NetEase Inc:1Q Beat on E-commerce,but Likely Marks the Peak of the Year

1Q results beat mainly due to stronger e-commerceperformance. However, we see the decline in deferred revenueas implying a potential sequential decline in 2Q revenue. Weremain cautious on the game pipeline in 2017. Stay EW.

    1Q beat on e-commerce: NetEase's 1Q17total revenue grew 72% YoY and 13%QoQ, to Rmb13.6bn, beating our estimate by 5% and consensus by 15%, mainly onstrong e-commerce growth and slightly better-than-expected mobile gameperformance. We believe consensus substantially underestimated the deferredrevenue impact from 4Q on 1Q revenue so our 1Q sales forecast was muchhigher than consensus. 1Q non-GAAP net profit grew 63% YoY and 10% QoQ toRmb4.3bn, 3% below our estimate given higher margin drag from e-commerceand a higher effective tax rate.

    Better mobile game offset by weaker PC performance. Online games revenuegrew 78% YoY/20% QoQ to Rmb10.7bn, mainly driven by strong mobile revenuegrowth. PC revenue was Rmb2.9bn in 1Q, up 30% YoY, but down 10% QoQ,mainly due to slowdown in new licensed game sales coupled with continueddecline in in-house games. The company will launch a few expansion packs for itskey game titles, such as TX3, Heroes of Tang Dynasty Zero, WWJ and DemonSeal, in the next few months to further boost PC revenue. On the other hand,mobile games recorded sequential growth of 37%, or 107% YoY to Rmb7.8bn,with meaningful contribution from Onmyoji and Demon Seal as well as resilientperformance of legacy titles. However, deferred revenue declined 8%sequentially to Rmb7.0bn as a result of faster-than-expected grossing declinefor Onmyoji. NetEase will host its annual game conference on May 20to unveilthe key pipelines for 2H17and 2018. In addition, according to the company, thetesting feedback for Minecraft PC version has been very positive, and thecompany will launch the mobile version in July.

    E-commerce outshone despite weak seasonality while margin contractionremains a concern. Other revenue reached Rmb2.5bn, up 63% YoY but down 1%QoQ, driven by strong promotions efforts for its eCommerce business. On theother hand, gross margin declined sequentially to 15% from 23% in 4Q16and 34%in 3Q16, and COGS increased 11% QoQ, implying strong 1P e-commerce sales anda significant decline in high margin 3P e-commerce business.