Business Context and Reporting Period
Company: NetEase, Inc. (NASDAQ: NTES)
Filing Type: Form 6-K (Press Release)
Reporting Period: First Quarter ended March 31, 2007
Business Overview: NetEase is a leading China-based Internet technology company providing online game services, advertising, and wireless value-added services. The quarter was highlighted by record peak concurrent users for its flagship game, Fantasy Westward Journey.
Key Financial Metrics
| Metric | Q1 2007 (RMB) | Q1 2007 (USD) | Q4 2006 (RMB) | Q1 2006 (RMB) |
|---|---|---|---|---|
| Total Revenues | 554.6 million | 71.8 million | 540.3 million | 529.8 million |
| Net Profit | 301.5 million | 39.0 million | 320.2 million | 293.7 million |
| Earnings Per ADS (Basic) | US$0.31 | |||
| Earnings Per ADS (Diluted) | US$0.29 | |||
| Gross Profit | 430.1 million | 55.7 million | 456.7 million | 420.8 million |
| Operating Cash Flow | 277.0 million | 35.9 million | 531.5 million | 412.4 million |
| Cash & Time Deposits | 4.0 billion | 520.6 million | 3.9 billion | 3.8 billion |
Segment Performance
- Online Games: Revenue RMB481.9 million (US$62.4 million), up 6.7% quarter-over-quarter. Gross margin was 89.6%.
- Advertising: Revenue RMB56.2 million (US$7.3 million), down from RMB72.1 million in Q4 2006. Gross margin declined to 35.7% due to seasonal demand and higher costs.
- Wireless & Others: Revenue RMB16.6 million (US$2.1 million), relatively flat. The segment reported a gross loss margin of 36.1%.
Material Changes vs. Prior Period
- Revenue Growth: Total revenue increased 2.7% quarter-over-quarter and 4.6% year-over-year, driven primarily by online game services.
- Profit Decline: Net profit decreased 5.8% quarter-over-quarter (from RMB320.2 million to RMB301.5 million). This was largely due to the absence of a one-time RMB35.5 million business tax refund recorded in Q4 2006.
- Margin Compression: Online game gross margin decreased slightly (90.3% to 89.6%) due to the prior quarter's tax refund and increased staff/server costs. Advertising margins dropped significantly (50.5% to 35.7%) due to seasonal demand declines and increased production costs.
- Operating Expenses: Total operating expenses decreased to RMB117.7 million from RMB123.9 million in Q4 2006, aided by an RMB8.2 million reversal of provision for doubtful debts.
Guidance, Outlook, and Management Commentary
- Game Development: Management plans to release an expansion pack for Fantasy Westward Journey in the second half of 2007. Westward Journey III will enter internal closed beta testing in Q3 2007.
- Delays: The commercial launch of Tianxia II has been delayed to correct design issues following unsatisfactory open beta testing in March.
- Marketing Strategy: NetEase intends to increase marketing spending for its MMORPGs to maintain competitive positioning. Marketing for a new proprietary search engine is scheduled to begin at the end of Q2 2007.
- Share Repurchases: The Board authorized a new US$100 million share repurchase program on March 13, 2007. As of March 31, the company had repurchased approximately 1.1 million ADSs for US$20.8 million under this program.
- Management Changes: CFO Denny Lee resigned effective June 30, 2007, for personal reasons but will remain on the Board. Onward Choi, Financial Controller, was named Acting CFO. Director Donghua Ding resigned due to retirement.
Investor Verification Checklist
- Revenue Sustainability: Verify if the 6.7% growth in online game revenue can be sustained given the delay of Tianxia II and increased competition.
- Margin Trends: Monitor the advertising segment's gross margin, which dropped to 35.7%, to see if it recovers post-seasonal decline.
- One-Time Items: Confirm the impact of the Q4 2006 tax refund on year-over-year comparisons and normalize earnings accordingly.
- Cash Flow Volatility: Investigate the significant drop in operating cash flow (from RMB531.5 million in Q4 to RMB277.0 million in Q1) and its drivers.
- Executive Transition: Assess the stability of financial reporting and strategy execution following the resignation of the CFO.