Business Context and Reporting Period
This summary covers the Annual Report on Form 20-F for NetEase, Inc. for the fiscal year ended December 31, 2006. NetEase is a leading Chinese internet technology company primarily engaged in online games, advertising services, and wireless value-added services. The company operates through a Cayman Islands holding company and utilizes contractual arrangements with Variable Interest Entities (VIEs) in China to comply with local regulations regarding foreign ownership in telecommunications and internet services.
Key Financial Metrics (Year Ended Dec 31, 2006)
| Metric | 2006 (RMB) | 2006 (US$) | 2005 (RMB) |
|---|---|---|---|
| Total Revenues | 2,217,241,745 | 284,112,421 | 1,694,418,383 |
| Net Revenues (after business tax) | 2,164,359,470 | 277,336,204 | 1,612,363,481 |
| Net Profit | 1,242,777,584 | 159,246,751 | 931,990,169 |
| Operating Cash Flow | 1,596,108,793 | 204,521,827 | 1,104,789,431 |
| Capital Expenditures | (142,513,502) | (18,261,363) | (92,608,975) |
| Cash and Time Deposits | 3,937,873,213 | 504,590,307 | 3,377,720,336 |
| Long-Term Debt (Convertible Notes) | 780,253,918 | 99,980,000 | 806,858,596 |
Note: US$ amounts are translated at the rate of RMB 7.8041 = US$1.00 as of December 31, 2006.
Revenue Composition (2006)
- Online Game Services: RMB 1,856.1 million (83.7% of total revenue). Driven primarily by "Fantasy Westward Journey" and "Westward Journey Online II".
- Advertising Services: RMB 285.8 million (12.9% of total revenue).
- Wireless Value-Added Services: RMB 75.4 million (3.4% of total revenue).
Material Changes vs. Prior Period
- Revenue Growth: Total revenues increased 31.0% year-over-year, while net revenues grew 34.2%. Online game revenue surged 34.6% due to the continued popularity of "Fantasy Westward Journey," which saw peak concurrent users rise to over 1.3 million in December 2006.
- Profitability: Net profit increased 33.3% to RMB 1.24 billion. The effective tax rate was 9.6% in 2006 compared to 9.2% in 2005.
- Expense Increases: Operating expenses rose 39.7% to RMB 503.2 million. This was largely driven by a significant increase in share-based compensation costs (RMB 101.3 million) following the adoption of SFAS 123(R) in 2006, as well as increased R&D spending for new game development.
- Share Repurchases: The company repurchased approximately 5.99 million ADSs for an aggregate of US$110.2 million during 2006 under two board-approved programs.
Guidance, Outlook, and Risks
Management Commentary and Outlook
- Game Development: Management is focusing on transitioning from 2D to 3D games. They are developing "Tianxia II" (3D) and "Westward Journey Online III." Beta testing for "Tianxia II" received less positive feedback than expected, requiring further development and cost.
- Advertising: The company expects continued growth in the Chinese online advertising market, particularly in paid search services.
- Capital Allocation: Future capital expenditures are expected to be funded by operating cash flows. The company is in discussions to purchase land in Hangzhou for approximately RMB 27 million to construct buildings for its game development division.
Risks and Contingencies
- Regulatory Environment: Significant risk exists regarding Chinese government regulations on online games, including restrictions on minors (anti-addiction systems), content censorship, and foreign ownership limits in telecommunications.
- Game Lifecycle: Revenue is heavily dependent on two specific games ("Fantasy Westward Journey" and "Westward Journey Online II"). Failure to maintain their popularity or successfully launch new titles could materially harm results.
- Tax Reform: A new Enterprise Income Tax Law effective January 1, 2008, will unify tax rates at 25%. Management cannot currently assess the full impact on deferred tax assets/liabilities as transitional rules are not yet finalized.
- Variable Interest Entities (VIEs): The company relies on contractual arrangements with VIEs to operate in China. If these entities or their shareholders breach agreements, operations could be disrupted.
Investor Verification Checklist
- Game Dependency: Verify the user retention rates and concurrent user trends for "Fantasy Westward Journey" and "Westward Journey Online II" to assess revenue sustainability.
- New Game Pipeline: Monitor the commercial launch dates and initial reception of "Tianxia II" and "Westward Journey Online III" to evaluate future growth drivers.
- Regulatory Compliance: Track the implementation of the government-mandated anti-addiction system for minors and any new content restrictions.
- Tax Impact: Review the final implementation rules of the 2008 PRC tax reform to understand the impact on the company's effective tax rate and deferred tax balances.
- Share-Based Compensation: Assess the impact of SFAS 123(R) on future earnings, as stock-based compensation costs are expected to remain a significant expense item.