Business Context and Reporting Period
Company: NetEase, Inc. (NASDAQ: NTES)
Filing Type: Form 6-K (Press Release)
Reporting Period: Third Quarter ended September 30, 2008
Release Date: November 13, 2008
NetEase is a leading Chinese Internet and online game services provider. The company reported unaudited financial results for Q3 2008, highlighting continued growth in its online gaming sector driven by the popularity of "Fantasy Westward Journey" (FWJ) and new expansion packs. The company also noted improvements in its advertising portal and wireless value-added services.
Key Financial Metrics
| Metric | Q3 2008 (RMB) | Q3 2008 (USD) | Q2 2008 (RMB) | Q3 2007 (RMB) |
|---|---|---|---|---|
| Total Revenues | 806.6 million | 118.8 million | 715.9 million | 571.1 million |
| Gross Profit | 631.3 million | 93.0 million | 722.8 million | 441.9 million |
| Net Profit | 313.3 million | 46.1 million | 438.2 million | 260.2 million |
| Earnings per ADS (Diluted) | US$0.36 | |||
| Operating Cash Flow | 495.5 million | 73.0 million | 513.3 million | 339.2 million |
| Cash & Time Deposits | 5.28 billion | 777.5 million | As of Dec 31, 2007: 4.16 billion RMB |
Revenue by Segment (Q3 2008)
- Online Games: RMB675.1 million (US$99.4 million)
- Advertising Services: RMB113.0 million (US$16.6 million)
- Wireless Value-Added Services (WVAS) & Others: RMB18.5 million (US$2.7 million)
Material Changes vs. Prior Periods
- Revenue Growth: Total revenue increased 12.7% quarter-over-quarter (QoQ) and 41.1% year-over-year (YoY). Online game revenue grew 13.5% QoQ and 44.0% YoY.
- Gross Profit Decline: Gross profit decreased 12.7% QoQ primarily due to the absence of a RMB146.8 million business tax refund received in Q2 2008 and increased content costs related to the Beijing Olympics. YoY gross profit increased 42.9%.
- Net Profit Decline: Net profit decreased 28.5% QoQ and increased 20.4% YoY. The QoQ decline was significantly impacted by a net foreign exchange loss of RMB68.3 million (US$10.1 million), compared to RMB26.4 million in Q2.
- Margin Compression: Advertising gross profit margin dropped to 26.9% from 52.6% in Q2 due to Olympic-related content cost increases. Online game margins remained stable at 89.7%.
- Debt Reduction: The company fully redeemed its zero-coupon subordinated convertible notes in July 2008, eliminating this liability from the balance sheet.
Guidance, Outlook, and Risks
Management Commentary
CEO William Ding stated that the online gaming industry in China shows no signs of slowing. Key drivers include the success of FWJ (reaching 2.3 million peak concurrent users in August) and new game launches such as "Heroes of Tang Dynasty" and "Legend of Westward Journey." The company also signed a licensing agreement with Blizzard Entertainment.
Outlook
Management expects healthy growth for the China Internet market in 2009, driven by rapid user expansion, e-commerce popularity, and a shift of advertising spend from traditional media to the Internet.
Risks and Contingencies
- Foreign Exchange: Significant translation losses on USD and Euro-denominated deposits impacted net profit.
- Taxation: The company adopted a 25% statutory tax rate effective Jan 1, 2008. While some subsidiaries enjoy unexpired tax holidays, the company is applying for New/High Technology Enterprise (NHTE) status to secure preferential rates. Excess provisions may be reversed if approved.
- Content Costs: Olympic-related price increases from content providers pressured advertising margins.
- Regulatory: Risks related to Chinese government regulation of the online game market and potential changes in tax laws.
Share Repurchase
On September 12, 2008, the Board authorized a new share repurchase program of up to US$100 million for a period not exceeding one year. As of September 30, 2008, approximately US$63,000 had been spent under this new program.
Investor Verification Checklist
- Foreign Exchange Impact: Verify the magnitude of the RMB68.3 million FX loss and its effect on future quarters given currency volatility.
- Tax Status: Monitor the progress of NHTE applications for subsidiaries to confirm if the 25% tax rate will be reduced in future periods.
- Content Cost Sustainability: Assess whether Olympic-related content cost increases are temporary or indicative of a new baseline for advertising margins.
- Game Pipeline Execution: Track user adoption and monetization of new titles ("Heroes of Tang Dynasty") and expansion packs to ensure continued revenue growth.
- Cash Deployment: Review the execution of the new US$100 million share repurchase program and capital allocation strategy.