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Initiation: Raising Its Game China Information Technology 24 June 2016 NetEase (NTES US) NetEase Target price: USD190.00 Share price (23 Jun): USD172.91 | Up/downside: +9.9% Initiation: raising its game John Choi (852) 2773 8730 Strong mobile-game pipeline and Overwatch point to revenue upside [email protected] Prudent management warrants valuation premium, in our view Alex Liu (852) 2848 4976 Initiating at Outperform (2) with 12-month target price of USD190 [email protected] Investment case: We initiate coverage of NetEase, the second-largest Share price performance online-game platform by revenue in China (after Tencent), and one of the (USD) (%) most established China Internet players, with an Outperform (2) call. We 185 130 believe NetEase has pursued a sound catch-up strategy in the mobile- 164 115 game market with its launch of 2 popular titles, FWJ Mobile and WWJ 143 100 121 85 Mobile, in 2015. 100 70 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 We see upside for the stock following its 20% rise in the past 3 months (vs. NetEase (LHS) Relative to S&P 500 Index (RHS) 5% for the MSCI China index) and recommend that investors position themselves ahead of NetEase’s 2Q16 results (August 2016). We are 12-month range 107.14-184.73 upbeat on NetEase’s 2H16 mobile-game pipeline and potential revenue Market cap (USDbn) 22.75 upside from Overwatch, the hit PC game it has licensed from Blizzard. The 3m avg daily turnover (USDm) 79.98 Shares outstanding (m) 132 Bloomberg consensus forecast calls for only 12% HoH revenue growth for Major shareholder William Ding (44.0%) NetEase in 2H16, which we think understates the incremental revenue to come from the mobile-game pipeline. Indeed, our 2016-18 earnings Financial summary (CNY) forecasts are 14-15% above the market’s. Year to 31 Dec 16E 17E 18E Revenue (m) 36,298 44,079 51,712 Operating profit (m) 11,972 13,568 15,376 As for NetEase’s ecommerce business, despite near-term regulatory Net profit (m) 11,277 12,826 14,520 headwinds, the company has deep pockets to gain ground in the Core EPS (fully-diluted) 85.065 96.750 109.528 cross-border ecommerce market in China. On the other hand, EPS change (%) 51.6 13.7 13.2 Daiwa vs Cons. EPS (%) 14.3 15.3 14.3 management’s CNY50-100bn long-term annual ecommerce GMV target PER (x) 13.4 11.8 10.4 seems aggressive. Dividend yield (%) 1.7 2.0 2.2 DPS 19.834 22.424 25.273 PBR (x) 3.9 3.1 2.5 We consider NetEase’s management to be one of the most prudent EV/EBITDA (x) 8.8 7.1 5.7 among its China Internet peers, given its capital market-friendly stance (it ROE (%) 33.5 29.8 27.1 is the only large-cap China Internet stock to offer a quarterly dividend). Its Source: FactSet, Daiwa forecasts track record of solid corporate governance and 11-year listing history on the NASDAQ also argue for a valuation premium, in our view. Catalysts: We would see the following as share-price catalysts: 1) a continuation of the high rankings for FWJ and WWJ, in terms of gross revenue, 2) improved rankings for newly launched mobile games, including New Ghost and FWJ: Warrior, and 3) positive news flow for Overwatch. Valuation: We have a 12-month TP of USD190, based on a target PER of 14x applied to the average of our 2016-17E non-GAAP EPS. Our target multiple is in line with NetEase’s average past-10-year forward 12-month PER. Hence, we view the stock’s 11x 2017E PER as attractive, backed by our forecast 14% earnings CAGR for 2016-18. Risks: The main risks include: 1) slower-than-expected mobile-game roll- outs, 2) faster-than-expected declines in revenue from its legacy PC-game titles, and 3) regulatory uncertainty over NetEase’s Kaola platforms. See important disclosures, including any required research certifications, beginning on page 44 NetEase (NTES US): 24 June 2016 Table of contents Initiation: raising its game ....................................................................................... 6 Executive summary .......................................................................................................... 6 Mobile game: assessing revenue sustainability .................................................... 7 Success of FWJ and WWJ: a recap .................................................................................. 7 Mobile game pipeline also looks strong ............................................................................ 8 The bigger question: is online game a hit-or-miss business after all? ...............................10 PC game: stable yet flattish revenue growth ....................................................... 16 Maturing in-house titles; licensed titles stabilizing ............................................................16 PC game pipeline looks thin with the exception of MineCraft ...........................................20 Booming PC game broadcasting sector: NetEase is a major beneficiary .........................20 Ecommerce: where’s the sky? .............................................................................. 22 Kaola: NetEase’s cross-border ecommerce venture ........................................................22 Yanxuan: NetEase’s private label ecommerce business ..................................................25 Advertising: leading mobile products with monetisation ramping up ............... 28 NetEase Music (网易云音乐) ............................................................................................28 NetEase News (网易新闻手机版) .....................................................................................29 NetEase Portal & Email ...................................................................................................30 Financial Analysis & valuation .............................................................................. 31 Financial forecasts ...........................................................................................................31 Valuation ................................................................................................................. 35 PER-based target price of USD200 .................................................................................35 Risks ................................................................................................................................37 Appendix 1: company background ....................................................................... 39 Appendix 2: online game industry landscape ...................................................... 41 2 NetEase (NTES US): 24 June 2016 How do we justify our view? Growth outlook Valuation Earnings revisions Growth outlook NetEase: revenue growth forecasts We forecast NetEase’s total revenue to increase by 59% CNYm 95% YoY to CNY36.3bn in 2016 and 21% YoY to CNY44.1bn in 60,000 100% 2017, backed by solid revenue performance from 50,000 51,712 80% NetEase’s PC-game business (with the help of the newly 59% 40,000 44,079 launched Overwatch) and healthy mobile-game revenue 60% performance given the company’s strong pipeline. 30,000 36,298 27% 40% 20,000 21% 22,803 17% 12% 12% As for NetEase’s ecommerce business, we continue to 10,000 20% expect robust revenue growth as we believe the company 8,201 9,196 11,713 0 0% will start to consolidate the market despite some regulatory 2012 2013 2014 2015 2016E 2017E 2018E uncertainties currently. Netease total revenue YoY growth % Source: Company, Daiwa forecasts Valuation NetEase: past-10-year forward 12-month PER NetEase has traded at 9-16x forward 12-month PER 25 over the past 10 years, in line with global game 23 platforms but lower than China large-cap Internet 21 19 +2 SD = 18.1 companies such as Tencent and Baidu, likely due to 17 +1 SD = 15.8 market concerns over the revenue sustainability of 15 10 yr average = 13.5 NetEase’s popular PC games. 13 11 -1 SD = 11.2 9 The stock has had a significant rerating since 2015, after 7 -2 SD = 8.8 NetEase launched Fantasy Westward Journey Mobile. 5 We believe NetEase’s expanded position in the PC and Jun-10 Jun-11 Jun-06 Jun-07 Jun-08 Jun-09 Jun-12 Jun-13 Jun-14 Jun-15 Dec-06 Dec-07 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 mobile-game industries merits a premium valuation over Dec-08 the stock’s historical average. Source: Bloomberg Earnings revisions NetEase: consensus earnings forecasts The Bloomberg consensus 2016 and 2017 non-GAAP CNY earnings forecasts have been steadily increasing over the 90 80 past year. The upward revisions stem mainly from the 70 strong revenue performance of NetEase’s mobile-game 60 and ecommerce businesses, as well as margin expansion 50 40 resulting from a more rational competitive landscape for 30 the cross-border ecommerce sector in China. 20 10 Our 2016-18 non-GAAP earnings forecasts are 14-15% 0 Jul-15 Oct-15 Apr-16 higher than the consensus, likely as the market is being Apr-15 Jun-15 Jan-16 Feb-16 Feb-15 Mar-15 Mar-16 Nov-15 Dec-15 Aug-15 Sep-15 May-15 May-16 unduly conservative on NetEase’s expected mobile-game non-GAAP EPS - 2016 non-GAAP EPS - 2017 revenue growth in 2H16 and 2017. Source: Bloomberg 3 NetEase (NTES US): 24 June 2016 Financial summary Key assumptions Year to 31 Dec 2011 2012 2013 2014 2015 2016E 2017E 2018E Mobile game revenue (CNYm) 0 0 40 759 7,900 18,440 23,007 27,158 Mobile game revenue YoY growth % 0.0 0.0 0.0 1,810.3 940.5 133.4 24.8 18.0 Ecommerce revenue YoY growth % 51.5 90.9 47.8 220.1 235.7 66.1 45.0 30.0 Ecommerce business gross margin % (9.0) 0.7 (6.7) 42.7 7.9 13.3 14.0 15.0 Profit and loss (CNYm) Year to 31 Dec 2011 2012 2013 2014 2015 2016E 2017E 2018E Online game 6,449 7,201 7,864 9,266 17,314
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