NetEase 'Jumping Up and Down'? Veterans Still Have Hard Power

$NTES-S(09999.HK) $NetEase(NTES.US) released its Q2 2025 financial report for the Hong Kong stock market after the close on August 14, Beijing time. The overall performance was not poor, but it did not match the optimistic expectations and valuation increases prior to the report, resulting in a negative market reaction. Short-term adjustments are needed to digest the expectation gap.

Specifically:

1. Game revenue below expectations: Q2 game and value-added services grew by 13.7%, with core games growing by 15%, below market expectations. The growth was mainly driven by new games such as "Yan Yun Sixteen Sounds," "Marvel Duel," "Seven Days World," and "Outlandish Tide," as well as the evergreen mobile game "Identity V."

After Q1, the market no longer solely relies on third-party platform revenue data to underestimate NetEase's operational capabilities (especially for old games that can guide users to pay through official channels). Considering several high-quality PC games were released in Q2, the market had optimistically expected core game growth to exceed 17%.

Although below expectations, the current revenue is not bad. Although the current revenue recognition fell short of expectations, the deferred revenue growth of 25% year-on-year, significantly higher than the 15% revenue growth, indicates that NetEase's true strength has not yet been fully unleashed, providing strong support for next quarter's growth.

2. Pressure in the second half, can evergreen games provide a cushion? From the pipeline perspective, there is indeed pressure in the second half. The new game "Destiny: Stars" (public beta on August 28) has low market expectations, possibly due to concerns about fierce competition in the shooting game genre.

Shooting games have been popular from last year to this year, not only due to demographic changes (the growing college student population) but also with Tencent's assistance. Currently, Tencent has four major shooting games, and the mobile version of "Valorant" will also be in public beta in August. NetEase's "Destiny," which lacks an IP foundation, may face suppression when it launches a week later.

At this time, the cushioning ability of old games is needed. During the summer, several evergreen games from NetEase are celebrating anniversaries, so whether event operations can contribute incremental revenue is crucial. Currently, the event effects are satisfactory, with "Egg Party," "Justice Online," and "Fantasy Westward Journey" showing revenue recovery and record-high online users, respectively.

Although there is pressure, from actual financial indicators, the revenue growth in the second half is not much slower than in the first half, so there is no need to panic, mainly due to the low base effect. As for next year's revenue growth, it depends on the management's updates on the subsequent pipeline during the conference call.

3. Is the increase in marketing expenses good or bad? Q2 sales expenses quickly rebounded, with nearly 1 billion more spent compared to the previous quarter, which may be another point of dissatisfaction for the market. Since the internal anti-corruption review began in the second half of last year (the company's stance is that it optimized promotion strategies), sales expenses in Q4 and Q1 were directly reduced by one-third year-on-year.

Although the company had already warned in the previous two quarters' conference calls that marketing expenses would fluctuate significantly with the game launch schedule, the market originally expected "optimization of sales expense ratio" to be a long-term trend, representing an improvement in NetEase's new product customer acquisition and internal operational efficiency. Therefore, the sudden return to growth in Q2 sales expenses caught people off guard.

Dolphin Research speculates that this may be due to several new games launching overseas in Q2, leading to higher overall acquisition costs compared to the past. Additionally, it may reflect the current intensified industry competition, requiring increased promotion efforts for the anniversary celebrations of evergreen games and the pre-launch of new games in Q3.

However, Dolphin Research also believes that the increase in marketing expenses should not be viewed too negatively. For a gaming company, only during the bottom cycle is it necessary to be particularly restrained with expenses. For a multi-product matrix gaming company like NetEase, short-term revenue gaps can be filled through operational means.

Yesterday, Tencent's financial report also indicated that evergreen games have a high cushioning and value excavation ability. However, in terms of ROI on investment, Tencent, with its channel advantage, still has the upper hand in the competition between Tencent and NetEase.

Ultimately, core operating profit under GAAP was 9.1 billion, a year-on-year increase of 30%, but the profit margin was 32.5%, a decline of more than 3 percentage points quarter-on-quarter, larger than the usual seasonal fluctuations.

4. Subsidiary businesses focus on profitability: Beyond gaming, Youdao Education and Cloud Music focus on continuous profit improvement: expanding high-margin businesses or directly reducing costs and increasing efficiency.

Besides reducing social entertainment business costs, sales expenses continued to decline significantly. Ultimately, Cloud Music's operating profit margin continued to rise to 20%, narrowing the gap with Tencent Music.

5. Decline in shareholder return attractiveness: In Q2, NetEase planned to distribute approximately 2.6 billion in dividends, with a payout ratio of 27%. The stock price was strong in Q2, and the company did not repurchase much, spending less than 100 million USD to repurchase 500,000 shares.

The three-year 5 billion repurchase plan approved in January 2023 has only spent 2 billion USD so far. Unless extended, it implies that 3 billion USD needs to be repurchased in less than a year. Although the probability of extension is not low, if it can be implemented on schedule, combined with the expected dividend plan of about 12 billion this year (30% annual payout ratio), the implied comprehensive return rate is 5%. However, if the low repurchase intensity of the first half continues, the annualized return rate is only 2%.

6. Overview of key financial indicators

Dolphin Research's View

The outstanding performance in Q1 led the market to raise expectations, anticipating that NetEase would continue to exceed expectations. The improvement in "Egg Party" revenue in July, the record high DAU of "Fantasy Westward Journey" in a single month, and the approval of "Diablo IV" license catalyzed NetEase's valuation from 13x in Q1 to 16x (18x at the July stock price peak), with a 27% increase ranking among the top in Chinese concept stocks.

Therefore, when the actual mediocre performance was released, facing the dual pressure of "high EPS expectations + high sentiment valuation," the pre-market plunge seemed to reenact the "ghost story" of a lackluster new game reserve in the second half.

In addition, the sudden increase in sales expenses also disrupted the market's preset for NetEase's long-term profitability improvement. Regarding the change in expenses, Dolphin Research is not too worried:

Short-term sales expenses are often accompanied by product cycle warm-ups, not only for new games but also for new versions after content updates of old games. If the large-scale acquisition increase is for new games, NetEase's performance under the product cycle will not be bad, and the market will welcome it;

If it is for old game updates, due to the high penetration rate of "official channels" for old games, looking at the extended lifecycle, the overall monetization efficiency of old games will only be higher, bringing more profits to the company.

At the same time, as in the previous quarter, Dolphin Research will again reverse expectations. So, what are the possible expectation gaps when pessimism spreads in the market?

1) The potential for value excavation of evergreen games. This is a lesson learned from Tencent's strategic adjustment in gaming over the past year, which has achieved good results. In the process of continuous improvement in industry supply, new games need more vigorous promotion to quickly break out.

Therefore, at this time, if secondary development is carried out on evergreen games with existing long-term popularity and a large base of users, it can supplement the pipeline in the form of another "high-quality new game."

AI can bring more assistance to this strategy, such as providing users with intelligent NPCs, content UGC generation, and other new gaming experiences.

This ability to achieve long-term operations through content updates is precisely the advantage that NetEase has proven over the years, with "Egg Party," "Conqueror's Blade," "Infinite Lagrange," "Identity V," and "Fantasy Westward Journey" having been repeatedly activated in the past few years. The activation effects of the above evergreen games during the July-August anniversary events were good.

2) Low expectations for new games. Although NetEase's short-term pipeline is indeed not as promising as in the past two years, the market may have underestimated the performance of NetEase's new games, such as "Marvel Secret Invasion" and "Destiny," after their future launches, similar to the situation with "Marvel Duel" in the first half of the year.

In addition, since NetEase's subsequent games are basically cross-platform and globally distributed, there is a high possibility of exceeding expectations in overseas markets and non-mobile platforms. Each subsequent release in new markets and platforms may activate existing users in the original markets and platforms.

3) Channel cost optimization remains a long-term logic. The growth in current expenses has not completely broken the long-term logic of improving monetization efficiency for leading gaming companies. With experience from thousands of products, NetEase has a mature marketing strategy, and there are many cost-effective content marketing strategies at present, rather than the simple acquisition strategy of the past.

Recent developments in the lawsuit between Epic and Apple in overseas expansion have brought imagination space for NetEase's channel cost optimization in overseas markets. If this adjustment can be replicated domestically, then for NetEase's games, which have higher iOS channel revenue than Android, the marginal improvement is also expected to be more significant.

Finally, from a valuation perspective, the current valuation of 83 billion corresponds to the performance expectations for 2025/26 (GAAP net profit after tax, lower than adjusted net profit), with P/E ratios of 18x/16x, at the median level. Compared to the obvious undervaluation in the previous quarter, the risk-reward ratio has decreased.

However, referring to past years, during the product cycle explosion, the valuation peak is likely to hover at the forward P/E position of 18x~20x.

Therefore, after short-term sentiment digestion, if there is positive progress in "Infinity" before the end of the year, short-term sentiment can also help push up to the above optimistic valuation, with a 10~20% space compared to the current level.

Below is a detailed analysis

1. Games below expectations

Q2 game and value-added revenue was 22.8 billion, with core game revenue at 22.2 billion, a year-on-year increase of 15%, mainly driven by PC games. The financial report still did not disclose the breakdown of mobile and PC games. Dolphin Research estimates (for reference only, subject to revision if disclosed in the conference call) that mobile games declined by 2%, improving from Q1, while PC games grew by 73%, still benefiting from the low base effect caused by Blizzard.

Looking at deferred revenue, Q2 grew by 25% year-on-year, significantly higher than the 15% revenue growth, indicating that NetEase still has untapped potential, providing strong support for next quarter's growth.

(1) Mobile games rely on evergreen games, gradually stabilizing: The lack of new games has led to a continued decline in mobile game revenue. However, according to Sensor Tower data, NetEase's mobile game revenue in Q2 has already returned to positive growth, stabilizing faster than Dolphin Research expected.

(2) High growth in PC games, driven by Blizzard + new products: Several new PC games were released in Q2, all of good quality. Notable ones include "Marvel Duel" and "Yan Yun Sixteen Sounds" released at the end of last year, both contributing significant increments. Of course, the main contribution still comes from Blizzard games, but this low base effect will gradually weaken in the second half.

At the 520 Game Conference, NetEase announced the development of 9 new games, but according to news, one "Three Kingdoms" game has been suspended. At the end of Q2, another Marvel series game "Marvel Secret Invasion" was launched, and two PC games and one casual mobile game were launched consecutively in July-August, with the shooting game "Destiny: Stars" to be launched at the end of August.

2. Subsidiary businesses focus on profitability improvement

Beyond gaming, Youdao Education and Cloud Music focus on continuous profit improvement: expanding high-margin businesses or directly reducing costs and increasing efficiency.

In Q2, Youdao Education's revenue grew by 7%, slightly exceeding market expectations, with growth mainly from advertising revenue. Cloud Music's revenue declined, mainly dragged down by a 43% year-on-year decrease in social entertainment revenue, but the overall profit margin also improved simultaneously. Besides reducing social entertainment business costs, sales expenses continued to decline significantly. Ultimately, Cloud Music's operating profit margin continued to rise to 20%, narrowing the gap with Tencent Music.

Note: Subsidiary businesses are not closely tracked by Dolphin Research, so they are not elaborated here.

3. Sudden increase in marketing expenses, good or bad?

Q2 GAAP operating profit (excluding investment income, interest, exchange gains and losses, and other non-core business items) was 9.1 billion, a year-on-year increase of 30%, with a profit margin of 32.5%. Despite seasonal fluctuations, the quarter-on-quarter decline of 4 percentage points was still larger than usual.

The main influencing factor was sales expenses, which suddenly returned to growth against the trend, while R&D and management expenses decreased year-on-year. The marketing expenditure in Q2, compared to the expected trend change, was 5-10 billion more, with the sales expense ratio increasing from 9.4% in Q1 to 12.8%, breaking the market's original preset for a long-term decline in the sales expense ratio.

Dolphin Research speculates that the sudden increase in expenses is mainly due to: several new games in Q2, but with fewer mobile games with inherent popularity, the promotion demand would be relatively higher, and the impact of preheating for the anniversary celebrations of multiple games in the second half, causing short-term fluctuations in marketing expenditure. Specific explanations can be heard from the management during the conference call.

In Dolphin Research's view, the increase in marketing expenses should not be viewed too negatively. For a gaming company, only during the bottom cycle is it necessary to be particularly restrained with expenses. For a multi-product matrix gaming company like NetEase, short-term revenue gaps can be quickly filled through operational means.

Yesterday, Tencent's financial report also indicated that evergreen games have a high cushioning and value excavation ability. Of course, in the competition between Tencent and NetEase, Tencent, with its channel advantage, still has the upper hand in terms of ROI on investment.

The main surprise in gross margin is the continuous improvement in game gross margin, driven significantly by self-developed PC games like "Yan Yun," as self-developed PC games mean less channel sharing and lower IP development sharing, allowing gross margins to reach 80-90% levels. Ultimately, Non-GAAP net profit was 9.5 billion, with a profit margin of 34%, below market expectations.

4. Too little repurchase, shareholder returns are no longer attractive

At the end of Q2, NetEase had a net cash of 19.8 billion USD, a net increase of 900 million USD compared to Q1. The stock price was strong in Q2, and the company did not repurchase much, spending less than 100 million USD to repurchase 500,000 shares. The sparse repurchase for two consecutive quarters raises doubts about whether the three-year 5 billion repurchase plan will be extended again.

If not extended, it implies that 3 billion USD needs to be repurchased in less than a year. Although the probability of extension is not low, if it can be implemented on schedule, combined with the expected dividend plan of about 12 billion this year (30% annual payout ratio), the implied comprehensive return rate is 5%. However, if the low repurchase intensity of the first half continues, the annualized return rate is only 2%, which cannot significantly support the valuation.