NetEase Inc.:Buy,Slow mobile in 2H17ahead of a reboot in 2018

Weaker 2H17but stronger 2018. NetEase, in our view, remains the most skilleddeveloper of hard-core, massive multi-player online role playing games (MMORPG) forPC and mobile. We are optimistic about the company’s ability to maintain strongpositions for its legacy mobile games and expand into other genres, including sandbox(Minecraft), MOBA (Onmyogi MOBA) and survival games. It currently has a pipeline of40-50games (from 30internal studios) but is deliberately delaying releasing many ofthese until 1H18. In addition, other mobile games have declined in revenue from 2Q17.As a result, we lower our estimates for 3Q-4Q17and our target price.。

    Mobile momentum slowing. NetEase grew net revenue by 79% y-o-y in 1Q17and49% y-o-y in 2Q17, with mobile game revenue up 108% y-o-y in 1Q17and 74% y-o-yin 2Q17. That said, deferred revenue declined 12% q-o-q in 2Q17; and, since June,Onmyogi has fallen out of the top 10in terms of revenue ranking in 3Q17. In addition,we believe other mobile games, including Fantasy Westward Journey (FWJ), haveseen revenue declines m-o-m in 3Q17. To account for these factors, we lower ourmobile gaming revenue estimate by 16% and now expect a decline of 22% q-o-q in3Q17and 3% q-o-q in 4Q17. While newly launched Minecraft remains strong(consistently ranked top 5-10by daily downloads), management is focused on usergrowth instead of on monetisation, which should begin when it launches for Android on12October. Further, it will expand testing of Onmyogi MOBA in October, but a fulllaunch by year-end suggests limited revenue in 2017. That said, we see potential for anew genre of mobile survival games to be launched in 4Q17or 1H18.。

    Estimate changes. We lower our revenue and adjusted EPS estimates by 6%/15%and 2%/8% for 2017-18, respectively. Mobile gaming, in our model, should grow by47%, accounting for c50% of total revenue in 2017. We expect mobile game revenueto ramp in 2H18, with Minecraft, survival games and other new games, leading to34% growth in 2108. We continue to forecast email and e-commerce to grow66%/37% for 2017-18, accounting for 25-30% of total company revenue.。

    Maintain Buy and lower PEG-based TP to USD316(from USD336). Our thesisrests on three points. First, NetEase’s proven game development capabilitiesrepresent high barriers to entry and its existing PC and mobile games could have alonger-than-expected life span. Second, the e-commerce business could generatematerial value in the future. Finally, the valuation is attractive, trading at a 19x PE/a14x PE on our revised EPS estimates for 2017-18. We derive our TP of USD316byapplying a 1x PEG (unchanged) to our 2017EPS estimate of USD14.04and a threeyearEPS CAGR of 23% (was 21%). Our 2017revenue/EPS estimates are 4%/12%below consensus. Catalyst: 3Q17results call in November when management mightprovide an update on Minecraft and survival games. Key downside risks includedelays in game launches.。