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.


Anonymous said...

Thanks again for your analysis.

I never remember NTES acquired any companies of significant size. In fact Ding publicly said he shuns buying companies, preferring growing organically. And he does what he says by hoarding cash! I believe his last dollar holding will ultimately goes toward buying back shares.

This is in contrast to Sohu. I was browzing Sohu's latest 10K just couple of days ago, which is Not exactly my idea of having a good time. I became a bit curios to the discussion $90mil Zero coupon convertible ($44/sh convert) Sohu issued back in 2003. I remember myself in 2003 rather puzzled by this debt placement when sohu was rolling in money with WAP.

As I pieced together the timing of several sohu's acquisitions (map, focus, goodfeel, 17173), share buyback, zero coupon buyback, Olympic sponsorship buying headquarter office space, and $58million zero coupon redeem timing etc. After giving much thoughts as my mind works rather slowly, I realized that the $90mil zero coupon was probably the single BEST thing happened to Sohu in the ever, next to the IPO. Most of sohu's buying spree would not be possible without the $90mil cash to prop up the financial position. That $90mil is now $1 billion and counting. On the other side of the transaction, the people who bought the zero coupon must feel like idiots looking back at what sohu has done with their money.

Miser NTES & miser SINA were hoarding their much greater cash positions while Sohu actually borrowed $$$ to finance its acquisitions, with Olympic sponsorship to boot.

From Virgina.

HenryC said...

Thanks for your insight.

I was hoping these big portals can buy those new you-tube like video sharing site start-ups.

So far, nothing had happened.


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