Business Context and Reporting Period
Company: NetEase, Inc. (NASDAQ: NTES)
Filing Type: Form 6-K (Press Release)
Reporting Period: Third Quarter ended September 30, 2009
Business Overview: A leading Chinese Internet and online game services provider. Key products include self-developed games (e.g., Fantasy Westward Journey, Tianxia II) and the licensed operation of World of Warcraft (commenced commercial operation in China on September 19, 2009). The company also provides online advertising, wireless value-added services, and email services.
Key Financial Metrics
| Metric | Q3 2009 (RMB) | Q3 2009 (USD) | Q2 2009 (RMB) | Q3 2008 (RMB) |
|---|---|---|---|---|
| Total Revenues | 879.4 million | 128.8 million | 872.1 million | 806.6 million |
| Gross Profit | 627.0 million | 91.9 million | 691.9 million | 631.3 million |
| Net Profit | 393.8 million | 57.7 million | 468.1 million | 313.3 million |
| EPS (Basic/Diluted ADS) | US$0.45 / US$0.44 | |||
| Operating Cash Flow | 270.0 million | 39.5 million | 544.4 million | 495.5 million |
| Cash & Time Deposits | 6.4 billion | 939.1 million | 5.6 billion (as of Dec 31, 2008) |
Segment Performance (Q3 2009)
- Online Games: RMB775.1 million revenue (79.9% gross margin). Slight sequential decline due to World of Warcraft ramp-up costs.
- Advertising: RMB86.0 million revenue (23.1% gross margin). Sequential increase driven by operational consolidation and new marketing strategies.
- WVAS & Others: RMB18.3 million revenue (45.0% gross loss margin). Losses attributed to increased bandwidth and staff costs.
Material Changes vs. Prior Periods
- Revenue Growth: Total revenue increased 9.0% year-over-year (YoY) and 0.8% quarter-over-quarter (QoQ). Online game revenue grew 14.8% YoY but declined 0.8% QoQ.
- Profitability Decline: Net profit decreased 15.9% QoQ and increased 25.7% YoY. Gross profit declined 9.4% QoQ primarily due to additional costs for World of Warcraft (server depreciation, custody fees, royalties).
- Margin Compression: Online game gross margin dropped from 88.3% (Q2 2009) to 79.9% (Q3 2009) due to World of Warcraft launch costs. Advertising margin improved from 16.6% to 23.1% QoQ.
- Operating Expenses: Increased 25.2% QoQ and 33.0% YoY, driven by nationwide game promotions, World of Warcraft relaunch marketing, and increased R&D headcount.
- Foreign Exchange: Recorded a net foreign exchange gain of RMB25.3 million (vs. RMB47.2 million gain in Q2 and RMB68.3 million loss in Q3 2008), driven by Euro-denominated deposit fluctuations.
Guidance, Outlook, and Risks
Management Commentary & Outlook
- Game Pipeline: Plans to release four expansion packs in Q4 2009 for Legend of Westward Journey, Tianxia II, New Fly for Fun, and Transformer Online. Two new item-based games (Ghost and Heroes of Tang Dynasty) are expected to commercialize in December 2009.
- Advertising: Management remains cautiously optimistic about the remainder of 2009 and into 2010, citing sequential gains in active advertisers and revenue.
- Share Repurchase: The US$100 million share repurchase program authorized in September 2008 ended on September 11, 2009. The company spent approximately US$13.1 million in aggregate.
Risks and Contingencies
- Regulatory Uncertainty: There is ongoing regulatory uncertainty regarding World of Warcraft following an announcement by the PRC General Administration of Press and Publication (GAPP). NetEase is seeking clarification from authorities.
- Restricted Cash: RMB82.0 million is held as restricted cash (security deposit) with a court in Guangzhou regarding arbitration proceedings against a property developer.
- Forward-Looking Risks: Risks include failure of new game launches, inability to maintain market leadership, government penalties or suspension of services, and fluctuations in the Renminbi exchange rate.
Investor Verification Checklist
- Regulatory Status of World of Warcraft: Verify the resolution of the GAPP announcement and potential impact on future revenue from this licensed title.
- Cost Structure Sustainability: Assess whether the elevated costs associated with World of Warcraft ramp-up are temporary or indicative of a new baseline for operating expenses.
- Advertising Recovery: Confirm if the sequential growth in advertising revenue is sustainable post-Olympic effect and amidst global economic slowdown.
- Arbitration Outcome: Monitor the status of the Guangzhou property developer arbitration to determine if the RMB82.0 million restricted cash will be released or if further liabilities exist.
- New Game Performance: Track the commercialization success of Ghost and Heroes of Tang Dynasty in December 2009 as planned.