Inside NetEase

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NETEASE

iChinaStock.com profiles Chinese firms that are publicly-listed or may list soon in overseas markets

REPORT BY

ONLINE-GAMES AND WEB PORTAL

© July 2011 iChinaStock

NASDAQ: NTES

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SUMMARY   NetEase.com, Inc was founded by Mr. William Lei Ding in 1997 and went public on the Nasdaq in 1999. As of July 8, 2011, its market cap was $6.1 billion.   NetEase has 3 revenue sources: online-game services (87.4% of revenues), advertising services (11.2%), and value-added services (1.5%),   Westward Journey II came into operation in 2002, and PCU (Peak Concurrent Users) reached a record 1.19 million in May, 2010.   NetEase gained exclusive licenses to operate the popular games World of Warcraft and Starcraft II in China from the US-based firm Activision Blizzard, Inc. in 2008.

  NetEase operates an Internet portal www.163.com, that ranked first in view rates by iResearch in 2009.

  NetEase owns eight email server centers, with userbase totaling over 360 million, as of April, 2011.

  NetEase also operates self-developed search engine, Youdao, a micro-blog and WAP mobile services.

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NetEase

Online games (revenues via virtual goods

and premium services)

Games developed in-house

Games licensed from Blizzard

Portal (revenues via ads)

Content

Community Communicate

Search Engine Micro-blog

Mail (revenues via VAS and

ads)

WVA (revenues via ads)

BUSINESS STRUCTURE

Disclaimer: This is not the firm’s official structure, but rather iChinaStock’s representation of the firm’s key properties Source: NetEase Inc. F-1 SEC Filling

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GAMING INDUSTRY OVERVIEW

Source: CGIGC, China Online-game Industry Report

29.0%

15.3% 13.9%

7.3% 6.8% 4.0%

23.7%

Market Share 2010

Tencent

NTES

GAME

PWRD

CYOU

GA

Others

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

2006 2007 2008 2009 2010

NTES Market Share

Introduc6on Gaming is the most developed industry on the Chinese Internet. Web games and MMORPGs operate predominantly on a freemium model whereby games are free to play, but virtual goods cost real money. Many of China’s listed tech companies are gaming companies.

A hit-‐driven and top-‐heavy industry In 2009, 321 new online-‐games were produced in China. But less than 5 games reached over 600,000 average concurrent users. The 6 players held 76% of market share in 2010. Netease was in second place with 15.3% of the market.

Challenges Games face increasing R&D costs in a compeYYve industry where hits are difficult to come by. Growth has leveled off in recent years..

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ADVERTISING INDUSTRY OVERVIEW

Source: iMeigu

0

10000

20000

30000

40000

Sina Sohu NetEase Tencent iFeng

190 150 130 260 73

7,900 6,500 6,400

36,000

5,900

UV PV

Sina, 57% Baidu, 13%

Tencent, 21%

Sohu, 6% NetEase, 3%

Sina Baidu Tencent Sohu NetEase

Microblog Market

Portal Market

Micro-‐blog Sina and Tencent together occupy 78% of market share. NetEase recently invited 200 presYgious local economists to its Micro-‐blog.

Top Portals NetEase is among China’s top 5 Internet portals, though it has fallen behind and now holds only 3% market share in adverYsing.

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REVENUES

Source: NetEase Inc. F-1 SEC Filling

0 50 100 150 200 250 300

0 1,000 2,000 3,000 4,000 5,000 6,000

2003 2004 2005 2006 2007 2008 2009 2010

Total Revenues Online game services

AdverYsing services Wireless value-‐added services

70.0%

80.0%

90.0%

100.0%

2008 2009 2010

84.0% 88.1% 87.4%

13.6% 10.0% 11.2% 2.4% 1.9% 1.5%

Online game services AdverYsing services

Wireless value-‐added services

Growth Rate 7-‐year CAGR of Total Revenues, Online Game Services, AdverYsing Services, and Wireless Value-‐added Services is 38.8%, 57.8%, 33.0%, and (16.1%) respecYvely.

Netease Segmenta6on The Online Game Services Department is the cash cow of NetEase, contribuYng 87.4% of total revenues in 2010. Netease has not been able to reduce its dependence upon gaming revenues in recent years.

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PROFITABILITY


80.2% 75.1% 78.9% 80.4% 78.0%

84.8%

73.4% 65.5%

56.7%

46.1% 55.0% 56.1% 54.8% 53.6%

48.4% 39.5%

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0%

2003 2004 2005 2006 2007 2008 2009 2010

Gross Profit Margin Net Income Margin

In Millions of RMB

Online game revenues 2008-‐2010 14,009

Warcraa Total Expenses 2,200

NegaYve Impact to Gross Margin (aprx.) 15.7%

Profit Margins Gross Margin saw a 15% decrease from around 80% to 65% during the past 7 years. Net Income Margin also saw the same trend as Gross Margin. Looking forward, management expects the margin will remain at the same level as in 2010.

Primary Factor As Netease signed a 3-‐year contract to operate Warcraa with Blizzard , the cost associated with royalYes, amorYzaYon of license fees and technical consultancy service fees amounted RMB 2,200 million, bringing down gross margin by roughly 15%.

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BALANCE SHEET

Disclaimer: This is not the firm’s official structure, but rather iChinaStock’s representation of the firm’s key properties Source: NetEase Inc. F-1 SEC Filling

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2003 2004 2005 2006 2007 2008 2009 2010

1,688 2,289

3,378 3,938 4,159

5,613

7,141

9,620

828 839 818 792

10 0 0 35

Cash Debt

Leverage NetEase sits on huge amounts of cash and keeps very low financial leverage. Cash / share In 2010, the company has RMB 9.6 billion in cash and deposits, $11.1/share.

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BUSINESS ANALYSIS


9.6%

11.1%

10.5%

9.4%

8.5%

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

0

100

200

300

400

500

600

700

800

2006 2007 2008 2009 2010

Internet User Paying Online Game Player

ARPU as a % of Internet User

28.4%

18.3%

13.6% 13.1% 15.3%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2006 2007 2008 2009 2010

Revenue of Online Game Industry

Online-‐game Revenue of NetEase

Market Share of NetEase

NetEase Market Share As compeYYon increased over Yme, NetEase lost market share during 2006 and 2009. However, market share will remain stable as NetEase has very strong pipeline underway.

Online-‐game Market Growth 1) Paying Online Game Player Growth The Internet User base grew by 28.6% annually during 2006 and 2010, the Paying Online Game Player expanded by 20.4% correspondingly. 2) ARPU (Average Revenue Per User) Growth 5-‐year CAGR of ARPU during 2006 and 2010 was 14.4%.

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BUSINESS ANALYSIS


MMORPG (Self R&D) Revenue Model Game Status Westward Journey Online II Time-‐Based Launched 2002.8 Fantasy Westward Journey Time-‐Based Launched 2004.12 Datang Time-‐Based Launched 2006.7 Westward Journey Online III Time-‐Based Launched 2007.9 Tianxia II Item-‐Based Launched 2008.6 Legend of Westward Journey Item-‐Based Launched 2008.9 New Fly for Fun Item-‐Based Launched 2008.11 Westward Journey Genesis Time-‐Based Close-‐beta TesYng 2011.3 Ghost Unknown Close-‐beta TesYng 2011.4 Legend of Fairy Unknown Close-‐beta TesYng 2011.5

0

0.5

1

1.5

2

2.5

3

3.5

0

5

10

15

20

25

30

35

40

2003 2004 2005 2006 2007 2008 2009 2010

Average Annual Stock Price New Game

R&D Expenses NetEase is a R&D driven company. Developing new games incurs considerable R&D expenses.

Pipeline NetEase’s Westward Journey series has had an outstanding track record. NetEase has had a gap of new games 2009-‐2010, but plans to release 3 new games in 2011.

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MANAGEMENT

  Current CEO Mr. William Lei Ding founded NetEase in 1997, and holds a 45% stake in the company. Mr. Ding holds a Bachelor of Science degree in Communication Technology from the University of Electronic Science and Technology of China.

  Mr. Ding maintains very tight control over NetEase.   NetEase has closed only one M&A deal in its history, when it spent RMB 10

million to acquire GuangZhou TianXia Technology in 2001.

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VALUATION

Source: Yahoo Finance

NetEase’s P/E and EV / EBITDA relative to other Chinese gaming firms

June 18, 2011 Trailing P/E Tencent (HK) 37.7 NTES 14.1 GAME 8.6 PWRD 7.4 CYOU 5.2 GA 12.3

ATVI 24.6 ERTS (Forward) 22.0

June 18, 2011 EV/EBITDA Tencent N/A NTES 8.6 GAME 5.1 PWRD 4 CYOU 6.6 GA N/A

ATVI 8.7 ERTS 483.7

EV / EBITDA As of June 18, 2010, EV / EBITDA of NetEase was 8.6.

P/E As of June 18, 2011, P/E of NetEase was 14.1.

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RISKS

  Though NetEase has a broad range of portfolio projects, over 86% of revenue comes from online games. Increasing competition in the online-game market might negatively impact NetEase.

  COO Zhonghui left NetEase in May, 2011. His departure might negatively impact the Online-games Service Department.

  Regulations are still subject to change in China’s online gaming industry. GAPP

(General Administration of Press and Publication of the People's Republic of China) and MCPRC (Ministry of Culture of the People's Republic of China) both overlook the industry.

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WEB PORTAL Email Login �

Micro-blog�

Online-payments�

Games�

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WESTWARD JOURNEY II��（WESTWARD JOURNEY IS NETEASE’S LONG-RUNNING FRANCHISE)

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GHOST ��（GHOST IS A NEW MMORPG UNDER DEVELOPMENT)

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WORLD OF WARCRAFT ��（NETEASE IS THE OFFICIAL OPERATOR OF WOW IN CHINA)

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ABOUT ICHINASTOCK

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© March 2011 iChinaStock， report by Richard Chen

Inside NetEase

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