NetEase’s R&D Strengths Are Key to Developing Next-Generation Blockbuster Games

Senior Equity Analyst

Ivan Su

NetEase started as a Chinese internet portal in the late 1990s but has now become the second-largest mobile game company in the world. The firm owns one of the most well-known massively multiplayer franchise in China—Fantasy Westward Journey. Over the past decade, NetEase has capitalized on the industry shift toward mobile gaming and now focuses on developing innovative, high-quality, and long-cycle games with a mobile-first approach. Over the past years, the firm has established iconic titles such as Onmyoji, Knives Out, and Identity V. Every year, the company publishes dozens of games across almost every genre and game play. In addition, NetEase is also collaborating with firms such as Blizzard, Marvel, and Microsoft to release games based on famous global intellectual property like Diablo, Harry Potter, and Lord of the Rings. Over the foreseeable future, we expect NetEase to continue to leverage its in-house research and development team and user data to develop next-generation games.

Like its global gaming peers, NetEase maintains a high level of profitability (above 30% operating margin) for its gaming business, thanks to stable revenue from core titles and the steady development of new franchises. We believe the firm is positioned to not only continue capitalizing on the success of Westward Journey titles, but to also keep diversifying its revenue into new franchises. 

While games will remain NetEase’s core cash flow driver, we think the firm’s investments in other areas (music streaming, online education, e-commerce) also offer long-term potential. Cloud Village, the group’s music streaming arm, had over 200 million monthly active users in 2023 and remained the second-largest music streaming platform in China. Youdao is the group’s attempt at cracking the online education market, but recent regulatory changes in China add uncertainty to this business model.

Business Strategy & Outlook

We assign NetEase a narrow moat rating based on its intangible assets from its widely recognized intellectual property in the form of compelling game franchises. We believe that NetEase will continue to generate excess returns on capital over the next decade. Games generated more than 70% of NetEase’s total revenue and more than 100% of its net profit in 2023. The operating margin for the segment has been running at above 30%. Over the past 10 years, NetEase generated an average ROIC of 89%, and we expect the business to generate an average ROIC of 30% for the next decade, well exceeding its weighted average cost of capital of 8.5%.

NetEase is the second-largest game publisher in China, with about 20% of the revenue market share in 2023. Over the past decade, China's game industry has seen a shift from PC to mobile, and NetEase has capitalized on the transition and turned itself into a publisher with multiple franchises across mobile and PC. The firm has published a total of more than 30 PC games and 100 mobile games. Some of the most well-known franchises include Fantasy Westward Journey, Westward Journey Online, Onmyoji, and the recently published Naraka Bladepoint.

The initial success of NetEase was primarily found in its title, Fantasy Westward Journey (FWJ)—one of the most played and highest-grossing franchises over the past two decades. The importance of FWJ to NetEase is comparable to the relationship between World of Warcraft (WoW) and Blizzard. Like WoW, FWJ is a massively multiplayer online game (MMO) that comes with a step learning curve and requires massive time investments. Because playing MMOs requires many combat and non-combat collaborations between different players, virtual relationships (friends, mentors, guilds, or even families) naturally formed between players. These relationships, coupled with deep knowledge of the game and high sunk investments, have effectively kept players sticking around FWJ. This is why the game can maintain a high level of concurrent players after 18 years of launch. With players continuing to spend time in the game, NetEase monetizes their IP year after year through expansion packs, version upgrades, merchandise sales. We estimate that the FWJ franchise contributed to more than 10% of NetEase's game revenue in 2023.

NetEase has capitalized on the industry shift toward mobile gaming by (re)developing new high-quality IP with a mobile-first approach. The group's mobile game portfolio has expanded from just 12 titles in 2014 to over 100 in 2023. The mobile version of FWJ was launched in 2015 and remained in the top 10 global highest grossing income in history. Onmyoji is another flagship IP that was developed in-house by NetEase. Since its launch in 2016, Onmyoji's annual revenue has been grossing over CNY 2 billion. The success of the first Onmyoji game has allowed NetEase to create multiple other games based on the same IP but with different genres. In addition to what has already been mentioned, NetEase has also seen successes with self-owned titles like Identity V, Invincible, and Naraka Bladepoint. In essence, we think NetEase's existing portfolio of successful franchises will allow the firm to monetize its intellectual property through in-game microtransactions for an extended period while the firm invests some of these returns into creating more innovative titles.

In addition to in-house games, NetEase partners with global leading game developers, mainly Blizzard and Mojang, to publish their popular games in mainland China, which has diversified the genres of NetEase's online games offering. Although we don't think the intangible assets derived from these exclusive licenses are as significant, we believe these partnerships have strengthened NetEase's leading position in China. In addition, we believe that there are certain switching costs for NetEase's partners because all the licensed games are operated on NetEase's servers. If they switch to another local operator, they will need to discontinue the operation of the games for a while for the replacement of the server, which will impact players' experiences. Since 2008, Blizzard has licensed NetEase the exclusive rights to publish its PC-client and mobile games, including StarCraft II series, World of Warcraft, Heroes of the Storm, Hearthstone, Diablo III, and Overwatch.

Like other Chinese conglomerates, NetEase has leveraged its online presence and robust profitability from games to create new products in other high-growth categories. Most of these new ventures operate at negative margins to achieve market share, dragging down the overall company's profitability.

Youdao is NetEase's online education business, but recent regulatory changes in China add massive uncertainty to this business model. Even before the regulatory crackdown, Youdao has been generating losses since 2017. Given the highly competitive landscape in Chinese online education, we surmise this would be a no-moat business even if the government allows them to profit from after-school academic tutoring.

Lastly, we do not have confidence that NetEase's other ventures will generate excess ROICs. This segment (mainly consists of online music streaming and audio live streaming) has been generating operating losses for the group for many years. While its music streaming arm, Cloud Village, is the second-largest one in China, we do not expect the business to achieve operating breakeven until 2025, as it will continue to invest in content acquisition, sales and marketing, and research and development over the next few years. Nonetheless, we are confident that the business will see margin expansion thanks to the cost leverage from increasing subscribers and lower fixed content payment to music labels under nonexclusive agreements.

Narrow

Economic Moat

NetEase

NetEase, Inc. is an internet technology company, which engages in the provision of premium online services centered around content, community, communication and commerce. It develops and operates some of the most popular PC-client and mobile games in China. The firm also operates some of the most popular international online games in China by partnering with Blizzard Entertainment, Mojang AB (a Microsoft subsidiary) and other global game developers. NetEase also offers other services, including the intelligent learning services of its majority-controlled subsidiary, Youdao, its music streaming platform, NetEase Cloud Music, and its private label e-commerce platform, Yanxuan. The company operates through the following business segments: Online Game Services, Youdao, Cloud Music, and Innovative Businesses and Others. The Online Game Services segment produces online PC-client games. The Youdao segment is an online education service provider in China. The Cloud Music segment represents revenue from online music services through the sales of membership subscriptions in various content and service packages. The Innovative Businesses and Others segment offers other services, which includes live video streaming and its private label e-commerce platform, Yanxuan. The company was founded by Lei Ding in June 1997 and is headquartered in Beijing, China.

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