Business Context and Reporting Period
Company: NetEase, Inc. (NASDAQ: NTES)
Filing Type: Form 6-K (Report of Foreign Private Issuer)
Reporting Period: First Quarter ended March 31, 2010
Release Date: May 20, 2010
Business Overview: NetEase is a leading Chinese Internet and online game services provider. Its primary revenue drivers are online games (including in-house titles like Fantasy Westward Journey and licensed titles like World of Warcraft), online advertising, and wireless value-added services.
Key Financial Metrics
| Metric | Q1 2010 (RMB) | Q1 2010 (USD) | Q4 2009 (RMB) | Q1 2009 (RMB) |
|---|---|---|---|---|
| Total Revenues | 1,194.9 million | 175.1 million | 1,290.2 million | 781.7 million |
| Gross Profit | 780.7 million | 114.4 million | 844.1 million | 641.7 million |
| Net Profit | 452.3 million | 66.3 million | 571.8 million | 416.7 million |
| Operating Cash Flow | 676.5 million | 99.1 million | 712.4 million | 567.8 million |
| Cash & Time Deposits | 7.7 billion | 1.1 billion | 7.0 billion | N/A |
| Earnings per ADS (Basic) | N/A | $0.51 | N/A | $0.48 |
Segment Performance (Q1 2010):
- Online Games: RMB 1.1 billion (72.1% gross margin). Growth driven by new games and World of Warcraft.
- Advertising: RMB 91.5 million (22.9% gross margin). Doubled year-over-year but declined 50% quarter-over-quarter due to seasonality.
- WVAS & Others: RMB 18.1 million (34.0% gross loss margin).
Material Changes vs. Prior Periods
- Revenue: Total revenue increased 53% year-over-year (YoY) but decreased 7% quarter-over-quarter (QoQ). The QoQ decline was primarily due to a seasonal drop in advertising revenue.
- Profitability: Net profit increased 9% YoY but decreased 21% QoQ. The QoQ decrease was driven by lower advertising revenue and a net foreign exchange loss of RMB 39.5 million (compared to RMB 15.3 million in Q4 2009).
- Margins: Online game gross margin improved slightly QoQ (70.8% to 72.1%) due to product mix changes but decreased YoY (90.0% to 72.1%) due to royalty and license fees associated with World of Warcraft. Advertising gross margin dropped significantly QoQ (58.4% to 22.9%) due to revenue volume decline.
- Tax Rate: The effective tax rate increased to 17.4% in Q1 2010 from 11.3% in Q4 2009 and 12.9% in Q1 2009, largely due to the standard 25% tax rate applied to World of Warcraft operations.
Guidance, Outlook, and Risks
Management Commentary & Outlook:
- Game Releases: Plans to launch two expansion packs for Westward Journey II and III in Q3 2010. A new expansion for Tianxia II is scheduled for September 2010. An expansion for Heroes of Tang Dynasty is planned for Q4 2010.
- World of Warcraft: The application for the Wrath of the Lich King expansion is under regulatory review. Management is testing expansion into second- and third-tier cities.
- Advertising: Management notes a rebound in the Chinese advertising market, with portal traffic growing steadily and new e-mail accounts reaching a one-year high.
Risks and Contingencies:
- Regulatory Risk: Potential suspension of operations or penalties from Chinese government authorities regarding online games.
- Licensing Risk: Dependence on Blizzard Entertainment's World of Warcraft and the uncertainty of regulatory approval for new expansions.
- Market Risk: Competition in the online game market and the effectiveness of marketing programs for advertising.
- Currency Risk: Fluctuations in the Renminbi (RMB) against other currencies, specifically noted regarding Euro-denominated deposits.
Investor Verification Checklist
- Regulatory Approval Status: Verify the timeline for the approval of the Wrath of the Lich King expansion, as this is a key growth driver.
- Advertising Seasonality: Confirm if the Q1 advertising decline is consistent with historical seasonal patterns or indicative of broader market weakness.
- Foreign Exchange Exposure: Review the company's hedging strategies regarding Euro-denominated deposits, which caused a significant translation loss in Q1.
- Cost Structure: Monitor the impact of royalties and license fees on the gross margin of the World of Warcraft segment compared to in-house titles.
- Audit Status: Note that the financial information is unaudited and preliminary; final audited figures in the Form 20-F may differ.