NetEase Inc.:Buy,2Q miss no cause for concern

Slight miss in bottom line: Netease reports 2Q17 results with in-line
revenue but aslight miss at the bottom line, mainly due to a change in
revenue mix and higherthan-expected sales & marketing expense. We
believe Netease, as a leading gamedeveloper, will be able to continue
delivering strong growth in the long term. Anypotential negative
reaction to the temporary miss in results would be an opportunityto add
to positions, in our view. We expect solid results in the coming
quarters giventhe strong underlying fundamentals, backed by 1) mobile
Minecraft likely launchingby end-3Q17 (albeit delayed from July 2017),
2) a strong pipeline with Index andForever 7 in testing, and 3) a robust
overseas expansion strategy and ecommercegrowth in Kaola.com and
Yanxuan.

Weaker 2H17but stronger 2018. NetEase, in our view, remains the most
skilleddeveloper of hard-core, massive multi-player online role playing
games (MMORPG) forPC and mobile. We are optimistic about the company’s
ability to maintain strongpositions for its legacy mobile games and
expand into other genres, including sandbox(Minecraft), MOBA (Onmyogi
MOBA) and survival games. It currently has a pipeline of40-50games (from
30internal studios) but is deliberately delaying releasing many ofthese
until 1H18. In addition, other mobile games have declined in revenue
from 2Q17.As a result, we lower our estimates for 3Q-4Q17and our target
price.。

Revenue in line; Bottom-line missed on higher promotion spending. Total
revenue wasRMB13.4bn, up 49% YoY, down 2% QoQ, and 2% higher than our
estimate of RMB13.1bn, withe-commerce revenue beating our estimate by
10%. Bottom-line (non-GAAP EPS was RMB26.18)was 6% lower than our
estimate (RMB27.85), on lower-than-expected gross margin for
thee-commerce business and more aggressive promotion spending for online
games. Gross marginwas 50%, down 5ppts/9ppts QoQ/YoY, where 1) the YoY
decline in gross margin was mainlydue to higher revenue contribution
from mobile games; 2) the QoQ decline was attributable tolower gross
margin for the e-commerce business due to changes in revenue mix.
Operatingprofit margin declined by 10ppts on a QoQ basis, as S&M/R&D
expenses increased by 37%/14%QoQ, while revenue remained flattish
compared with the previous quarter.

    2Q results. Net revenue grew 49% y-o-y to RMB13.4bn vs our estimate
ofRMB13.1bn and consensus of RMB13.1bn. Online gaming revenue increased
46.5%y-o-y to RMB9.4bn, of which mobile game revenue is 2% above our
estimate but PCgame revenue is 10% lower. Email, e-commerce and other
revenue growth furtheraccelerated to 69% y-o-y from 57% in 1Q due to
strong growth during the Junepromotion. Gross margins were 50%, slower
than our 52% estimate, as relative lowmargin businesses (mobile game and
ecommerce) account for a large proportion oftotal revenue. Operating
margins were 30% compared to our estimate of 34%, due toa 37% q-o-q
increase in sales & marketing expense. The company increasedmarketing
activities in 2Q mainly to promote Onmyogi’s new expansion packs in
bothdomestic China and overseas. The company continues to expect lots of
promotionactivities in the quarter to extend the lifespan of existing
games as well as to increaseuser acquisition for the new games. Adjusted
2Q EPS of USD3.80 misses ourestimate by 9%. We note that deferred
revenue declined 12% q-o-q due to the lack ofnew game launches in 2Q.

    Mobile momentum slowing. NetEase grew net revenue by 79% y-o-y in
1Q17and49% y-o-y in 2Q17, with mobile game revenue up 108% y-o-y in
1Q17and 74% y-o-yin 2Q17. That said, deferred revenue declined 12% q-o-q
in 2Q17; and, since June,Onmyogi has fallen out of the top 10in terms of
revenue ranking in 3Q17. In addition,we believe other mobile games,
including Fantasy Westward Journey (FWJ), haveseen revenue declines
m-o-m in 3Q17. To account for these factors, we lower ourmobile gaming
revenue estimate by 16% and now expect a decline of 22% q-o-q in3Q17and
3% q-o-q in 4Q17. While newly launched Minecraft remains
strong(consistently ranked top 5-10by daily downloads), management is
focused on usergrowth instead of on monetisation, which should begin
when it launches for Android on12October. Further, it will expand
testing of Onmyogi MOBA in October, but a fulllaunch by year-end
suggests limited revenue in 2017. That said, we see potential for anew
genre of mobile survival games to be launched in 4Q17or 1H18.。

    Revenue fluctuation of Onmyoji resulted in the QoQ decline in mobile
game revenue; thehighly anticipated licensed game Minecraft is to be
launched in 2H17. Total game revenuewas RMB9.4bn, down 12% QoQ, and in
line with our estimate. The QoQ decline came fromlower revenue
contribution from mobile games, and PC games also experienced QoQ
revenuedecline due to a lack of expansion pack during 2Q17. Mobile game
revenue was RMB6.8bn,down 13% QoQ, up 74% YoY, contributing 72% of total
game revenue, compared with 73% inthe previous quarter. Onmyoji has
experienced revenue fluctuation in China since 2Q17.

    Estimate changes. We cut our game revenue estimates to reflect the
delay ofMinecraft as well as the lower estimate for PC game revenue
growth. We increaserevenue growth assumptions of ecommerce segment
attributable to Kaola andYanxuan. With increasing promotion activities,
we also increase our sales &marketing expenses assumption. Overall, our
2017-19 revenue estimates are largelyunchanged, but we lower our
2017-19e EPS estimates by 5-6%Maintain Buy rating, cut TP to USD336
(from USD356). Our target price is derivedfrom a 1x PEG, based on our
2017 EPS estimate of USD16.33 (from USD17.38) anda three-year EPS CAGR
of 21% (was 20%). Our TP implies 6.6% upside: we rate thestock Buy as we
expect NTES to deliver growth in the long term. Current marketprice and
our TP implies 18.7x/20.5x 2017e respectively. Key downside risks
includefurther delay of key games.

必赢56net手机版,    Estimate changes. We lower our revenue and adjusted EPS estimates by
6%/15%and 2%/8% for 2017-18, respectively. Mobile gaming, in our model,
should grow by47%, accounting for c50% of total revenue in 2017. We
expect mobile game revenueto ramp in 2H18, with Minecraft, survival
games and other new games, leading to34% growth in 2108. We continue to
forecast email and e-commerce to grow66%/37% for 2017-18, accounting for
25-30% of total company revenue.。

    Netease will launch new content to maintain user engagement and is
actively expanding thisgame to the global market, with satisfactory
feedback from Japan, Korea and SEA. Gamepipeline includes: 1) licensed
game Minecraft, where the PC version has started beta testingfrom August
8, and the mobile version will be launched during 3Q17; 2) two Japanese
themedRPGs (Index, and Forever 7) to be launched in 3Q17 to broaden the
game portfolio by furtherpenetrating into the ACG generation; 3) a
handful of new games targeting the overseas market.

    Maintain Buy and lower PEG-based TP to USD316(from USD336). Our
thesisrests on three points. First, NetEase’s proven game development
capabilitiesrepresent high barriers to entry and its existing PC and
mobile games could have alonger-than-expected life span. Second, the
e-commerce business could generatematerial value in the future. Finally,
the valuation is attractive, trading at a 19x PE/a14x PE on our revised
EPS estimates for 2017-18. We derive our TP of USD316byapplying a 1x PEG
(unchanged) to our 2017EPS estimate of USD14.04and a threeyearEPS CAGR
of 23% (was 21%). Our 2017revenue/EPS estimates are 4%/12%below
consensus. Catalyst: 3Q17results call in November when management
mightprovide an update on Minecraft and survival games. Key downside
risks includedelays in game launches.。

    Kaola.com and Yanxuan continued strong growth momentum in revenue,
while profitabilityis not the priority yet. Revenue from e-mail,
e-commerce and others increased by 69% YoY toRMB3.4bn, exceeding our
estimate, on solid performance from Kaola.com and Yanxuan, whichprovided
products and services with better value proposition and reasonable price
to domesticcustomers. Revenue from the online advertising business was
RMB596m, up 34%/12% QoQ/YoY, driven by seasonality/improved monetization
capability in mobile. The top sectors for theadvertising business were
automobile, internet services, and real estate.

    Valuation. We lower our game revenue estimate for 2017E/2018E, and
expect the sequentialdecline in game revenue to continue in 3Q17,
considering there is no hit mobile game for now,and no major expansion
pack or new PC game is expected to be launched during the quarter.

    We lower 2017E/2018E total revenue estimate by 2%/1%, and lower
2017E/2018E net profitestimate by 9%/9%, given lower-than-expected gross
margin and higher promotion spendingon the gaming business. Based on
10-year DCF model for 2018E-2027E, we lower our valuationfor the gaming
business to USD33bn, and maintain the valuation for the e-commerce
businessat USD7bn. We lower TP from USD340 to USD335. As we believe
revenue growth of Netease islikely to slow down in the short term, we
downgrade Netease to LT Buy. We are still positive onthe R&D capability
of Netease’s gaming business, and the growth potential for Kaola.com
andYanxuan e-commerce platform considering the consumption upgrade in
China. In addition, thelaunch of new games such as Minecraft, if
successful, may become catalysts for share price. Wewill pay close
attention to Netease’s game pipeline, and review our rating accordingly.

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