NetEase.com, Inc. 2010 Form 20-F Summary
Business context and reporting period
NetEase.com, Inc. is a Cayman Islands holding company operating primarily in China through subsidiaries and variable interest entities. Its principal businesses are online games, Internet advertising, and wireless value-added and other services. The filing is an annual Form 20-F for the fiscal year ended December 31, 2010, prepared under U.S. GAAP. It is not a quarterly filing, although the requested period is identified as 2010 Q4.
Online games remained the core business, including internally developed MMORPGs and licensed Blizzard games, principally World of Warcraft. The company also operates the NetEase portal, advertising services, Youdao search, e-mail and related premium services.
Key financial metrics
| Metric | 2010 | 2009 | Change |
|---|---|---|---|
| Total revenue | RMB5,659.8 million | RMB3,823.5 million | +48.0% |
| Net revenue | RMB5,507.7 million | RMB3,756.9 million | +46.6% |
| Online game net revenue | RMB4,854.5 million | RMB3,339.9 million | +45.3% |
| Advertising net revenue | RMB572.7 million | RMB346.7 million | +65.2% |
| Wireless value-added and other net revenue | RMB80.5 million | RMB70.3 million | +14.5% |
| Gross profit | RMB3,708.8 million | RMB2,784.6 million | +33.2% |
| Operating profit | RMB2,544.3 million | RMB2,023.4 million | +25.7% |
| Net income attributable to shareholders | RMB2,235.8 million | RMB1,850.4 million | +20.8% |
| Operating cash flow | RMB2,855.0 million | RMB2,094.5 million | +36.3% |
- Gross margin declined to approximately 67.3% from 74.1%; operating margin declined to approximately 45.0% from 53.9%; net margin declined to approximately 40.6% from 49.3%.
- Online games represented 88.1% of net revenue, advertising 10.4%, and wireless value-added services and others 1.5%.
- Online game gross margin fell to 71.6% from 80.9%, primarily because of Blizzard royalties, technical fees, server costs, license amortization, depreciation and higher staffing costs.
- Advertising gross margin improved to 45.4% from 32.0%, reflecting stronger sales execution, cost control and event-related revenue.
- Wireless value-added services and others remained loss-making at a gross loss margin of 34.0%.
- Basic and diluted earnings were RMB0.69 per ordinary share and RMB17.22 and RMB17.14 per ADS, respectively.
Cash, liquidity and debt
- Cash was RMB1,285.1 million and time deposits were RMB8,194.0 million at December 31, 2010. Restricted cash was RMB140.6 million.
- Working capital was RMB8,798.7 million, compared with RMB6,594.6 million at year-end 2009.
- Total liabilities were RMB1,863.0 million, including current liabilities of RMB1,828.2 million and long-term payables of RMB34.8 million. The filing reports no interest-bearing debt outstanding and no interest expense in 2009 or 2010.
- Total shareholders’ equity was RMB9,723.6 million. Total assets were RMB11,586.7 million.
- Capital expenditures were RMB298.0 million, primarily for the Hangzhou research and development complex, office improvements, servers and software.
- Investing cash outflow was RMB2,621.2 million, driven mainly by placement and rollover of time deposits. Financing cash inflow was RMB24.1 million, primarily from employee option exercises.
- Management stated that cash, cash equivalents and operating cash flow should be sufficient for anticipated needs for at least the next 12 months.
Material changes versus the prior comparable period
- Growth was led by the first full year of World of Warcraft operations, the Wrath of the Lich King expansion, and growth in Tianxia II, Heroes of Tang Dynasty and Westward Journey Online II.
- Game licensing revenue represented 25.6% of total net revenue in 2010, compared with 9.8% in 2009.
- Cost of revenue increased 85.0%, substantially faster than revenue, as Blizzard-related royalties and technical costs increased. Online-game technology costs rose to RMB677.9 million from RMB214.7 million.
- Selling and marketing expense increased 86.8% to RMB657.0 million, reflecting game promotions, branding, advertising and higher sales compensation.
- Research and development expense increased 30.2% to RMB317.9 million. The company had approximately 1,400 personnel dedicated to online-game research and development.
- Net foreign exchange expense was RMB89.5 million in 2010 versus a net foreign exchange gain of RMB9.6 million in 2009, primarily due to translation losses on euro-denominated deposits.
- The effective tax rate declined to 13.4% from 14.6%, reflecting preferential tax treatments. Such benefits increased 2010 net income by an aggregate RMB376.7 million, according to the filing.
- Management reclassified facility costs in the fourth quarter of 2010 among cost of revenue, selling and marketing, research and development, and general and administrative expense. Prior periods were reclassified for comparability; total operating costs and cash flows were unchanged.
- The company recognized RMB42.1 million of revenue from dormant game accounts in 2010, compared with RMB101.6 million in 2009.
Guidance, outlook, commentary, risks and unusual items
- No specific quantitative revenue, earnings or margin guidance is provided. Management expects continued investment in new games, game updates, 3D technology, branding, paid search and online video capabilities.
- Management expects increasing competition, higher staffing and marketing costs, greater bandwidth requirements and continued pressure from the shift toward item-based games.
- The company expects portal fixed costs and bandwidth expenses to rise for at least the next several quarters without a corresponding increase in revenue; online video may require additional streaming technology investment.
- The company guaranteed certain Blizzard-related license, royalty, consultancy, marketing and hardware obligations if Shanghai EaseNet lacks sufficient funds. Outstanding license-contract commitments were approximately RMB1.3 billion at December 31, 2010, and potential hardware commitments could reach approximately RMB1.4 billion over the applicable license terms.
- Blizzard-related arrangements involve Shanghai EaseNet, which is wholly owned by William Lei Ding, NetEase’s founder, CEO, director and major shareholder, creating related-party and concentration risks.
- NetEase relies on VIE contractual arrangements because of Chinese restrictions on foreign ownership and licensing in Internet and online-game businesses. Regulatory authorities could challenge the structure, require restructuring or restrict consolidation of the VIEs.
- The Wangyibao online payment platform was preparing an application for a Payment Service Permit required under new People’s Bank of China rules. Failure to obtain the permit could materially affect operations and profitability.
- Other principal risks include dependence on a limited group of major games, regulatory changes affecting online games and virtual currency, content and censorship requirements, competition, foreign-exchange volatility, tax incentive expiration, cybersecurity and system outages, intellectual-property claims, and restrictions on movement of cash from China.
- The company reported no material pending legal proceedings and stated that its disclosure controls and internal control over financial reporting were effective as of December 31, 2010. PricewaterhouseCoopers issued an unqualified opinion on the financial statements and internal controls.
- The company has never paid cash dividends and states that it historically retained earnings to fund operations and expansion.
Most important facts for an investor to verify
- Whether World of Warcraft and other licensed-game revenue can be sustained despite substantial royalties, license amortization and contractual minimum commitments.
- The amount, timing and enforceability of NetEase’s guarantees for Blizzard-related obligations, including the potential hardware commitment.
- The continued legal and regulatory status of the VIE structure and the company’s ability to control and receive cash from VIEs.
- Whether the Wangyibao payment permit and other required Chinese licenses were obtained after the filing date.
- The durability of preferential tax rates and the potential impact of a higher effective tax rate.
- Whether declining consolidated gross and operating margins stabilize as licensed-game costs, marketing spending and staffing investments mature.
- Exposure to foreign-exchange losses, restricted cash, statutory reserves and other limitations on transferring PRC cash to the offshore holding company.
- Whether the accounting estimates for permanent in-game item lives, dormant-account revenue and deferred revenue remain appropriate as player behavior changes.