Little Sweetheart becomes Lady Boy, Has NetEase Been Abandoned Again in the "Revaluation of Chinese Concepts"?

$NetEase(NTES.US)$NTES-S(09999.HK) released its Q4 2024 financial report after the Hong Kong stock market closed on February 20th, Beijing time, reiterating that regardless of the secondary market's reputation, product-driven companies ultimately need to rely on products and performance.

1) Games: Q4 growth relied entirely on PC games. The main mobile games, which account for two-thirds, faced a gap with no new releases, and last year's "Nirvana in Fire Mobile" set a high year-on-year comparison threshold, resulting in over 10% negative growth this quarter; this significantly missed the market's original expectation of a slowdown to single-digit declines.

Although the return of Blizzard brought a good increment to PC games (up 57% year-on-year), overall gaming and value-added services slightly exceeded expectations. However, in the view of Dolphin Research, this still represents a financial report that weakens profitability efficiency—Blizzard's agency share is too high.

Nonetheless, December's "Marvel Showdown" and the end-of-year "The Sixteen Sounds of Yanyun" performed exceptionally well, reversing some of the weak expectations and contributing to a small market rally for NetEase in December-January.

Dolphin Research reviewed the current key pipeline, noting that in 2025, growth may still rely on PC games, while mobile games will face pressure at least in the first half of the year, depending on the continued breakout and long-term operation of "The Sixteen Sounds of Yanyun." In the second half of the year, the base will decrease, and there are also expectations for the performance of new games like "Seven Days World" and "Code Name Infinite."

2) Gross Profit: The return of Blizzard also brought up another issue in this financial report—poor gross profit performance. Both year-on-year and quarter-on-quarter gross profit showed negative growth, with a gross profit margin barely at 61%, below market expectations.

3) Music, Youdao, and Other Innovations: Currently, it seems that these areas do not provide much support for NetEase's performance—whether it's the continuously declining Youdao Education, the competition from deep-pocketed music streaming services affecting Cloud Music, or the lack of presence of Yanxuan.

The common characteristics of these businesses are: small scale, pressure on growth, and a strategic contraction at the group level focusing on reducing losses or achieving profitability, which overall does not bring more valuation storylines to NetEase.

4) Is Core Profitability Inflated or Genuine Capability? In a situation where total revenue and gross profit are mediocre, NetEase managed to achieve significantly better-than-expected operating profit this quarter. The key here is that marketing expenses dropped by 80%, which was over 1 billion lower than market expectations.

The company states that innovative marketing tools and methods have improved marketing efficiency, suggesting that such optimization may have some sustainability; however, Dolphin Research still finds it hard to understand such a sudden drop. There were indeed reports at the end of last year about the suspension of marketing budgets for several evergreen games, and it is unclear whether this is related to the recent internal anti-corruption efforts in NetEase's marketing and distribution line therefore, the profit margin in Q4 still has some one-off factors. Although there is potential for continued optimization in the medium to long term based on the Apple tax investigation, Dolphin Research suggests not to linearly extrapolate the Q4 situation in the short term.

5) Shareholder Returns: At the end of last year, NetEase had a net cash balance of USD 18 billion, an increase of 18% compared to the previous year, still a solid cash cow business.

In Q4, USD 220 million was repurchased, a significant slowdown compared to USD 570 million in Q3, indicating a clear deceleration in shareholder returns. Therefore, NetEase's repurchase plan is generally based on market value fluctuations. In addition, a dividend of USD 1.22 per ADS was distributed in Q4.

Based on this, Dolphin Research calculates that NetEase's dividends in 2024 will be close to USD 1.7 billion, with repurchases nearing USD 1.3 billion, totaling nearly USD 3 billion, a year-on-year increase of 30%. The corresponding return rate based on the current stock price is about 4.5%, which is neither high nor low. Additionally, there is still USD 3.1 billion left in the repurchase quota, which has a validity period of only one year, meaning either the repurchase period will be extended or the repurchase pace will accelerate.

Dolphin Research assumes that if dividends and repurchases continue to grow by 30% in 2025, reaching nearly USD 4 billion, then the current valuation of USD 65 billion would imply a return of 6% from this year's dividends and repurchases, which would be a decent yield.

Dolphin Research's Viewpoint

In this round of revaluation of Chinese concept stocks, NetEase has lagged. On one hand, mobile games still have fluctuations, and on the other hand, two new games have already repaired their valuations in advance and are not sufficiently aligned with the AI theme.

The quarterly report reflects that, in the absence of hope for other businesses, NetEase is now a "pure-blood" gaming stock. Although the performance of games in Q4 was not as bad due to the return of Blizzard games and the exceeding expectations of "Marvel Duel," the overall gaming results were not too grim.

However, the gross profit of agency-operated games is low, making it difficult to compensate for the awkward decline in self-developed mobile game revenues in terms of profits. Ultimately, relying on unclear sustainable marketing cost reductions to squeeze out profits is challenging. Without discussing the expectations for "Yanyun," looking purely at this quarter's results, Dolphin Research believes it is primarily skewed.

For product-driven companies, revenue differences purely represent past results. When looking at company opportunities, aside from whether the stock price has dropped to a sufficiently low level, the real key is how the upcoming products perform.

Currently, the worst times are over: Firstly, the new game "Yanyun" will launch in January, and both user and revenue data are performing well; "Seven Days World" will also launch in April, and with a lower base in the second half of the year, there is anticipation for a blockbuster-like "Code: Infinite"; on the PC side, "FragPunk" and Blizzard's "Overwatch" return, which will generate new increments; this will be much better compared to the transitional fourth quarter of last year.

Considering NetEase's long-term competitive position, assuming a long-term EPS growth of 10%, the current valuation is still undervalued. Based on the current product cycle, compared to the third quarter when macroeconomic conditions were poor + competition was fierce + lack of new products (mainly mobile games) + a tumultuous period, and multiple negative factors combined to produce a 12x Non-GAAP P/E. After switching to the 2025 expectations, Currently, NetEase is currently valued at 66.5 billion USD, and according to Dolphin Research, the Non-GAAP P/E valuation currently exceeds 14x, leaving only about 10% space to the central valuation of 16x.

However, this year's profit side will still show pressure due to the base effect and high revenue sharing from agency-end games, with growth expected to be at a single-digit level. Therefore, either through shareholder returns, with a normal repurchase pace and dividend ratio, there is hope for decent support during adjustments. From a safety perspective, one can observe the explosive potential of new games to determine whether to provide sufficient safety margins.

The following is a detailed analysis.

1. Games: When will mobile games rebound is key this year

In the fourth quarter, game revenue was 20.5 billion, a year-on-year increase of 5%, mainly relying on PC games, which accounted for one-third of the revenue, with a 57% increase this quarter. Mobile games unexpectedly continued to weaken, with a year-on-year decline of 11%.

Looking at deferred revenue, several new PC games in Q4 are expected to continue supporting short-term growth, but whether they can bring unexpected growth mainly depends on the performance of the mobile game "Yan Yun Shi Liu Sheng" in the first half of the year.

(1) PC Games: Still need to bear the brunt this year

In the fourth quarter of PC games, the old game "Dream of the Red Chamber" has stabilized, and among the incremental revenue, the return of Blizzard's Chinese server accounted for a large portion, followed by the rapidly popular "Marvel Showdown" after its launch in December. "Marvel Showdown" topped the Steam bestseller list within four hours of its launch, attracting over 10 million players in three days, and has accumulated over 40 million players to date. At the beginning of January, the season started, creating another small peak in online player numbers. For example, on February 21, the peak number of online players reached 440,000, ranking third on the Steam leaderboard.

In addition to "Marvel Showdown," the year-end release "Yanyun Sixteen Sounds" also performed well. However, as a Chinese ancient-style action-adventure RPG, "Yanyun" primarily targets the Chinese market, so its energy is more focused on the mobile version released in January.

(2) Mobile Games: High Base + Lack of New Games

In the fourth quarter, mobile games continued to decline by 11%, which is worse than market expectations. The market originally thought that the stable revenue from "Egg Boy" and "Nirvana in Fire" mentioned by management in the third quarter, along with the incremental revenue from "Naraka: Bladepoint," would lead to a slowdown in the decline.

It can only be said that "Nirvana in Fire" in 2023 was truly phenomenal. This year, there was only one key new game with a bit of operational threshold, "Naraka," and another Marvel IP mobile game "Marvel Ultimate Reverse" released in August performed poorly. Additionally, "Egg Boy" also faced base effects (limiting daily spending), making it very difficult to maintain growth.

This year, the first half is expected to still face pressure, mainly relying on the operation of "Yanyun." Once the "Yanyun" mobile game was launched, both its reputation and revenue were quite good, dominating the iOS bestseller list for two consecutive weeks. However, after the Spring Festival and winter vacation, the revenue ranking of the "Yanyun" mobile game has declined, and the download ranking is barely stable. Let's see how the company promotes activity and attracts new users through operations in the future.

The mobile game "Seven Days World" will be launched in April, and in the second half of the year, we expect the first-hand "Code Name Infinite," along with a lower base, so the pressure in the second half will be slightly less.

2. Outside of the main gaming business, overall contraction and efficiency improvement are underway

In the fourth quarter, other innovative revenues such as Cloud Music, Youdao, and Yanxuan all experienced year-on-year declines, with some profitability improving, indicating that the group's current strategy for these businesses is to prioritize profit over expansion.

Although the return on investment for individual businesses has increased, from the group's perspective, under this strategy, businesses outside of the main gaming sector find it difficult to bring many valuation storylines to NetEase.

3. Current profits have some fluff, with potential for improvement in the medium to long-term

The better-than-expected Non-GAAP net profit in the fourth quarter mainly came from a significant decrease in sales expenses and a one-time foreign exchange gain of 1.5 billion. This partially offset the drag on gross profit due to pressure on mobile game revenue and high distribution shares from PC game agencies.

This time, sales expenses were more than 1 billion lower than market expectations. The company explains that innovative marketing tools and methods have improved marketing efficiency, suggesting that there may be some sustainability in such optimization; however, Dolphin Research still finds it hard to understand such a sudden drop. There were indeed reports at the end of last year about several evergreen games pausing their marketing budgets, and it is unclear whether this is related to the recent internal anti-corruption efforts in NetEase's marketing and distribution line.

In terms of optimizing other expenses, the main areas were server cost optimization and personnel optimization. For example, management expenses in the fourth quarter decreased by 7% year-on-year, with equity incentives for operational management personnel also declining by 6%. R&D expenses were nearly flat year-on-year in the third quarter, but equity incentives continued to increase by 25%, indicating that the focus of optimization was not on R&D personnel but on other basic resource costs directly related to R&D, such as server depreciation.

Therefore, it is evident that the profit margin in Q4 still has some one-time fluff. Although there is potential for continued optimization in the medium to long term based on the Apple tax investigation, Dolphin Research suggests not to linearly extrapolate the Q4 situation in the short term.

Ultimately, the operating profit of the core main business (excluding foreign exchange gains and losses) increased to a profit margin of 29.2% quarter-on-quarter. The Non-GAAP net profit was 9.7 billion, with a profit margin of 31.2%. In addition to sales expenses, there was also a foreign exchange gain of 1.5 billion, while last year there was a foreign exchange loss of 800 million. If we exclude the impact of foreign exchange, the actual non-GAAP net profit is flat compared to last year.

4. What about shareholder returns this year?

At the end of last year, NetEase had net cash of 18 billion USD on its books, an increase of 18% compared to the previous year, and still a solid cash cow business. In the fourth quarter, it repurchased 220 million USD, a slowdown compared to 570 million in the third quarter, indicating that the management's overall repurchase pace is determined by market value fluctuations. In addition, a dividend of 1.22 USD/ADS was distributed in the fourth quarter, and NetEase generally has higher dividends in the fourth quarter according to Dolphin Research's calculations, in 2024, NetEase's dividends will be close to USD 1.7 billion, and share buybacks will be close to USD 1.3 billion, totaling nearly USD 3 billion, a year-on-year increase of 30%. The overall payout ratio for buybacks and dividends is 60%. Corresponding to the current market value of USD 66.5 billion, the return rate is approximately 4.5%, which is neither high nor low. Additionally, there is still USD 3.1 billion left for buybacks, with only one year remaining in the validity period, meaning that either the buyback period will need to be extended, or the buyback pace will need to be accelerated.

Dolphin Research assumes that in 2025, with dividends and buybacks continuing to grow by 30%, if the remaining buyback amount is used up and a normal dividend of less than USD 1.4 billion is issued (as this year's profit growth will still be relatively low), then if the overall amount reaches nearly USD 4.5 billion, the current valuation of USD 66.5 billion would mean that this year's dividend and buyback return exceeds 6%, which would be considered a good return.