NetEase Earnings: Underlying Profitability Improves; Raising Fair Value Estimate 5% to $146

Narrow-moat NetEase’s 09999 first-quarter earnings exceeded our and Refinitiv consensus expectations. We attribute strong margin performance during the quarter to a favorable revenue mix shift and the one-off timing benefit related to Activision Blizzard revenue recognition. Owing to NetEase’s stacked game release schedule this summer, we remain upbeat on its financial performance going into the rest of this year. We have slightly raised our fair value estimate to $146 from $139. We find NetEase’s valuation multiples do not recognize the company’s narrow moat, with the shares trading at 17 times price/consensus earnings and 11 times price/core earnings (after removing net cash from market cap and net losses from Cloud Music and Youdao from NetEase’s bottom line). We continue to believe the current risk/reward profile is highly attractive.

During the first quarter of 2023, NetEase grew its game revenue by 8% year over year, despite the 4-percentage-point loss in revenue from Blizzard’s games. The solid revenue growth came from both legacy titles (such as Fantasy Westward Journey) and new releases, such as Eggy Party. Profitability was a key highlight in this quarter, as NetEase clocked in an operating profit margin of 28.8%, representing a more than 1,100-basis-point margin expansion from the same period last year. Although some one-off items benefited margins in the first quarter, we were still impressed by the improvement in underlying profitability even after excluding these one-off benefits. We think two key drivers will continue to fuel NetEase’s margin expansion over the long run: 1) a growing revenue base that brings more operating leverage; and 2) the increasing popularity of cross-platform games means more gamers will be paying NetEase directly on their PCs, allowing the firm to pay less in revenue sharing fees to mobile app stores.