Business Context and Reporting Period
NetEase, Inc. filed an annual Form 20-F for the fiscal year ended December 31, 2017, prepared under U.S. GAAP. The filing includes audited consolidated results for 2015–2017. It is not a standalone fourth-quarter filing; the source text does not provide a clear Q4-only income statement or cash flow statement.
NetEase operates primarily in China through subsidiaries and variable interest entities, with four reported segments: online games, e-commerce, advertising, and e-mail and other services. Its ADSs trade on Nasdaq under the symbol NTES, with each ADS representing 25 ordinary shares.
Financial Performance and Position
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Net revenues | RMB54,102.0 million | RMB38,178.8 million | +41.7% |
| Gross profit | RMB25,912.7 million | RMB21,663.8 million | +19.6% |
| Gross margin | 47.9% | 56.7% | Down 8.8 percentage points |
| Operating profit | RMB12,153.8 million | RMB12,628.9 million | Down 3.8% |
| Net income attributable to shareholders | RMB10,707.9 million | RMB11,604.5 million | Down 7.7% |
| Net margin attributable to shareholders | 19.8% | 30.4% | Down 10.6 percentage points |
| Net cash from operating activities | RMB11,889.2 million | RMB15,488.3 million | Down 23.2% |
| Capital expenditures | RMB1,842.9 million | RMB1,135.5 million | +62.2% |
2017 diluted earnings were RMB3.23 per ordinary share and RMB80.74 per ADS. Income tax expense was RMB2,162.4 million, with an effective tax rate of 16.6%, compared with 15.1% in 2016.
- Online games: Revenue rose 29.7% to RMB36,281.6 million, representing 67.0% of total revenue. Mobile games excluding Blizzard titles generated RMB25,421.6 million, while Blizzard-licensed game revenue declined 17.4% to RMB3,467.7 million.
- E-commerce: Revenue increased 157.0% to RMB11,670.4 million, or 21.6% of total revenue. Active Kaola and Yanxuan users increased from 6.8 million to 23.0 million, and fulfilled orders increased from 27.0 million to 81.1 million.
- Advertising: Revenue increased 11.9% to RMB2,408.8 million, or 4.5% of total revenue. The top ten advertisers represented 39.6% of advertising revenue, up from 29.4%.
- E-mail and others: Revenue increased 6.8% to RMB3,741.1 million, but gross margin fell sharply to 7.7% from 48.5%, primarily because of higher live-streaming revenue-sharing costs and music-content amortization.
Cash, time deposits and short-term investments totaled approximately RMB43.1 billion at year-end, comprising RMB2.8 billion of cash and cash equivalents, RMB30.7 billion of current time deposits, RMB0.1 billion of non-current time deposits and RMB9.7 billion of short-term investments. Short-term loans were RMB6.6 billion, and total liabilities were RMB24.0 billion. Restricted cash totaled approximately RMB5.9 billion, including deposits securing borrowings and customer funds held through Wangyibao.
Material Changes Versus the Prior Comparable Period
- Revenue growth was driven by mobile games and rapid e-commerce expansion, but the mix shifted toward lower-margin businesses. Product revenue increased to 21.2% of total revenue from 11.6%.
- Cost of revenues increased 70.7%, faster than revenue, reflecting merchandise costs, mobile-game revenue sharing, staff costs, technology costs, live-streaming revenue sharing and music-content costs.
- Online-game gross margin declined to 62.9% from 64.4%, mainly because mobile games generally have lower margins than PC-client games due to app-store and distribution fees.
- E-commerce gross margin declined to 10.3% from 12.2%, primarily because of increased promotions and discounts.
- Operating expenses rose 52.3% to RMB13,758.9 million. Selling and marketing expenses increased 55.2%, general and administrative expenses 61.3%, and research and development expenses 43.5%.
- Share-based compensation increased to RMB2,004.3 million from RMB990.1 million. Unrecognized compensation cost was RMB4,386.8 million at year-end, with a weighted-average remaining vesting period of 3.06 years.
- Operating cash flow declined as inventory increased RMB3,896.8 million; net inventories rose from RMB1,578.1 million to RMB5,474.9 million.
- Net foreign-exchange expense was RMB448.8 million, compared with a RMB146.5 million gain in 2016. Interest income increased to RMB667.3 million, supported by higher cash and deposit balances.
- The company separately disclosed e-commerce as a reporting segment beginning in the fourth quarter of 2017 and retrospectively revised prior-period segment information.
Guidance, Outlook, Commentary, Risks and Unusual Items
Management did not provide specific numerical revenue, earnings or margin guidance in the filing. It expects continued investment in new mobile and PC games, international game expansion, e-commerce infrastructure, content, marketing and research and development. Management stated that available liquidity, operating cash flow and short-term investments should meet anticipated cash needs for at least the next 12 months.
- Online-game performance depends on retaining the popularity of key titles and successfully launching new games. Several games accounted for 46.9% of total 2017 revenue, creating concentration risk.
- Mobile games represented 70.8% of net game revenue in 2017 and depend on third-party app stores, payment channels and revenue-sharing arrangements.
- The e-commerce business carries inventory risk. Inventory increased materially, exposing the company to obsolescence, markdowns, write-downs and working-capital pressure.
- NetEase guaranteed certain Blizzard-related obligations. Outstanding Blizzard license commitments were approximately RMB2,944.5 million through 2020, in addition to potential hardware commitments of up to RMB94.3 million.
- Total contractual obligations, excluding Blizzard commitments, were RMB2,725.5 million, including RMB970.4 million of capital commitments. Capital commitments due in 2018 were RMB904.6 million.
- NetEase uses a PRC VIE structure for regulated businesses. Changes in Chinese foreign-investment, telecommunications, online-game, data-protection or content regulations could restrict operations or prevent consolidation of VIEs.
- The company’s ability to move cash from PRC subsidiaries and VIEs is restricted by PRC dividend, reserve and foreign-exchange rules. Approximately RMB6.8 billion of net assets was restricted from transfer at year-end.
- In April 2018, PUBG Corporation and PUBG Santa Monica sued NetEase regarding Rules of Survival and Knives Out, alleging copyright, trademark and unfair-competition violations. Damages were unspecified and the company stated that it intends to defend the action vigorously.
- The company adopted new revenue-recognition guidance in the first quarter of 2018. The expected transition adjustment included an approximately RMB81.7 million reduction in deferred revenue and a RMB27.4 million net increase in retained earnings, principally from earlier recognition of unused online-point breakage.
- Management and the independent auditor concluded that internal control over financial reporting was effective as of December 31, 2017. The company stated that it did not believe it was a PFIC for 2017, while noting that PFIC status is determined annually and remains uncertain.
Most Important Facts for Investors to Verify
- Whether mobile-game launches and updates can offset declining Blizzard-licensed revenue and sustain online-game margins.
- Inventory turnover, markdowns, write-downs and the cash-flow effect of the expanding Kaola and Yanxuan businesses.
- The sustainability of the 2017 cost structure, including marketing, revenue-sharing, content and share-based compensation expenses.
- The amount and terms of short-term borrowings, pledged deposits, subsidiary guarantees and Blizzard-related obligations.
- The enforceability and regulatory status of the PRC VIE arrangements, including the impact of evolving foreign-investment and telecommunications rules.
- The outcome and potential financial or operational impact of the PUBG litigation.
- The effect of the 2018 revenue-recognition and financial-instrument accounting changes on reported revenue, retained earnings and investment-income volatility.
- The availability of PRC subsidiary cash for dividends, acquisitions and corporate funding, after statutory reserves, withholding taxes and foreign-exchange restrictions.