NetEase returns to Hong Kong IPO: the hope and reality in its story

After 20 years of listing on the NASDAQ, NetEase launched a secondary listing on the Hong Kong stock exchange at $123 Hong Kong dollars per share.

As a Chinese gaming company, NetEase's market value has reached $10 billion. However, seeking new profit growth engine and drawing a broader business map are much better than only focusing on gaming business.

In fact, from games field to e-commerce, music, and education field, NetEase has gone through several business transformations since its listing in 2001.

In the tough 2019, NetEase first included "games, e-commerce, education, music" in the four major strategies. And then NetEase started the company's structural optimization: its cross-border e-commerce platform Kaola unit was sold to Alibaba for $2 billion; its private-label e-commerce brand Yanxuan changed person in charge, and at the same time, its online education brand Youdao made its debut on the New York Stock Exchange.

The relatively stable game business gives NetEase more opportunities to explore diverse businesses. However, as these businesses encounter development bottlenecks to varying degrees, it seems that there is no way to get rid of the over-reliance on the game business.

NetEase's game business growth slowdowns 

As a portal, NetEase's game business made its market value higher than Sohu and Weibo, which is currently the second largest Chinese game manufacturer after Tencent. From 2001 to 2007, NetEase relied on "A Chinese Odyssey 2" and "Fantasy Westward Journey" to establish its end-game market position. In 2007, the year-on-year growth rate of game revenue dropped to a low of 4%, so NetEase began to make force on the mobile game market.

With the mobile game adapted from the IP of end-game mobile games, NetEase achieved an explosive growth in mobile game revenue from 2015 to 2016. Since 2018, the focus of the game has been tilted overseas, especially in the Japanese market.

The strong strength of NetEase's game business supports its financial performance. In the latest quarterly report, game revenue accounted for about 80% of total revenue. During the epidemic, gaming has become one of the main ways of home entertainment, and has driven the growth of users' game time and new users. In the whole year of 2019, the revenue of the game business reached 46.22 billion yuan, accounting for 78% of the overall.

But even it is the revenue pillars, it is still facing growth bottlenecks.

Although the entire industry chain layout of the game business has been formed, it is indisputable that the growth rate of the business slows down.

In terms of performance, from 2016 to 2019, NetEase's game business revenues were 280, 363, 402, and 46.4 billion yuan, with a year-on-year growth rate of 60%, 32%, 11%, and 15.5% respectively. In Q1 2020, 14.1% of the game revenue growth rate is lower than the overall company revenue growth rate of 18%.

In 2018, the market environment changed, and the game version number was suspended for approval. Games that do not receive a version number are at risk of not being released or being removed at any time. In Q4 2018, the total net revenue of NetEase's game business accounted for only 55.53%, which exceeded 60% in the first two quarters.

By 2019, the release of the version number finally returned to normal, but the tightening of supervision has become the norm in the industry, and there have been no signs of loosening the quantity about the online operations of new games. In 2019, the revenue growth rate of the Chinese game industry is only 8.7%. The market has entered an era of single-digit growth.

Analysts of China Merchants Bank's media team have pointed out that if the review progress of the version number is lower than expected, or if Sino-US relations are turbulent and extend to the entertainment sector companies to obtain US IP (such as "Diablo"), NetEase's revenue would also be affected.

In addition, NetEase is also facing pressure from a slowdown in the Chinese game market and intensified industry competition.

NetEase ranks second in the gaming market. In addition to Tencent, the rival of NetEase also included the third-ranked 37 Entertainment and the ambitious ByteDance. 

Unwilling to be an advertising platform and game distribution channel for game developers only, ByteDance has seized the game market by forming thousands of R&D teams and subsidizing platform game developers to form a positive competition with giants such as NetEase.

The dividend of the gaming industry has peaked, and going abroad has become an important way for game companies to find incremental markets. In this Hong Kong stock prospectus, NetEase also put special emphasis on the globalization of game business. NetEase said it will continue to enrich online game content in overseas markets (such as Japan, the United States, Europe and Southeast Asia), and enhance the company's global R&D and game design capabilities to improve the company's global influence. Meanwhile, NetEase will continue to explore overseas opportunities by investing in and cooperating with international game developers, IP and content owners.

NetEase has set an important agenda for overseas as early as 2017, and the overseas game division was established and independently calculated KPIs.

The game "Onmyoji" in Japan has achieved remarkable results. The list of "2019 Q2 Chinese mobile games revenue in Japan top20 (App Store + Google Play)" shows that the game "Knives Out" alone has made more than $117 million in profit.

However, in the North American market, NetEase's market position still faces unknown challenges. "2019 Q2 Chinese mobile games in the United States (App Store + Google Play)" top20 and top20 downloads in the two lists, NetEase does not appear.

E-commerce business is also difficult to boost NetEase's revenue growth

The way that relies on game business to drive the revenue growth does not work, so Ding Lei put some of his energy to e-commerce field, hoping to "use e-commerce to build a new NetEase."

In 2014, NetEase Koala was born during the window period when the policy dividend of the cross-border e-commerce market was released. The positioning of purely self-operated cross-border e-commerce has made it differ from its competing products such as Tmall and JD.com. NetEase Koala once achieved the highest market share in the industry.

In 2016, NetEase Kaola improved the efficiency of product distribution services, which made its cross-border imported goods achieve substantial growth.

After the introduction of Koalas targeting the high-end market, in 2016, NetEase launched its private-label e-commerce brand Yanxuan for the mid-end market. It mainly relies on the OEM manufacturing dividends of excess production capacity, seizes the opportunity of industrial chain integration, and achieves direct factory supply by intervening in the upstream supply chain.

In the first month of its launch in April 2016, Yanxuan's GMV exceeded 30 million yuan. In the second half of the year, Yanxuan contributed 30 million users and an average monthly turnover of 60 million yuan.

Due to the outstanding performance of e-commerce, NetEase began to disclose the revenue of e-commerce business from the fourth quarter of 2017. Since then, this segment has been the fastest-growing independent business of NetEase's revenue, with the highest peak growth rate reaching 175%. In 2017, NetEase Koala and Yanxuan revenue totaled 11.7 billion yuan, a year-on-year increase of nearly 157%.

But the explosive growth did not last long. In June 2018, NetEase Koala officially entered the comprehensive e-commerce market. Unluckily, the expansion of commodity categories made the self-operated model that emphasized heavy assets further amplify the pressure on inventory and supply chain. Coupled with the continuous increase of e-commerce marketing costs, the development of Koala caught into an embarrassed situation.

After the launch of Yanxuan, the business model has also been followed up by many competitors. The quality assurance of goods source previously issued has also been caught in the turmoil of commodity quality many times. The performance of Yanxuan is under pressure. According to 36Kr, the goals that GMV reached 7 billion yuan in 2017 and 20 billion yuan in 2018 set by Yanxuan have not been achieved.

The problems of Koala and Yanxuan are all reflected in the e-commerce business data. NetEase's net profit in 2016-2018 was 116, 107, and 6.2 billion yuan, with a year-on-year growth rate of 72%, -8%, and -43%, respectively. The gross profit margin of the e-commerce business is low, while the related period expenses are high, which drags down the overall gross profit of the enterprise. Taking JD.com as an example, the gross profit margin of self-operated business is only 8%-9%, and the profit is more from third-party services.

In Q1 2018, the net income of e-commerce business was 3.732 billion yuan, an increase of 101.0% year-on-year. In 2018 Q3, the revenue of e-commerce business fell to 67%, and continued to decline by only 43.5% in the fourth quarter, the decline reached 3/4 of its peak period.

At the 2018 Q2 financial report conference call, NetEase CFO Yang Zhaoxuan stated that e-commerce should find a balance between growth rate and e-commerce profit model, and NetEase's business idea does not support that get rapid growth through loss-making.

The slowdown in revenue growth and the decline in gross profit margins finally brought about the outcome that Alibaba Group acquired NetEase Kaola for $2 billion.

After the business divestment of Kaola, the company's net profit increased by 245.2% year-on-year in 2019. On the one hand, it is because that NetEase Kaola, which have been losing money for years, no longer has a negative impact on financial results, and on the other hand, it is because that the sale of Kaola brings premium income.

Only Yanxuan is left in NetEase's e-commerce business, and it will not be disclosed separately in the financial report. Last year, the organizational structure of Yanxuan was significantly adjusted: the mailbox division was split, and Liang Jun, a member of the NetEase startup team, took over as general manager of the division. NetEase stated that Yanxuan is one of Netease's long-term core businesses, and they will continue to be optimistic about Yanxuan's long-term development.

In terms of its own positioning, Yanxuan still lacks a clear understanding, swinging between e-commerce platforms and consumer brands. 36Kr recently reported that at the 2020 Yanxuan annual meeting, Liang Jun said that Yanxuan's current goal is to become "a national brand that provides a better life for Chinese consumers."

After making a series of adjustment, it is unknown that whether Yanxuan can continue its online e-commerce dream.

NetEase explores the education field again

NetEase's e-commerce dream ended temporarily, but the task of "rebuilding NetEase" and finding new performance growth engine will continue. So Ding Lei turned his attention to the education industry.

NetEase Youdao started with search business in 2006. And later, it turned to dictionary tool field, launching educational hardware products. In 2014, NetEase launched Youdao as an online education platform to enter the Internet education.

In the first half of 2019, education was included in NetEase's four major strategies, which was also the first time that "education" was included in the group-level grand strategy. NetEase Youdao announced that it has completed integration with Hangzhou NetEase Education Division; in the second half of the year, Youdao went to the United States for independent listing. The various actions illustrate NetEase's determination to do a great job in education field.

Youdao is currently aimed at all ages, including pre-school, K12, college students and adult education, and the K12 education business is the core. The product form covers tool applications, course products and educational hardware.

Through the dictionary and other tools to attract traffic and users, provide teaching services and complete monetization with online courses, and then use smart hardware to enhance the learning experience, Youdao forms a closed-loop education business. 

Difficulties in obtaining effective traffic and high marketing and promotion costs are the pain points of the online education industry. Youdao's early tool products accumulated a rich user traffic pool, which can provide stable user base for its online education business. The number of its users is far ahead in the country, and it also highly overlaps with online education users. If it can effectively convert the scale, it is very considerable.

Youdao has high hopes. From the mid-May Q1 earnings call, Ding Lei expressed: "Our investment in NetEase Youdao will be bolder, because online education is a very big track."

Youdao CEO Zhou Feng once told the media that NetEase itself is a consumer company. It has a relatively deep understanding of consumption as a self-operated and branded company. It emphasizes on experience and how to combine technology, content and the entire supply chain, which is the same as the underlying logic of education.

Judging from the overall revenue scale, Youdao is accelerating its expansion. Especially in the first quarter of 2020, benefiting from the "stay-at-home economy" brought by the epidemic, the online education track is in rapid growth, and Youdao's revenue reached 540 million yuan, an increase of 139.8% year-on-year. Youdao's gross profit margin has increased significantly, from 23.4% in the same period last year to 43.5% this year.

Learning products and services mainly composed of online courses and intelligent hardware have become the main source of Youdao's revenue.

In 2018, the number of Youdao's paying users for Youdao courses reached 643,000, and revenue exceeded advertising for the first time as NetEase Youdao's largest revenue source. The number of Youdao's paying users for Youdao courses in 2019 reached 834,000, an increase of 30%. Among them, the number of Youdao's paying users on K12 field in 2019 Q4 increased by 336%.

Youdao smart learning products revenue increased by nearly 400% year-on-year in the fourth quarter of 2019. But it is too early to assert that Youdao can support the whole revenue growth.

The latest financial report shows that the net loss of Q1 in 2020 was 169 million yuan, a year-on-year loss expansion, which failed to achieve profitability. Among them, sales and marketing expenses were about 293 million yuan, an increase of 64 million yuan over the same period last year. Youdao said that the increase in expenses was mainly due to the strengthening of marketing.

Compared with the adult field, it is obvious that the K12 field has a longer user life cycle, stronger user needs and more users. Maybe, it is also the main reason why the competition on K12 online education business is increasingly fierce. And the key to win the competition lies in user scale, good content and services, and an effective business model.

A situation that cannot be ignored is that losing-money is the norm for the online education industry, which is likely to miss opportunities without increasing marketing. However, once the money is smashed into it without any revenue increase, it is easy to fall into the strange circle of losing money.

In 2019, the net loss attributable to Youdao was 601 million yuan, compared with a loss of 209 million yuan last year. Judging from the financial report, the main reason for the expansion of NetEase Youdao's losses is the increase on operating expenses. Among them, the marketing expenses in 2019 were 623 million yuan, compared with only 213 million yuan in the same period last year.

Even if it has obvious advantages in technology, product production and its own traffic, there is still a long way for NetEase to go.

This is an article from WeChat official accounts Yiouwang(ID: i-yiou), written by Liang Xili, translated by Chris Yuan.