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,
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,
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:
Thus, in the future quarter when
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.
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
Could it be NTES is going to license 2 or 3
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
For the 99 millions for licensing games or buying US companies, either finalize the deal or transfer the money back to
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
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
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.