from 53.3% to 62.2% as revenue growth produced operating leverage.
- E-mail, e-commerce and other gross margin improved from negative 6.7% to 40.8%, largely because e-commerce revenue is recognized net of related costs.
- The effective income tax rate rose to 12.1% from 10.7%, mainly because 2013 included a one-time RMB304.6 million tax benefit related to prior-year Key Software Enterprise approvals.
- Capital expenditures increased substantially due to new office construction, servers and mailbox infrastructure. Construction in progress was RMB574.9 million at year-end.
- NetEase launched eight self-developed and four licensed mobile games during 2014 and had 12 commercially launched mobile games by year-end.
Cash flow, dividends and commitments
Operating cash flow of RMB5,873.0 million exceeded net income. Investing cash flow was negative RMB4,520.2 million, primarily reflecting time-deposit placements, purchases of short-term investments, capital expenditures and transfers to restricted cash. Financing cash flow was negative RMB778.4 million, including RMB1,983.0 million of dividends and repayment of short-term borrowings.
In May 2014, the board adopted a quarterly dividend policy targeting approximately 25% of anticipated quarterly after-tax net income, subject to board discretion and financial conditions. Dividends declared for the four 2014 quarters were US$0.34, US$0.37, US$0.36 and US$0.39 per ADS. Total dividends relating to fiscal 2014 were RMB1,177.2 million. A US$100 million share-repurchase authorization expired in February 2015 with no repurchases under that program.
Non-Blizzard contractual obligations totaled RMB579.2 million, including rental, server custody, capital and other commitments. Outstanding commitments under Blizzard license agreements for StarCraft II, World of Warcraft and Hearthstone totaled approximately RMB1.7 billion, primarily payable in 2015 and 2016. NetEase also expected approximately RMB765.1 million of commitments for Heroes of the Storm and Diablo III after commercial launch and guaranteed certain obligations of Shanghai EaseNet if it lacked sufficient funds.
Guidance, outlook, commentary and risks
The filing does not provide numerical revenue or earnings guidance. Management emphasized continued investment in internally developed games, mobile games, advertising, e-commerce, research and development, infrastructure and new office facilities.
- Growth depends on maintaining the popularity of key games and successfully launching new games and expansion packs. Several major games accounted for approximately 89.8% of 2014 net game revenue.
- Mobile migration creates growth opportunities but may reduce margins because app stores generally retain approximately 30% of iOS revenue and 30%–50% of Android revenue.
- Blizzard licensing is material and subject to renewal, performance, regulatory approvals and minimum marketing, royalty and hardware commitments.
- Substantially all operations and revenues are conducted through PRC subsidiaries and VIEs. The contractual VIE structure may be difficult to enforce under evolving Chinese law and could be challenged or restricted by regulators.
- The draft PRC Foreign Investment Law discussed in the filing could affect VIE structures, depending on its final provisions and the applicable negative list.
- Online gaming, advertising, payment, e-commerce, content and data services face extensive Chinese regulation, licensing requirements and censorship obligations.
- Online lottery services were affected by a suspension of certain online purchase orders beginning in late February 2015 following regulatory notices. The filing states that the duration and outcome of the suspension were uncertain.
- Other risks include intense competition, dependence on key employees and content providers, cybersecurity and privacy incidents, system interruptions, Renminbi exchange-rate movements, loss of tax incentives, tax and transfer-pricing scrutiny, and restrictions on transferring funds from PRC entities to the Cayman Islands holding company.
- Management and the independent auditor concluded that internal control over financial reporting was effective as of December 31, 2014. No material legal proceedings were pending or threatened, although ordinary-course intellectual-property and other claims may arise.
Important facts for investors to verify
- Reconcile 2014 revenue growth with the sharp increases in marketing and research and development expenses and the resulting margin compression.
- Assess the sustainability and margins of mobile games, licensed games and the rapidly expanded e-commerce business.
- Review Blizzard license renewal status, remaining guaranteed payments, minimum marketing commitments and the commercial prospects of Heroes of the Storm and Diablo III.
- Monitor developments affecting the PRC VIE structure, the draft Foreign Investment Law, licensing requirements and the ability to repatriate cash.
- Verify the impact and duration of the online lottery-service suspension after February 2015.
- Consider the liquidity impact of RMB2.05 billion of short-term borrowings, restricted cash of RMB2.63 billion and substantial Blizzard and capital commitments.
- Evaluate the effect of expiring or changing preferential tax treatments and the RMB734.6 million of unrecognized deferred withholding-tax liabilities on undistributed earnings.
- Review revenue-recognition estimates for permanent virtual items and mobile-game playing periods, which are based on user behavior and may change prospectively.