NetEase: From defense to offense? The older, the wiser!

$NetEase(NTES.US) released its Q1 2025 earnings report after the Hong Kong market closed on May 15 Beijing time, once again exceeding expectations amid conservative forecasts. Beyond gaming performance, what surprised Dolphin Research the most was the extreme cost compression following internal organizational reforms.

This isn’t a one-time fluctuation. Although management mentioned short-term impacts from business adjustments and a gradual return to historical norms, we believe operational efficiency improvements will persist. This will directly support NetEase’s ability to achieve double-digit profit growth this year, even during a 平淡 (flat) mobile game pipeline period with potential revenue fluctuations.

From the commonalities in Tencent + NetEase’s Q1 reports, Dolphin Research derives two truths: 1) Gaming is highly profitable—once a hit is achieved, monetization efficiency can improve significantly. 2) Never underestimate the "renovation value" of evergreen games.

Details:

1) Where did gaming’s outperformance come from? Q1 growth was driven by PC games, including contributions from Blizzard and the new title Where Winds Meet. The earnings brief didn’t break down mobile/PC performance, but Dolphin Research estimates both segments exceeded expectations.

Since game gross margins improved sequentially (instead of declining due to Blizzard’s high revenue share), the upside surprise likely came from in-house PC and mobile games.

Among these, the standout was Where Winds Meet, which generated over ¥400 million in 流水 (revenue) within 36 days of its December launch. Mobile games declined 4% YoY in Q1, better than the expected 8% drop, showing gradual recovery (Q4: -11% YoY).

This warrants scrutiny, as Q1’s only new mobile title was Where Winds Meet, while Eggy Party and Justice Mobile faced tough comps. Sensor Tower data shows steep YoY declines for last year’s hits Justice Mobile and Eggy Party. So where did the growth come from?

Dolphin Research believes that aside from Where Winds Meet’s 意外 (unexpected) ¥1.5 billion 流水 (offsetting most declines from Eggy Party/Justice Mobile), the discrepancy with third-party data suggests mobile growth secrets may lie in older games:

- The report highlighted strong performance from Identity V, an evergreen game revitalized by content updates.
- Sensor Tower can’t track 官网 (official website) 充值 (top-up) 流水， which management said is concentrated in evergreen titles. We suspect hidden upside here.

This mirrors Tencent—both giants saw evergreen games "bloom anew" early this year. Dolphin Research attributes this to studios prioritizing brand-driven older games (with 玩法 (gameplay) 缝合 (stitching)) over costly user acquisition amid industry-wide 买量 (ad spending) cuts.

2) Can full-year expectations turn fully positive? Not yet. While older games’ revival is promising, NetEase lacks a blockbuster product cycle this year. Its mobile pipeline remains 平淡 (thin), with 4-5 储备 (backlog) games undated. Updates may come at the May 20 游戏 (gaming) 发布会 (conference).

The next potential hit is open-world game Infinity (late 2024/early 2025) or Animal Crossing-like Oddyssey (2025+).

However, after three straight quarters of beating conservative Sensor Tower-based estimates, the market should recalibrate its forecasting methods and acknowledge NetEase’s cycle-bottom resilience.

3) Operating leverage unlocked—did internal reforms work? Despite unclear revenue 前景 (outlook), cost efficiencies provide additional profit growth insurance.

Q1 sales/marketing expenses plunged 33% YoY (-¥1.5B), hitting a 4-year low—unexplained even by Eggy Party’s reduced ad spend or new game launches like Where Winds Meet/Seven Days World. This likely reflects anti-corruption measures from H2 2024.

Like Tencent, NetEase slashed promotions without revenue damage. Possible reasons: 1) Evergreen games’ brand strength reduces ad dependency; 2) Shift from brute-force 买量 to creator-driven 短视频 (short video)/直播 (livestream) 营销 (marketing).

4) Sub-businesses focus on self-sufficiency: Youdao, Cloud Music, and Yanxuan saw revenue declines but margin improvements, reflecting a profit-first strategy. These offer limited valuation upside.

5) Shareholder returns as defensive backstop: With ¥121B operating cash flow (+26% YoY), NetEase plans ¥3.1B dividends (28% payout). Buybacks were minimal (400K shares, <$50M), leaving $3.1B for its $5B 3-year plan. Combined with expected 2024 dividends (~¥11.5B, 30% payout), the ~7% implied yield provides downside protection.

Dolphin Research’s View

Q1 further shows the market underestimates NetEase’s cycle-bottom resilience. Lacking AI catalysts or a strong product cycle, it’s 被视为 (seen as) a defensive play. However, three straight 保守 (conservative) estimate beats—partly due to untracked evergreen game 官网流水—suggest reevaluation is due.

We raise 2025 profit growth forecasts from 6% to 13%, lifting target P/E from 13x to 15x (fair value: ¥79B). Further upside depends on 年底 (year-end)’s Infinity progress (potential 18x bullish case). Even in downturns, the 7% shareholder yield floors valuation.

Full Analysis Below

1. Gaming: What Did the Market Miss?

Q1 gaming revenue: ¥28.83B (+7.4% YoY), driven by PC (85% growth). Mobile fell 4% (better than -8% consensus).毛利率 (gross margin) expansion suggests outperformance from in-house PC/mobile titles.

Sensor Tower’s mobile data gaps (e.g.，官网充值 for Identity V) likely explain discrepancies. Like Tencent, NetEase benefits from evergreen games’ "reblooming" via 玩法翻新 (gameplay updates).

2. Sub-Businesses: Marginal segments (music/education) prioritize profitability over growth.

3. Operating Leverage: Sales 费用 (expenses) at 4-year lows (反腐 (anti-corruption) effects + marketing efficiency). Non-GAAP net profit hit ¥11.2B (39% margin).

4. Capital Returns: Net cash: $18.9B (+$900M QoQ). $490M total 2024 returns (buybacks + dividends) imply ~7% yield.

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Dolphin Research’s NetEase Coverage: [Links unchanged]