Is NetEase a Buying Opportunity in the Tech Crackdown? (Asia Tech Strategy – Daily Lesson / Update)

Legendary emerging markets investor Mark Mobius commented that the China “crackdown” on big tech is likely going to help some smaller digital companies. Those that have long been at a disadvantage to China’s tech giants. They may now have air cover from the government. If nothing else, the giants will be far more hesitant to exert their market power aggressively against smaller competitors.

This is the reason I have been focusing on specialty ecommerce these past weeks. I’ve been hunting for this scenario.

But what about in gaming?

If gaming giant Tencent is now being restrained, is that an opportunity for China’s #2 gaming company NetEase?

An Intro to NetEase (NTES)

NetEase was in the first wave of China’s internet companies. Everyone thinks digital China began Tencent, Alibaba and Baidu in 1998-1999. But that was actually the second internet wave. The first (the one Jack Ma missed out on) was Sina, Sohu, NetEase and other portal companies. These were pretty much copies of Yahoo.

NetEase was founded in 1997 by Ding Lei from Ningbo, Zhejiang. He was born in 1971 and went to college at the Chengdu Institute of Radio Engineering. He ended up working as an engineer at a local state department in Ningbo before moving to Guangzhou to work for enterprise software company Sybase.

In 1997, he founded NetEase. And by 2003, he was China’s richest person. He was also China’s first gaming billionaire. Note: he is also the guy that bought Elon Musk’s mansion in Bel Air.

NetEase began as Chinese language content site. Think Yahoo but in Chinese. NetEase created lots of content webpages and tools. Their email service (163.com) is something I still use for email in China today. Although nobody really uses email that much. Tencent was doing similar content and tools, but was mostly focused on its instant messenger tool QQ.

But NetEase, like Tencent, had a problem.

They were in the free content and tools business but digital advertising didn’t exist back then in China. The answer to that monetization for both companies was to do free PC gaming with lots of micro-transactions. That clever innovation turned out to be one of the best business models of all time.

  • You let millions of Chinese consumers play games for free and then buy small items for the game, such as skins, tools, avatars, weapons, etc. Being free encourages user and usage growth.
  • You then sell them digital items, which are both cheap and cost nothing to create.
  • If you get enough volume (which China has), you aggregate lots of micro-transactions into sizeable revenue.
  • And they are all prepaid by gaming cards so you also have negative working capital.

It’s just a great model. And the advertising model emerged over time as well.

NetEase built from content to gaming. Tencent built from messenger and social media to gaming. The Tencent model turned out to be more powerful. People love chatting with friends while they play. And messenger is really the ultimate internet utility.

But NetEase has a solid place as the #2 gaming company of China. Today, the company has three business lines:

1) Online Game Services Business

This is the main business by far.

As of 2017, NetEase had +100 licensed and/or self-developed games for mobile and PC. Gaming revenue in 2020 was 60B RMB. The business model is roughly the same, with most revenue coming from games that are free to play but with paid items. There is also a time-based model.

Here is a pretty good description of the gaming business (from their annual filing).

A big change has been the evolution from PCs to mobile. Which means NetEase now must go through app stores. Another important factor is their licensed games. Their arrangement with Blizzard has been a key deal for +12 years.

2) Youdao Business (i.e., Education)

Education was one of their recent growth initiatives. The recent political issues in edtech are a problem here.

3) Innovative Businesses and Other

NetEase has a lot of stuff that is “content, communication, community”. Really this is just a lot of websites and tools that have shifted to mobile, to some degree. This is also a freemium model with premium content.

This business also includes advertising. Most NetEase ads are per diem. But there is some pay for performance.

Finally, there is ecommerce, which is their non-gaming business that has gotten a lot of attention. They have tried quite a few innovative business models here, including C2M. Kaola and Yanxuan are important. They also have NetEase Cloud music, NetEase CC Livestreaming and other value add services.

Here’s how the revenues look overall. It is worth reading this entire slide.

But when you subtract the cost of revenue, you can see most all the gross profits (today) are coming from gaming. And the biggest expenses in gaming are licenses and app store fees.

The other operating expenses are standard.

So really, what we are talking about is gaming. That is where most of all of the gross profit comes from today. If ecommerce gets to scale, it could be a significant source of profits (in theory).

Overall, the financials look good. And have for a long time.

  • Gaming revenue growth has been solid over the past years.
  • Gross margin of 53%
    • Online gaming has a 64% gross margin.
  • Operating profit of 20%. The company has been operating profit positive for almost a decade.

Overall, it’s just a really good business model.

However…

The Porter’s 5 Forces Picture Is Concerning

Gaming has an interesting industry structure. It’s more complicated than ecommerce. And it’s usually not a platform business model. It’s closer to traditional media and entertainment, with an important power dynamic between content creation and distribution. It’s a bit like the dynamic between a popular TV show, a widely used television channel and the cable companies.

But it really is unique. And it is getting more complicated.

Think about Porter’s 5 Forces for NetEase.

Buyer Power?

  • Gaming is arguably the most powerful and engaging form of consumer media. Gamers love their games. It can be totally immersive. There are entire communities discussing the popular games and creating additional content and communities for them. People even watch videos of other people playing their games.
    • And the gaming companies are masters at creating addictive, engaging and habit-forming behavior. It makes other types of media (music, movies, television, books) look simple and shallow in comparison.
  • Distributors, channels and stores can also have power. Cable companies control physical distribution for television. But most of gaming is intangible. The console makers have some power. App Stores definitely have distribution power. In many cases, social media platforms have distribution power.
  • The shift from prepaid, expensive games ($50) to the freemium model online has really made gaming more powerful. It has dramatically expanded consumption.
  • The shift from solo-player to multiplayer has also increased demand-side engagement.

Supplier Power?

  • Complicated, advanced games have traditionally had blockbuster economics. A small number of games get most of the attention and a relatively small number of franchises, controlled by developers, have tremendous market power. The cost to develop a leading games is very high and risky. The licensing of games can be expensive. But successful game franchises can last for decades.

Substitutes, New Entrants and Rivals?

  • There are endless substitutes to playing games. Reading books, watching videos, listening to music, etc.
  • And in China and other places, there are pirated copies available.

Finally, keep in mind, the government is a significant force in this industry in China. Foreign games require government approval. And all domestic games are evaluated for “appropriate” content.

There are just a lot of significant players in the gaming industry with significant power.

And it gets worse.

Because it is all changing quickly. All the time.

  • The technology of gaming keeps advancing.
    • New types of game technologies (VR, multiplayer, etc.) keep emerging.
    • New business models are also emerging (freemium, advertising based, subscription, etc.)
    • The quality keeps improving. The bar keeps getting raised.
  • There are seismic technology changes on the horizon:
    • Games are becoming social. Roblox is more of an online community than a game.
    • Games are becoming ecommerce. Events, like concerts, are being added.
    • Gaming is incorporating gambling psychology and economics. Online gaming environments are starting to look a lot like Macau and Las Vegas.
    • The metaverse may happen soon. The idea of living and playing in virtual worlds is huge. Each having its own retail, advertising, money, property and economics.
      • Microsoft’s Satya Nadella recently said gaming is becoming “metaverse economies”.
      • Tencent is now calling video games “Hyper Digital Reality”. The company has “a moonshot project”, with the goal of becoming a top 10 Metaverse product.

It’s pretty daunting.

I think this is why so much attention is paid to casual games. It would shift the business away from the blockbuster economics of complicated games. It would mean more gaming options and less dependence on staying on the technological frontier. Casual gaming is a lot more like an audience-builder platform model (like YouTube). And less like running a Hollywood Studio.

What Are the Competitive Advantages of NetEase?

When I first looked at NetEase about 4 years ago, I wrote in my notes “great but fragile”.

Mostly because of the previous list of issues. I thought the revenue was too dependent on the popularity of certain games. That there were tooo many technology changes happening, which meant lots of required spending and less predictable popularity and revenue.

But NetEase definitely has lots of competitive advantages. You can see them in the financials, market share and ROIC. There are 5 competitive advantages that jump out at me.

  • There are two revenue and demand-side competitive advantages:
    • Share of the consumer mind. This is mostly within certain games that just command tremendous attention by users. People really love some games. There is not as much of this at the channel level. There are also some switching costs.
    • Direct network effects in multiplayer gaming. The more people that play these games, the better it gets. MMORPG, Battle Royale, esports and so on all benefit from this. And it is even more powerful when it is your friends and colleagues, not strangers.
  • There are two cost and supply-side competitive advantages:
    • Purchasing economies of scale. The bigger companies (NetEase and Tencent) are in a much stronger position for getting games on better financial terms. This is one of the places where Tencent has a real advantage over NetEase, but I think the government may limit their ability to exercise it.
    • Economies of scale in the fixed costs of content and IT. Licensed and in-house game development are major fixed costs that NetEase and Tencent can spread out over a large user base (relative to smaller competitors).
  • State-granted advantages. This is not a small thing. NetEase is shielded from the international gaming companies. And when popular Western games like Call of Duty want to enter China, they need to go through Tencent, NetEase or other. This is a great government-granted advantage.

Those are all good.

It’s just that Tencent has the same ones as NetEase in a bigger way. And then quite a few others.

Hence, my question about the Chinese government’s crackdown on the overly dominant platform businesses. This, in theory, should improve the situation for NetEase relative to Tencent.

Final Thoughts on NetEase and Gaming

Ok. So there are a lot of factors here.

But there are a few strategies I really do like in gaming (in terms of competitive strength).

One strategy is just to have popular game franchises. A developer that owns Call of Duty or Red Dead Redemption is like a studio owning the Avengers. That is just really valuable IP that can last for years, if not decades. This can be super profitable. It’s just really hard to get one.

A second strategy I like is “localization and immersion.” I like gaming channels, platforms and distributors that have big consumer bases and lots of engagement BECAUSE they have the most interactive and immersive games. The immersive, social and intensive multiplayer games (MMORPG, battle royale, esports, etc.) just really capture demand and engagement.

And I like when these companies also localize the content, advertising and partnerships for their markets. This puts the company in a stronger position against the popular game developers. I have cited Garena as having this strategy across the many markets of SE Asia.

But Tencent and NetEase have both done “localization and immersion” in China. They focused on the same highly immersive, multiplayer games and then localized them to the Chinese language and markets. Even today, NetEase says it does “Chinese language content and services”. It is in the localization business.

A third strategy I like, in theory, is casual gaming. Casual gaming looks more like a platform business model, with far more commoditized supply. This is still evolving but companies like Chinese Cocos are working on it. If consumers widely adopt casual gaming, it will decrease the power of the game developers and power will shift to the platforms. It will also reduce the cost structure and it will remove a lot of the technological spending and uncertainty.

A final strategy I like is big distribution power. That is basically the App Stores (Google Play, iOS), which have an international duopoly on distribution to smartphones. They are really gouging the gaming companies at 30%. Epic Games is fighting with Apple about this in the courts right now. In China, app stores are much more fragmented and the fees are also much lower. But it’s the same idea. Locking up distribution is a great strategy, if you can pull it off.

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That’s my take on NetEase right now. Let me know what you think. Is this an opportunity?

Cheers, Jeff

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Related articles:

From the Concept Library, concepts for this article are:

  • Gaming and Game Engines

From the Company Library, companies for this article are:

  • NetEase

Photo by Sean Do on Unsplash

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I write, speak and consult about digital strategy and transformation.

My book Moats and Marathons details how to measure competitive advantage in digital businesses.

I also host US-Asia Tech Strategy, a podcast and subscription newsletter on the strategies of the best digital companies in the US, China and Asia.

This content (articles, podcasts, website info) is not investment advice. The information and opinions from me and any guests may be incorrect. The numbers and information may be wrong. The views expressed may no longer be relevant or accurate. Investing is risky. Do your own research.

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