Investment Summary

NetEase's 3Q20 result slightly beat the market

NetEase's 3Q20 revenue was RMB 18.60 billion (+27.5% yoy). Within it, the revenue for online game business / Youdao / Innovative and other businesses were RMB 13.86 billion (+20.2% yoy) / RMB 0.90 billion (+159.0% yoy) / RMB 3.90 billion (+41.6% yoy). In terms of the revenue mix, the revenue share of online game business / Youdao / Innovative businesses were 74.3%/4.8%/20.9%, respectively. The company's 3Q20 gross profit was RMB 9.8 billion, with respective GPM at 52.9%, down by 0.8 ppts/0.9ppts yoy/qoq, respectively. More specifically, the GPM of online game business was 63.6%, which was basically the same both yoy/qoq. The GPM of Youdao was 45.9%, up by 20.1ppts yoy and 0.7ppts qoq. The GPM for innovative and other businesses was 16.8%, up by 1.6 ppts yoy and down by 1.7 ppts qoq. The company has realized a net profit / Non-GAAP net profit of RMB 3.0 billion / RMB 3.7 billion. Overall, the company's 3Q20 result slightly beat the market expectation, the online game business is growing at a stable rate with accelerated growth in Youdao business.

Steady Growth in the online game business

NetEase's 3Q20 online game revenue was RMB 13.86 billion, of which mobile game and PC game revenue were RMB 10.08 billion and RMB 3.78 billion, respectively, with a yoy growth of 23%/13% and a qoq growth of 1%/-1%. As compared with Tencent, Tencent's 3Q20 mobile game revenue was up by 61.2% yoy, the growth rate was significantly higher than NetEase in the same period. We believe that the difference in this growth is mainly due to the difference in the mobile game genres of the two companies (please refer to our initiation report). The social attributes and the lower entry thresholds characteristics of Tencent's main games "Honor of Kings" and "PUBG Mobile" are more suitable for beginners during the COVID-19 period in 20H1. Having said that, we believe that hardcore games` grossing billing of NetEaze will be more stable, especially after the COVID-19 period. In terms of overseas game business, the NetEase Game's international presence was strengthened with strong performances from Knives Out, LifeAfter and Identity V in Japan. According to the management, the company remains very optimistic about the prospects of the global game market and will continue to focus on expanding overseas markets, including Europe, America and the United States. Besides that, the company has many quality games in reserve, including Revelation mobile game, Infinite Lagrange, Harry Potter: Magic Awakened, The Lord of the Rings: Rise to War, Diablo® Immortal™ and Pokémon Quest. Several of these games, including Revelation mobile game, will be released before Chinese New Year.

Youdao is experiencing a high growth period

In 2Q20, Youdao has realized revenue of RMB900 million (+159% yoy). This extremely high growth was mainly driven by Youdao's learning services and products segment. The revenue of the learning services and products segment was RMB 763 million (+239% yoy). The turnover of Youdao online course was RMB 955 million (+228% yoy). Within it, the K-12 premium course was the main driver for the growth in the online course turnover, the turnover of K-12 premium course was up by 369% and reached RMB 676 million, and accounted for 77% of the total turnover of online premium course. Further, the turnover of adult courses was RMB 201 million (+185% yoy). On the other hand, the GPM of Youdao was further optimized and reached 45.9% in 3Q20 (+20.1ppts yoy). The optimization of GPM was driven by the improved economies of scale, and faculty compensation structure optimization for its learning services and products. In addition, Youdao's S&M expense was up by 397% yoy and reached RMB 1.1 billion, with S&M expense ratio at 123%. According to the management, they believe the current stage is the best time frame to spend high for acquiring customers. Although, we believe that the S&M expense will remain high in short term, nonetheless, the S&M expense ratio is likely to drop as high growth in revenue.

Valuation

We maintain our previous forecast to the company, steady growth in online game business, high revenue growth in Youdao, while innovative and other business continued to seek for the optimal monetization business model. We forecast the company's 2020/2021/2022 Non-GAAP EPS to be RMB 5.06/5.75/6.53, maintain TP at HKD 172.8, with respective 2020/2021/2022 Non-GAAP PE at 29.85x/26.31x/23.14x. We maintain Buy rating.

Risk

1) The tightening on Game regulations 2) The Games underperform comparing to expectation 3) The growth of Youdao is worse than expected 4) Failure in monetization for innovative businesses

Financial Statements

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