About this Blog

The purpose of this blog is for my personal use. It serves as my personal diary as I investigate Chinese internet/gaming companies for investment purpose. If you have any comments or disagreement, please give me feedbacks.

Thursday, May 22, 2008

NTES – Tax and Currency

I am an absolute novice as far as reading financial statement goes. But NTES’s 1st quarter report does intrigue me.

NTES provides its 1Q 2008 result. Its revenue blows away analyst estimate. Its gross margin hold steady. But its earning missed by 1 cent (30 cents rather than the analyst’s estimate of 31 cents). What gives?

I think I found the reason. Netease said the reason is the Chinese tax system. But I think the reason is two-folds.

The first reason is the Chinese tax system.

Before, in order to attract foreign investment, China provides preferential tax treatment to foreign companies. But China is suffering from too much of a good thing. So much foreign investment is giving China super high inflation (high commodity prices is the main culprit, but big foreign investment contributes to it also). To give its domestic companies a leveling playing field, and to cool the over-heated economy, China is completely re-tooling its tax system to a unified tax rate of 25% for both domestic and foreign companies.

This is good for NTES since it is a domestic company.

From what I understand, after a company starts to make money, the first 2 year is tax free and only pays 50% tax rate for the following 3 years. NTES is an established company and definitely won’t be able to qualify for it (unlike new companies like PWRD, etc.). But many of its divisions and subsidiaries are classified as High and New Technology Enterprise (HNTE) and can get tax benefit.

Starting January 1, 2008, China is starting its new tax regime of 25% unified tax. But companies had to re-apply for HNTE status. I think it will be a big surprise if most of NTES division won’t get this status. But still it will take time for the government to get the detail of the law out and to review and approve all of the companies applications. From NTES’s conference, the management is pretty confident it is going to be done this year. Once it is approved, the extra tax will be refunded back to the company.

The company think it would get an effective tax rate of 18% to 23%. If more divisions is able to get the HNTE status, the rate would be 18%. If the reverse is true, NTES would have to pay tax at a rate of 23%.

Now, we have enough information to calculate the tax refund NTES will get whenever Chinese government approves NTES’s applications:

Tax Rate






Income Tax





Tax Refund





Extra earning






Thus, in the future quarter when China approves NTES’s application, there will be a nice 1 to 4 cents pop to the bottom line.

Note that I think it applies to Sina, Sohu and other long established technology companies also. There will be nice pop to the bottom line whenever Chinese government finished reviewing company’s applications.

Without this issue, the earning this quarter would have been 31 cents to 34 cents. Not bad, but still not enough to explain the discrepancy. I think the bigger reason for the low earning is foreign exchange loss.

In this quarter, NTES take an expense of ($7,298,768) under the line item of “Other, net”. In both 4th quarter 2007 and this quarters’ earning conference call, the management explain that this is due to the foreign exchange loss.

Just a comparison, this expense is 7.3 million in this quarter, 4.299 million in 4th quarter 2007 and 0.104 million in 1st quarter 2007.

This $7.3 million contributed to a loss of 5.6 cents to the earning.

Note that this is not technical loss since you can’t have loss converting from USD to USD. But this is really theoretical loss in that if NTES put its money in the Chinese currency (RMB), NTES would have add additional $7.3 million directly to its bottom line.

Now from this, we can work back to estimate how much money NTES has in USD.

From the following link, we can estimate the exchange rate:


From the plot in the above link, we can estimate the exchange rate is 7.33 on 1/1/2008 and 7.02 on 3/31/2008. Thus, any money NTES has in USD would have a loss of 4.23% in the 1st quarter. Working backward using the $7.3 million, we get an estimate of $172.6 millions.

Therefore, NTES has roughly $172.6 million in USD.

But why? NTES makes money in RMB and spend it in RMB. What compel NTES to put money in USD and incur this loss unnecessarily?

I think the reason is three-folds.

1) China doesn’t allow for free currency exchange. If a company needs to change currency from RMB to USD, it needs to apply in advance and may have to wait for a long time before it gets approved.

2) company needs it for its share repurchase program. It can spent up to $120 million before 7/1/2008. But it had only spent $46.4 millions by the end of 1st quarter. Therefore, it still have $73.6 millions in USD waiting to be spent for this purpose.

If NTES has this $73.6 millions in RMB, it won’t suffer the 4.23% currency exchange loss. Divide by the outstanding number of ADS, we got an extra 2.4 cents of earning. Instead of earning of 30 cents, we would have earning of 32 to 33 cents. Rather than miss the wall street estimate (31 cents), we would have beat the street estimate.

There is a big difference in psychology in missing estimate vs. beating estimate. Is it ironic? Company buy back shares to boost stock price. But in this case, it actually does the opposite.

3) Now we are getting to the third reason. There is still $172.6 million - $73.6 million = $99 million left. Why would NTES have $99 millions in USD?

Could it be that NTES is buying a small US game company, maybe a 3d engine developer?

Could it be NTES is going to license 2 or 3 US games? I think $99 millions is too much for 1 game. We might be talking about a few games.

Also, every day NTES put the money in USD, they lose money, they must be getting very close in negotiation to finalize the deal.

Now, we know the reason. What can we deduct for the future quarters. First, from the currency exchange history, it has been relatively flat in the 2nd quarter. But why shall NTES even take the chance. We all know RMB is going up in the future.

For the 73.6 million left for the share repurchase program, either spend it or transfer the money back to China.

For the 99 millions for licensing games or buying US companies, either finalize the deal or transfer the money back to China.

It strikes me that the solution to solve this is quite easy. In the earning conference, the management said they will resolve this quickly.

For the share repurchase program, if they spend it this quarter, it will give a pop to the stock price. If they transfer the money back to China, there won’t be exchange loss. A win-win scenario.

For the 99 millions, if they are going to license games, it will definitely cause a pop in the stock price. Otherwise, if they can’t agree to a deal, they can just transfer the money back to China and no longer incur the currency exchange loss. Another win-win scenario.

But if they spend the 99 million on buying US game companies, it might not be positive on the stock price in the short term.

In summary, NTES shall have gotten from 1 to 3.5 cents of extra earning due to tax reason and 5.6 cents of extra earning due to foreign exchange loss. The extra tax will be refunded but the foreign exchange loss is gone forever. But the foreign exchange loss can be remedied easily and mostly likely significantly reduced in the 2nd quarter.

Combine the two, we shall have an earning in the range of 37 to 39 cents per ADS in the 1st quarter.

Wednesday, May 21, 2008

NTES - That $7,298,768 expense?

NTES just release its 1st quarter financial results.

Its revenue blow away the street estimate. Its gross margin hold steady. But its earning barely meets the wall street estimate.

Something is going on.

The biggest reason is the tax issue. I understand the tax issue. The company is paying the government a rate of 25% this quarter. But the real rate is most likely somewhere between 18% and 23%. If more NTES divisions can claim the preferential rate of 15%, the overall company tax rate will be closer to 18%. If less divisions can claim the high tech and new business rate of 15%, the overall tax rate will be closer to 23%.

Therefore, when the government gets its act together, a tax refund in the range of 1.3M (assuming 23% effective tax) to 4.6M (assuming 18% effective tax) will be returned to NTES. That will probably happen either in the 2nd or 3rd quarter.

But I think there is another factor at work here.

If you go to the 1st quarter financial result:

In the section "Netease.com, Inc, Unaudited Condensed Consolidated Statements of Operations", under the part "Other income (expenses)", there is a line item named "Other, net". Under this line item, there is an expense of (7,298,768) in US dollars for 1st quarter 2008.

The same mystery expense in 4th quarter 2007 is 4.3 millions, and in 1st quarter 2007 is 0.1 millions.

In other words, NTES increased this "Other, net" expense by 3 million from quarter to quarter; and it increased this expense by 7.2 millions year to year.

I am not a financial guy. Can some of you smart folks out there help me understand what is this "Other, net" expense?

Monday, May 12, 2008

News Coverage Race for the Great Earthquake

My previous article on advertising can be found here:


There is a magnitude 8.7 earthquake in China on 5/12/2008. It occurs on 2:28pm China time.

May I offer my utmost sadness to the people in China and best wish to you all. But I want to use this opportunity to check out the portals’ performance and how they can react to fast moving news.

All four major portals have dedicated section on this disaster. They are listed below:

Tencent: http://news.qq.com/zt/2008/dizhen/

Netease: http://news.163.com/special/00012MS5/sichuan0512.html

Sohu: http://news.sohu.com/s2008/dizhen/

Sina: http://news.sina.com.cn/z/08earthquake/index.shtml

It is now 3:13pm China time on 5/13/2008. It is exactly one day after the quake occurs (give or take 30 minutes). I did a quick count on the number of articles and number of video clips on each portal. The result is listed in the following table:





# of articles





# of video clips





From the above table, Sina has the most amounts of articles. Sohu is not far behind. Sohu and Tencents both have large amounts of video clips. In terms of numbers of articles, Sina and Sohu have more than twice as many news articles than NTES and Tencent. NTES is behind in securing video reporting. I am a little surprised that SINA’s video clips are only half of that of SOHU and Tencent.

Overall, I would say SOHU comes out on top, SINA comes in number two, Tencent comes in a strong number 3 while NTES is little disappointing.

SINA has the reputation as being the king of content in China. SOHU’s content department is really catching up fast.

Another point that can be observed from this study is that competition in China’s portals is fierce. I don’t think CNN or MSNBC or Yahoo would have this much information in such little time. Granted most (if not all) of the articles and video clips are sourced from third parties, but the amount of information is still tremendous.

Finally, it will be impossible for any TV stations in China to compete with China’s internet portals for the amount of information available.

This definitely points out the inevitable trend from TV, radio, or print to the internet.

Friday, May 9, 2008

TX2 going open beta (commercial) on June 6, 2008

My last TX2 post can be found here:


It is an exciting time for NTES. After three years of virtually no new successful games (XY3 are somewhat successful), there are a slew of new exciting games that will be in the market in the next 1 to 4 quarters. The XYQ is growing like crazy. The XY2 is growing as well. The XY3 has a good start, then slow some, but is now growing again. They are going to add many new contents for Datang. In addition, a free-to-play version of Datang will also be developed. They also talked about developing a free-to-play version of XY3. Fly for Fun 2 shall be out pretty soon also. Finally, they are continuing developing casual games.

But the most important of them all is probably TX2. From my last few posts on TX2, I suspected TX2 will go open beta on either June or July this year.

It looks like it will go open beta on June 6, 2008!

Netease released the official trailer for the new TX2 on 5/4/2008. You can download the official trailer from the following link:


You would need to have winrar to uncompress the file. The trailer is very nice. Watching movie trailer is definitely one of the more enjoyable thing to do when one trying to analyze a stock.

One can compare the official trailer from the old TX2, that trailer came out in about the same time (around May) in 2006. The old TX2 trailers has a lot of group fighting. That is to be expected. The old TX2 is centered on castle siege and global domination.

The current TX2 trailer is very similar to the official trailer for World of Warcraft. If one read my previous articles on TX2, I said that if TX2 can be converted to a Chinese clone of World of Warcraft, TX2 will then be a very successful game. So far, from all the users' feedback, it does seem that NTES is trying to emulate World of Warcraft. It seems to be very user friendly, especially for new users. It had upgraded the game engine so that it is no longer a game for only those users with fast computers. In addition, it will also keep a lot of group fighting features of the old TX2.

In a nutshell, the new TX2 is going to be a Chinese version of World of Warcraft. In addition it will have quite a few group/gang/tribe fighting features that WOW doesn't have.

But the most exciting thing about that trailer is that it announced at the end of trailer that the game will be operational on June 6, 2008.

Another thing I find useful to me is somebody had developed a flash player instruction on how to play the game. One can go to the following web site to see the user interface in flash form:


Finally, something I don’t like. Just like the marketing effort for the old TX2 (or more precisely, the lack of effort), there is no marketing effort for TX2 yet. It is less than 1 month from the official launch, NTES still have not started the marketing campaign!!! I hope NTES is not going back its old bad habit of pinching pennies.

Wednesday, May 7, 2008

FF2 Game Information

My last article on FF2 can be found here:


There are some user reviews on the new FF2.





At this early stage, it is difficult to tell from the user review how good this game is. Most of user complaints are something that can be solved by the developers.

Usually at this early stage, most users complain of little playability of the game. But it is to be expected because developers are concentrating on the foundation.

The above 4 links have hundreds (if not thousand) of in game graphics. At this point, the in-game graphics are expected to be incomplete, and they are. The background are sparse and the graphics in many locations are incomplete.

Any way, let me put some in game graphics to illustrate what kind of game this is:

Where one enter the game:

In some village:

One can tell the game developers haven’t build this location yet:

FF2 means Fly for Fun 2. It means the characters are usually flying:

Beautiful Building:

One can tell FF2 is catering the the young and female gamers. Its main competitors are the QQ Games that made Tencent so much money.

One can tell this game is not games based on ancient Chinese stories. The background and stories are based on western .

You will never see anything like that in any game based on Chinese mythology:

Hanging out with friends:

Everything about this game can be described as “cute”:

OK, this is all I have on FF2 so far.

Tuesday, May 6, 2008

FF2 Update

My last post on FF2 can be found here:


On 2/1/2008, Ntes started the first stage closed beta of Fly for Fun 2. Any additional information had been extremely hard to find.

But I did find some information that shed some light to the status of FF2.


From the above forum posting, FF2 might come out some where around September this year. Note that this is not the announcement from the company. It is just a guess from one of the FF2 development team. It is purely based on the development progress. It is entirely possible that Ntes could delay it due to market timing.

But at this point, it does look very likely that FF2 could start commercial operation starting 4th quarter this year.

I don’t think FF2 will be a blockbuster. But I do think it is very possible that FF2 can add 5 to 10 million per quarter to the bottom line.

Monday, May 5, 2008

TX2 criticism session with player representatives

My previous article on TX2 can be found here:


On 4/18/2008, NTES having a player criticism session. One can find the video of that session here:


NTES’s TX2 closed beta users elected about 12 representatives among them. On 4/18/2008, NTES paid them to come over to NTES’s headquarter to have a player criticism session with all of TX2 developer team.

In the video, the person in the green stripe shirt is the CEO of NTES. The complaints from users representatives were pretty technical. But I am pretty satisfied by the answers from the developers team. I think these complaints were solvable.

Interestingly, many other developers from NTES’s other games were present as audience.

I think this is a very good and cheap way for NTES to get its developers good ideas about real players concerns.

Typically, a session like this indicated that the game is getting ready. From the players feedbacks, none of the concerns requires NTES long time to correct.

Another confirmation that TX2 is getting ready to rock.

Friday, May 2, 2008

New Update on XY2

My last article on XY2 can be found here:


From the above article, I used my server count to derive an estimate of Average Concurrent Users (ACU) increase of 5.4% from the 1st quarter 2008 over the 4th quarter 2007. Because I only have partial server counts (I am not going to stay late and get up early every day to check for servers), there is always some doubt on how accurate my server count is.

On 4/29/2008, the CEO of NTES talked about XY2. One can get more information in the following article:


Let me translate the main points:

1. NTES will no longer do players migration from XY2 to XY3. NTES will devote complete effort to continuing develop XY2.

2. Ever since October of 2007 when NTES revived XY2, the number of players continues to increase. Its PCU had increased to 409k.

3. NTES is working on the expansion pact for XY2. It will be out in the 3rd quarter 2008.

Not much is new except for the new PCU estimate. In 4th quarter 2007, XY2’s PCU is 387k. It means it had a PCU increase of 5.7%

Again, this is another confirmation that XY2 is growing nicely. Considering that XY2 starts commercial operation on 8/15/2002, it is a 6 years old game already.

Even though the complete transition from XY2 to XY3 had proven to be a failure, but its un-intended effects winds up to be better than what NTES can ever hoped for.

Now XY2 is behaving like a 2 or 3 years old games. It will most likely have another 2 or 3 solid years ahead. In addition, XY3 becomes a complete new game and have a solid start in its young life.

It never cease to amaze me how different the Chinese market is to the west.


A test for now