Netease, Inc. annual report, Q4 FY2016

NetEase, Inc. Form 20-F Summary

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, Internet advertising, e-mail, e-commerce and other Internet services. The filing is an audited annual report for the fiscal year ended December 31, 2016, prepared under U.S. GAAP; it is not a quarterly filing, so the source does not provide a separate fourth-quarter income statement.

The company operated more than 100 mobile games, including Onmyoji and mobile versions of Fantasy Westward Journey and Westward Journey Online. Blizzard-licensed games included World of Warcraft, Hearthstone, Diablo III, Heroes of the Storm, StarCraft II and Overwatch. E-commerce platforms included Kaola and Yanxuan.

Financial highlights

Metric	2016	2015	Change
Total net revenues	RMB38,178.8 million	RMB22,802.9 million	+67.4%
Gross profit	RMB21,663.8 million	RMB13,403.6 million	+61.6%
Gross margin	56.7%	58.8%	Down 2.1 percentage points
Operating profit	RMB12,628.9 million	RMB7,272.1 million	+73.7%
Net income	RMB11,792.9 million	RMB6,836.9 million	+72.5%
Net income attributable to shareholders	RMB11,604.5 million	RMB6,735.1 million	+72.3%
Operating cash flow	RMB15,488.3 million	RMB8,076.9 million	+91.8%

Basic and diluted earnings per ADS were RMB88.40 and RMB87.72, respectively, compared with RMB51.27 and RMB50.94 in 2015. The effective tax rate was 15.1%, compared with 15.7% in 2015. Other income included RMB377.7 million of government incentives, RMB200.3 million of net investment income and RMB146.5 million of foreign-exchange gains.

Revenue mix and margins

Online games: Revenue increased 61.6% to RMB27,980.5 million and represented 73.3% of total revenue, versus 76.0% in 2015. Mobile-game revenue, excluding Blizzard mobile games, increased to RMB16,898.6 million from RMB7,590.7 million. Blizzard-licensed game revenue increased 82.5% to RMB4,196.4 million.
Advertising: Revenue increased 20.3% to RMB2,152.4 million, or 5.6% of total revenue. The number of traditional advertisers increased to 1,335 from 1,002, while average revenue per traditional advertiser declined to approximately RMB1.6 million from RMB1.8 million.
E-mail, e-commerce and others: Revenue increased 117.5% to RMB8,046.0 million, or 21.1% of total revenue, largely due to Kaola, Yanxuan and Duobao. The segment gross margin increased to 28.0% from 7.9%.
Online-game gross margin declined to 64.4% from 68.8%, principally because mobile games carry lower margins due to app-store and other revenue-sharing costs. Total cost of revenues increased 75.7% to RMB16,515.0 million.

Cash flow, liquidity and capital structure

At December 31, 2016, cash and cash equivalents were RMB5,439.5 million; time deposits totaled RMB19,911.1 million across current and non-current balances; short-term investments were RMB11,582.1 million; and restricted cash totaled RMB5,533.3 million.
Short-term loans were RMB3,815.7 million, generally fixed-rate and secured by approximately RMB3,995.0 million of pledged deposits. Total long-term liabilities were only RMB33.9 million on the selected financial data table.
Working capital was RMB30,384.7 million, compared with RMB22,741.5 million in 2015. Total assets were RMB58,031.9 million and total shareholders’ equity was RMB38,462.9 million.
Investing cash outflow was RMB14,001.8 million, driven mainly by time-deposit placements, purchases of short-term investments, restricted-cash transfers and capital expenditures. Financing cash outflow was RMB2,250.5 million, including RMB2,546.2 million of dividends, RMB1,199.1 million of share repurchases and net short-term loan activity.
2016 capital expenditures were RMB1,135.5 million. Additional capital commitments as of year-end were RMB1,149.2 million, primarily for office buildings and warehouses.
Management stated that cash, operating cash flow and short-term investments were sufficient to meet anticipated cash needs for at least the next 12 months.

Material changes versus the prior comparable period

The business mix shifted further toward mobile games and e-commerce. Mobile games represented 61.9% of total online-game revenue in 2016, compared with 45.7% in 2015.
Product revenue rose to 11.6% of total revenue from 4.9%, reflecting the expansion of direct merchandise sales.
Operating expenses increased 47.4% to RMB9,034.9 million. Selling and marketing expense rose 51.5%, general and administrative expense rose 48.5%, and research and development expense rose 41.1%.
Share-based compensation increased to RMB990.1 million from RMB684.5 million. Unrecognized compensation cost was RMB2,670.1 million at year-end, with a weighted-average remaining vesting period of 3.21 years.
Inventory increased 93.0% to RMB1,578.1 million from RMB817.8 million, reflecting e-commerce expansion and increasing inventory-management risk.
Accounts receivable increased to RMB4,251.3 million net from RMB2,614.1 million. One distribution channel represented 55.6% of total accounts receivable at year-end.
Cash and cash equivalents declined from RMB6,071.5 million to RMB5,439.5 million despite substantially higher operating cash flow, mainly because of large investment and financing-related cash uses.

Guidance, outlook, risks and unusual items

The filing does not provide numerical revenue or earnings guidance. Management expected to continue launching mobile games, expanding e-commerce and investing in research and development, marketing, infrastructure and new facilities. The company also expected online games to remain its principal revenue source, while acknowledging that mobile games and e-commerce generally produce lower margins than legacy PC-client games.

Blizzard commitments: The company guaranteed Blizzard-related obligations if Shanghai EaseNet lacks sufficient funds. Outstanding license commitments were approximately RMB3,458.5 million through 2020, including RMB471 million in 2017, RMB1,058 million in 2018, RMB984 million in 2019 and RMB945 million in 2020. Additional prescribed hardware commitments could reach RMB195.0 million.
Regulatory exposure: Online games, online publishing, advertising, payments, e-commerce and Internet services are heavily regulated in China. The ongoing suspension of unauthorized online lottery sales continued to affect Caipiao, and the timing and availability of required authorization remained uncertain.
VIE structure: The company does not directly own several operating entities, including Guangzhou NetEase, NetEase Advertising, Hangzhou Leihuo and Shanghai EaseNet. A regulatory challenge to the VIE structure or difficulty enforcing contractual arrangements could impair operations, cash flows and consolidation of the VIEs.
Concentration: Several major self-developed games and Blizzard titles generated 46.3% of total revenue in 2016. Mobile-game success depends on user preferences, frequent content updates and third-party app stores, which may retain approximately 30% to 50% of Android distribution revenue and approximately 30% for iOS.
Tax and cash-transfer risks: Preferential tax treatments contributed approximately RMB1,417.2 million of tax reductions in 2016 but are subject to renewal. PRC restrictions limited the transfer of approximately RMB4.5 billion of net assets from subsidiaries and VIEs, and the company accrued RMB404.8 million of withholding tax related to expected offshore distributions.
Unusual items: Government incentives increased to RMB377.7 million from RMB45.1 million. Investment income included a RMB234.1 million gain on disposal of an equity investment, while investment impairment and associated-company losses were also recorded.
Management and the independent auditor concluded that internal control over financial reporting was effective as of December 31, 2016. The filing reported no material pending legal proceedings.

Most important facts for investors to verify

Whether growth in Onmyoji, Fantasy Westward Journey, Westward Journey Online and other mobile titles is sustainable and how mobile revenue-sharing affects future margins.
The durability and profitability of Kaola and Yanxuan, including inventory turnover, markdowns, write-downs and working-capital requirements.
The status and enforceability of the VIE contracts and any developments concerning China’s proposed foreign-investment framework and online-game regulation.
The remaining Blizzard license, royalty, marketing and guarantee obligations, and the financial condition of Shanghai EaseNet.
The concentration of accounts receivable in the principal distribution channel and the collectability of balances.
The renewal of preferential tax treatments and the ability to transfer cash from PRC subsidiaries and VIEs to the Cayman Islands parent.
The effect of share-based compensation, the new US$1.0 billion repurchase authorization and the quarterly dividend policy on per-share value and cash allocation.