NetEase's first-quarter performance exceeded expectations overall. As a defensive stock, it once again beat conservative expectations:

1. The pillar once again outperformed: Overall gaming revenue exceeded expectations by nearly 1 billion yuan. This earnings report did not break down mobile and PC gaming performance. Based on rough estimates, there might be expectation gaps in both segments.

Gross margin did not decline quarter-over-quarter as expected (affected by high-royalty Blizzard games) but instead increased by 2 percentage points. This potentially indicates continued recovery in the mobile gaming business.

2. Subsidiary businesses under pressure but focused on profitability: Youdao, Cloud Music, and Yanxuan (NetEase's e-commerce platform) and other innovative businesses continue to face revenue growth pressure. However, gross margins did not deteriorate further, with Cloud Music's gross margin returning to 36%.

3. Continued release of operating leverage: First-quarter operating expenses were very low, especially sales and promotion expenses, which decreased by 33% year-over-year, a reduction of nearly 1.5 billion yuan. Even without the crazy marketing spending for "Eggy Party," it shouldn't have dropped to the lowest level in nearly four years, especially since Q1 should have included daily promotional expenses for new games like "Where Winds Meet," "Raging Tides," and "Once Human." This can only mean that the internal anti-corruption efforts in the second half of last year have paid off.

On the other hand, combining Tencent's situation, one phenomenon is that both gaming giants have significantly reduced promotion expenses, yet revenue remains unaffected. We believe there might be two reasons: (1) Increased focus on evergreen games, which are constantly "revamped" to extract value. Evergreen games come with brand effects and often don't require much external promotion. (2) Changes in promotion models, shifting from simple and direct ad buys to content marketing collaborations with gaming influencers (short videos, live streams), leading to higher conversion rates. NetEase already mentioned this last year.

Overall, the market may be slightly underestimating NetEase's resilience as an established gaming company at the bottom of the cycle. This year, due to the lack of AI catalysts and the passing of the product cycle peak, NetEase hasn't been aggressive in business expansion. With decent shareholder returns at low valuations, it is seen more as a defensive stock.

As a result, market expectations for its performance have remained low. Although Blizzard and "Where Winds Meet" have brought significant growth to PC gaming, concerns about the relatively flat mobile gaming pipeline have led to conservative market expectations for three consecutive quarters.

Therefore, regardless of subsequent performance, narrowing the expectation gap could slightly boost valuations. However, in terms of the pipeline, the next product boom cycle might need to wait until the end of this year or early next year with "Infinity." Short-term minor catalysts could include the anniversary event for "Naraka: Bladepoint," the overseas release of "Where Winds Meet," and the "revamping" of evergreen games (a strategy that seems to work well for both Tencent and NetEase). Here, we can pay attention to the earnings call and the upcoming 520 Game Conference.$NTES-S(09999.HK) $NetEase(NTES.US)