Description

NetEase (NTES) is a Chinese gaming powerhouse undergoing a wave of strategic actions and financial initiatives that prepare it for further success in 2021. A deep base of iconic franchises (Fantasy Westworld Journey (“FWJ” and “WWJ”), Onmyoji, Knives Out, etc.) with recurring in-game spend drove 30% compounded revenue growth since 2008, propelling NetEase to dominance in the Chinese gaming market alongside rival Tencent. After tighter Chinese gaming regulations created an air-pocket for new game approvals in 2018 and 2019, industry growth accelerated in 2020. With game launches now resumed, end-market growth has returned to 10% with NetEase outperforming the market in most years. NetEase’s rich pipeline of new games (Harry Potter, Revelation Mobile, and Diablo Immortal slated for launch in Q4 2020 and 2021) and core recurring franchises should preserve ongoing share gains. Further, NTES’s growing foothold in the Japanese market (now 6% share) and foray into western countries expand the addressable market. At a valuation of 22x 2021 P/E, shares appear mispriced relative to global gaming peers (23-30x) and the broader indexes. 

In the very near-term, analysts warn of earnings pressure from higher investment at majority owned Youdao (DAO), licensing rights for its streaming music businesses, and gaming promotions. NetEase, like other Chinese tech conglomerates, operates several businesses outside of its core gaming division. Management recently took steps to simplify the corporate structure by selling its largest e-commerce business to Alibaba, spinning-out the YouDao business (late 2019), and announcing its intention to list the streaming music business next year. As these loss-making divisions fade from the financials, we see long-term margin upside to pair with NTES’s double-digit gaming growth.

In an already healthy Chinese gaming market, NTES has outperformed the industry with it and Tencent consolidating the market (now 80% combined share). NetEase operates profitably in this competitive market, thanks to a recurring stable of core franchises and the steady development of hit titles. Revenue to CFO conversion has averaged 35% for the past few years (before SBC) with resilient core EBITDA margins and deferred revenue (pre-paid games) inflows. NetEase’s founder, Ding Lei (William), continues to serve as CEO after 23 years. Mr. Ding typically favors returning excess capital to investors through intermittent special dividends and share repurchases. And while there is the odd capital investment here and there (gourmet pig farming, land investments, etc), the capital allocation track record appears balanced.

NetEase Gaming is known for its long-standing MMO (massive multiplayer online) franchises that remain leaders in the category today. Now several years after their launches, FWJ, WWJ, Onmyoji, and other domestic titles still generate much of NetEase’s core gaming revenue. New titles like Diablo Immortal and Harry Potter should become additive to revenue and build appeal in international markets. But as the chart below demonstrates, the company's financial future does not ride on any new franchise. Instead, China’s mobile-first games model relies on recurring spend for in-game rewards. These games receive regular content updates to preserve customer involvement. This leads to a more sustainable monetization model and sticky franchise value.

Best known for its Chinese-language games, NetEase spent the past few years shifting resources abroad – buying foreign developers, launching major titles, and acquiring the rights to western IP. NetEase recently developed a hit in Japan (Knives Out) that now commands 6% of the $15bn Japanese gaming market (up from 3% share in 2018, 4% in 2019, and 5% in H1 2020). NetEase supports the competitive eSports scene in Japan for Knives Out, a strategy proven successful many times over in China, Korea, and the U.S, helping the title grow 31% y/y in August. Other meaningful Japanese games include Identity V and LifeAfter, both survival games. NetEase has long collaborated with Blizzard for the Chinese release of foreign titles like World of Warcraft and has plans to co-release Diablo Immortal for select markets. The initial reception for a smartphone-focused game jarred long-time PC-gamers of the franchise, but future collaborations like this may eventually build the NTES brand in western markets. NetEase continues to add western game studios to supplement its capabilities abroad: Jumpship in 2017, Second Dinner in 2018, and the opening of a Montreal office in 2019.

U.S. video game counterparts have, with stops and starts, benefited from a similar transition to mobile-gaming, in-game spend, and regular game updates, leading to renewed investor interest in gaming businesses over the past few years. After global shut-ins during the pandemic drove above-normal gaming growth in Q1 and Q2, the group has underperformed since mid-year on fears of tougher comparables in 2021 and a sequential slowdown as the world returns to work in Q3 and Q4. While NetEase faces the same immediate challenge, gaming as a form of entertainment continues to grow at a healthy rate. And in the Chinese gaming market, abnormally high 16% growth in 2020 should be followed by steady 10% growth in 2021.

NTES shares trade under 22x 2021 P/E (ex-SBC) before adjusting for less profitable non-gaming businesses. By comparison, global gaming franchises with recurring IP trade for 17x 2021 EBITDA and 23-32x 2021 P/E. We think NTES’s sustainable franchises, double-digit revenue growth, and non-core value warrant a valuation at least in-line with global peers. At 26x 2021 earnings, NTES shares would be worth $115, or 25% higher than their current valuation.

Like other Chinese conglomerates, NetEase has leveraged its online presence and robust profitability to create new products in other high-growth categories. NetEase began 2019 with standalone businesses in e-commerce, steaming music, and online education. Most operate at negative margins to achieve market dominance, thereby dragging down the profitability of the overall company. Realizing the dormant value in these assets, NetEase has been taking concrete steps to crystalize value in each of its sub-segments. It sold its cross-border retailer Kaola (~80% of ecommerce revenue) to Alibaba for $2bn and then took the education business Youdao public in October at 10x EV/Revenue – a feat achieved amidst the WeWork IPO-debacle and US.-China trade tension. NTES also sold a minority stake in NetEase Cloud Music to Alibaba, solidifying NetEase as the most legitimate competitor to Tencent’s music platforms. NetEase plans to list its Cloud Music business next, following Tencent’s lead – Tencent Music (TME) trades at a US$25bn market capitalization.  News articles place the post-money valuation of Alibaba’s investment in NetEase Cloud Music around $7bn, and the business continues to grow well. As its non-gaming segments further deconsolidate over time, NTES should see margin accretion towards 30%+ (adding back SBC to match convention) – much more consistent with global gaming peers Tencent, Activision Blizzard, and Electronic Arts that operate at 35-40%.

The path towards higher margins is not entirely linear: analysts expect higher Youdao expenses (consolidated on NTES statements), music investment, and gaming marketing expense to pressure margins in Q3 and into late 2020. But the years of investment into the Kaola business are in the past. The Cloud Music business is moving closer to profitability as it scales its user base to levels more comparable to TME and expands its paying ratio. And Youdao’s investment in sales and teaching staff will eventually lead to operating leverage to match the 100% y/y revenue growth.

Offsetting some of this investment in the coming year, NetEase’s new games pipeline should bear fruit in 2021. The crackdown in Chinese gaming approvals in 2018-2019 pushed several titles behind schedule, while game redesigns on western titles like Diablo also forced delays. But the regular cadence of domestic releases should proceed, complemented by popular franchises like the Harry Potter mobile game. Harry Potter is famously popular in China with 20m authorized books sold and a theme park planned for Beijing. Analysts expect it to contribute meaningfully beginning in 2021 and into 2022. NetEase plans to release other mobile games based on famous western IP, like Lord of the Rings, Marvel comic books, and Blizzard’s Diablo.

Alongside these potential blockbuster games, 2021 may include the public listing of NetEase Cloud Music. Analysts estimate Cloud Music burns RMB1-2bn/year to fund new music licenses and promote itself against Tencent’s platforms (Kugou, QQ, WeSing, Kuwo). The NetEase Cloud Music platform now supports 145m users and skews towards a younger demographic than Tencent. Compared to western streaming music businesses, both of China’s streaming music businesses appear under-monetized. The paying ratio for TME resides near 7% (vs. 40%+ for Spotify) since Chinese buying habits still favor buying albums ad-hoc (or pirating music). But as younger cohorts become more comfortable with unlimited streaming subscriptions, NetEase Cloud Music stands to benefit from the shift. TME recently reported +50% y/y growth in paying users against a flat MAU of 650m. Analysts expect NetEase Cloud music to grow revenue near 90% in the upcoming quarter, driven by both user engagement and better monetization.

Given these favorable attributes, we think the standalone multiple of 22x 2021 P/E is too low. Our belief is further supported by simple sum-of-the-parts math. (Because explicit financials are not readily available for the Cloud Music and standalone games divisions, we’ve borrowed from analyst estimates.) Using Morgan Stanley estimates for Games profitability ($3.1bn in 2021), the reported post-money valuation of Cloud Music ($7bn), Youdao’s public valuation (58% stake of $3bn), and a conservative 1x EV/Revenue on the other non-core businesses, we derive a price target near $115, or about 25% higher than the current share price. This triangulates to an earnings multiple near 26x 2021 P/E, placing NTES closer to its global gaming peers.

Despite Q3 and possibly Q4 likely to report mixed profitability given the lack of immediate game releases and higher spend across the non-gaming businesses, the core gaming portfolio continues to dominate its core market. Three or four of NetEase’s core franchises have sat within the top ten iOS grossing apps though much of the year. This core stability combined with steady FCF generation and a thoughtful capital allocation program should provide valuation support. Meanwhile, a richer new release pipeline in 2021, the spin of the Cloud Music business, and continued 10-15% revenue growth with steady margin expansion in the games business should result in above-average returns in the coming year.

Catalyst

- Listing of NTES Cloud Music
- 2021 games releases
- Optical financial improvement at the overall company level as non-gaming businesses are deconsolidated
- Steady double-digit growth and margin expansion in core games business
- Valuation multiple expansion to match peers