NetEase: All Eyes On Upcoming Q2 Earnings And Gaming Business

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Elevator Pitch

My Hold investment rating for NetEase, Inc.’s (NASDAQ:NTES) [9999:HK] stock remains unchanged as per my previous May 24, 2021 article for NTES. In that prior update for the company, I reviewed NetEase’s Q1 2021 financial performance. and touched on the impact of a new music distribution agreement for the company.

With this latest article for NTES, I do a preview of NetEase’s upcoming Q2 2022 earnings and discuss about the prospects of its gaming business. NTES’ upcoming Q2 2022 financial results announcement should be a non-event, as I expect its second-quarter earnings to be in line with expectations. The company’s expected strong YoY growth in Q2 2022 is largely driven by a low base for Q2 2021, while the company’s revenue and earnings are predicted to decrease slightly on a QoQ base. More significantly, NetEase has yet to secure any new game approvals in China since August 2021, and this makes it even more critical that NTES achieves success in venturing abroad. Taking into account all these factors, I consider the risk-reward for NTES as fair and deserving of a Hold rating.

Consensus Expectations For NetEase’s Upcoming Second-Quarter Results

NetEase has previously issued a press release on August 2, 2022, announcing that it will be disclosing its Q2 2022 financial results on August 18, 2022 prior to trading hours.

According to the sell-side’s consensus financial estimates sourced from S&P Capital IQ, NTES should have been able to deliver robust top line and bottom line growth in the second quarter of this year. The consensus numbers point to NetEase’s YoY revenue expansion improving from +12.9% in the second quarter of the prior year to +13.3% in the second quarter of this year. The analysts also expect NetEase to reverse from a -21.4% YoY decline in non-GAAP earnings per share for Q2 2021 to achieve a +21.2% normalized EPS growth for Q2 2022.

I am of the opinion that the market’s consensus forecasts for NetEase are realistic and reasonable, taking into account the fact that Q2 2021 was a low base for NTES. The company’s top line growth in RMB terms had moderated from +25.6% YoY in Q4 2020 and +20.2% in Q1 2021 to +12.9% in Q2 2021. Similarly, the YoY bottom line growth for NetEase had turned from a +20.6% in the first quarter of 2021 to -21.4% in the second quarter of last year.

On a QoQ basis, NetEase’s expected financial performance is less impressive. The sell-side analysts are predicting that NTES’ QoQ top line and bottom line growth rates for the second quarter will be -1.3% and -1.9%, respectively. The lackluster QoQ growth numbers aren’t a big surprise, considering the outlook and prospects for NTES’ core gaming business which I will detail in the subsequent sections.

I choose to focus primarily on NetEase’s online games services or gaming segment for the purpose of this article, as this business contributed 87% of its gross profit last year as per its FY 2021 20-F filing.

Regulatory And Policy Headwinds For Core Gaming Business

New game approvals in China have been put on hold between August 2021 and March 2022, and this is an indicator of policy headwinds for the Chinese gaming industry. China is concerned about minors being obsessed with playing games, and the earlier suspension of approval for new games in the country is widely perceived to be one of the measures put in place by the government to address this issue. Last year, China had initiated new rules to place restrictions on the number of gaming hours for minors.

To make things worse, NetEase and its key Chinese gaming peer, Tencent Holdings Limited (OTCPK:TCEHY) (OTCPK:TCTZF) [700:HK] didn’t have any of their games approved in the past few months since new game approvals resumed in April 2022. As an illustration, more than 130 new games secured approval from the Chinese regulatory authorities for July and August 2022, but both gaming giants, Tencent and NetEase didn’t obtain any new game approvals. It is very likely that regulators in China have chosen to give greater priority to gaming companies which are of smaller scale. In my view, the Chinese authorities are probably still eager to curb monopolistic behavior in a general sense, and they prefer that bigger players don’t expand their market share and influence in a meaningful way.

New Game Release And Potential Geographical Diversification Are Key Positives

On the flip side, there is a short-term catalyst for NTES in terms of a new major game release (that was previously approved in February 2021), and there are signs of the company becoming more aggressive in international market expansion.

NetEase announced on July 25, 2022 that “it has officially launched the highly anticipated Diablo Immortal in the Chinese market on iOS and Android mobile platforms on” the same day. According to a Goldman Sachs (GS) report (not publicly available) titled “Thoughts on Diablo Immortal releases in China” published on July 25 as well, sell-side analysts from GS have estimated that Diablo Immortal will achieve an “annualized gross revenue of Rmb5.1bn in China within a year of its release” based on a comparison with “the game’s Korean counterparts.” This gross revenue estimate for Diablo Immortal is equivalent to a significant 6% of NTES’ trailing twelve months revenue as per S&P Capital IQ data.

Separately, NTES has established two new gaming studios in the US in the past few months. The company opened its first US gaming studio in Austin in May 2022, which was followed by a second gaming studio in Seattle in August 2022. Although NetEase doesn’t disclose the revenue split for the company, NTES’ qualitative disclosures indicate that it is very much dependent on its home market, China. In its FY 2021 20-F filing, NetEase mentioned that “substantially all of the Group’s revenue of reportable segments are derived from China.” But NetEase is taking a step in the right direction with its recent moves to have a bigger presence in the US.

Closing Thoughts

NetEase warrants a Hold rating. I don’t expect major positive or negative surprises associated with NTES’ upcoming Q2 2022 earnings release. In the intermediate to long term, the gaming business’ outlook is mixed with regulatory headwinds being offset by international expansion plans and a promising new game release, Diablo Immortal.