Business Context and Reporting Period
NetEase, Inc. is a Cayman Islands holding company whose operations are conducted primarily in China through subsidiaries and variable interest entities (VIEs). Its principal businesses are online games, e-commerce, advertising, and innovative businesses including Cloud Music, education, live streaming and e-reading. The filing is an audited Form 20-F for the fiscal year ended December 31, 2018, prepared under U.S. GAAP. It does not provide a clearly separable standalone fourth-quarter 2018 income statement; the “2018 Q4” reference is therefore treated as the fiscal-year filing context.
ADSs trade on Nasdaq under NTES, with each ADS representing 25 ordinary shares. The company had 3,199.0 million ordinary shares outstanding at year-end.
Key Financial Metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Total net revenue | RMB67,156.5 million | RMB54,102.0 million | +24.1% |
| Gross profit | RMB28,403.5 million | RMB25,912.7 million | +9.6% |
| Gross margin | 42.3% | 47.9% | Down 5.6 points |
| Operating profit | RMB7,892.9 million | RMB12,153.8 million | -35.1% |
| Net income | RMB6,477.4 million | RMB10,849.1 million | -40.3% |
| Net income attributable to shareholders | RMB6,152.4 million | RMB10,707.9 million | -42.5% |
| Shareholders’ net margin | 9.2% | 19.8% | Down 10.6 points |
| Operating cash flow | RMB13,415.9 million | RMB11,889.2 million | +12.8% |
| Capital expenditures | RMB2,528.1 million | RMB1,842.9 million | +37.2% |
U.S. dollar amounts in the filing use an exchange rate of RMB6.8755 per US$1.00. Reported 2018 revenue was US$9,767.5 million, attributable net income was US$894.8 million, and operating cash flow was US$1,951.3 million.
Segment Performance
| Segment | 2018 Revenue | Share of Revenue | 2018 Gross Margin | Year-over-Year Revenue Change |
|---|---|---|---|---|
| Online games | RMB40,190.1 million | 59.9% | 63.6% | +10.8% |
| E-commerce | RMB19,235.5 million | 28.6% | 8.0% | +64.8% |
| Advertising | RMB2,500.8 million | 3.7% | 64.4% | +3.8% |
| Innovative businesses and others | RMB5,230.1 million | 7.8% | (6.2%) | +39.8% |
- Mobile-game revenue increased to RMB28,536.9 million from RMB25,678.6 million, supported by Knives Out and Chu Liu Xiang. Licensed-game revenue declined 2.1% to RMB3,826.5 million.
- E-commerce active users increased from 23.0 million to 41.0 million, while fulfilled orders increased from 81.1 million to 139.4 million. Promotions and discounts reduced the segment margin.
- Innovative businesses and others reported a gross loss, primarily because of higher licensed music-content costs and revenue-sharing expenses.
Liquidity, Debt and Other Financial Metrics
- Year-end cash and cash equivalents were RMB5,389.2 million; time deposits were RMB33,000.3 million; restricted cash was RMB4,817.3 million; and short-term investments were RMB11,674.8 million.
- Short-term loans were RMB13,658.6 million, compared with RMB6,623.5 million in 2017. The weighted-average interest rate on outstanding short-term loans was approximately 3.14%.
- NetEase entered into a three-year US$500 million revolving facility in August 2018. The filing reports US$100 million outstanding under the syndicated facility at year-end and compliance with its covenants.
- Total liabilities were RMB35,556.3 million and redeemable noncontrolling interests were RMB5,385.7 million. Total shareholders’ equity was RMB46,025.8 million.
- Cash used in investing activities was RMB13,569.5 million, including property, equipment and software purchases of RMB2,528.1 million, land-use-right purchases of approximately RMB3,008.0 million, and investments in other equity interests of RMB2,751.0 million.
- Cash provided by financing activities was RMB1,587.4 million, reflecting short-term borrowing and Cloud Music financing, partly offset by RMB7,516.7 million of share repurchases and RMB1,440.2 million of dividends.
- Total contractual obligations were RMB13,586.3 million, including RMB1,900.4 million of capital commitments and RMB10,265.2 million of royalties and licensed-content commitments.
Material Changes Versus the Prior Comparable Period
- Revenue growth accelerated through e-commerce and mobile games, but the mix shifted toward lower-margin product sales: product revenue rose to 27.8% of total revenue from 21.2%.
- Cost of revenue increased 37.5%, materially faster than revenue, reducing gross margin from 47.9% to 42.3%.
- Operating expenses increased 49.1%. Selling and marketing expense rose 36.9%, general and administrative expense 31.3%, and research and development expense 78.3% to RMB7,792.6 million.
- Research and development spending increased substantially because of higher staffing, compensation, game-content design and technology costs. Share-based compensation rose to RMB2,529.7 million from RMB2,004.3 million.
- The effective tax rate increased to 27.6% from 16.6%, principally because certain subsidiaries incurred higher operating losses and because of changes in valuation allowances and withholding-tax effects.
- The company repurchased approximately 4.6 million ADSs, equivalent to 114.9 million ordinary shares, for approximately US$1,178.5 million under the 2017-2018 program. A new US$1.0 billion authorization became effective in November 2018.
- NetEase adopted ASC Topic 606 using the modified retrospective method. The adoption reduced deferred revenue by approximately RMB81.7 million and increased opening retained earnings by approximately RMB27.4 million after tax; comparative periods were not restated.
- Cloud Music completed an offshore preferred-share financing of US$716.3 million while NetEase retained control. The company also repurchased previously issued Cloud Music onshore interests for RMB975.0 million in aggregate.
Guidance, Outlook, Commentary and Risks
The filing does not provide formal quantitative revenue or earnings guidance. Management expects continued investment in mobile games, international game distribution, e-commerce infrastructure, research and development, and new products. Management states that available cash, operating cash flow and short-term investments should fund anticipated needs for at least the next 12 months.
- Management expects to continue launching new mobile games and expanding internationally, but acknowledges that game demand, product life cycles and the profitability of mobile games are difficult to predict.
- China’s game-approval process experienced delays during 2018, although approvals resumed near year-end. Future approval delays could affect game launches and revenue.
- The VIE structure is essential to operations in regulated Chinese Internet, gaming, advertising and related sectors. Changes in regulation, challenges to contractual arrangements, or limits on consolidation could materially affect operations and cash flows.
- Other principal risks include intense competition, reliance on third-party mobile-app platforms and payment channels, lower e-commerce margins, inventory and counterfeit-product risks, data-security and privacy obligations, currency volatility, restrictions on transferring funds from China, and the loss or non-renewal of licensed games.
- As of year-end, management reported effective internal control over financial reporting, and PricewaterhouseCoopers Zhong Tian LLP issued an unqualified audit opinion on the financial statements and internal controls.
- A lawsuit by PUBG concerning Rules of Survival and Knives Out was settled by March 31, 2019. The filing states that management was not aware of other legal proceedings likely to have a material adverse effect.
Most Important Facts for Investors to Verify
- Whether mobile-game launches and international expansion can offset mature-game declines and preserve the 63.6% online-games gross margin.
- Whether e-commerce growth can become more profitable after higher promotions, fulfillment costs and inventory investment.
- The sustainability of operating cash flow relative to share repurchases, dividends, capital commitments and licensed-content obligations.
- The composition, maturity and refinancing requirements of the RMB13.7 billion short-term loan balance, including pledged deposits and foreign-currency exposure.
- The enforceability and regulatory status of the VIE arrangements and the ability to repatriate cash from PRC subsidiaries and VIEs.
- The effect of Cloud Music preferred-share redemption terms, continued operating losses, and ongoing music-license costs.
- The renewal of preferential PRC tax treatments and the potential impact of a higher effective tax rate.
- Future game approvals, platform revenue-sharing rates, major licensing renewals, litigation developments and any changes in China’s Internet, gaming, e-commerce or data-protection regulations.