NetDragon Wows Investors With Its 'Tale Of Two Cities'

Key Takeaways:

• NetDragon’s revenue declined 13% in the first half of 2023, mostly due to a sharp drop in its education business following strong gains the previous year
• Revenue growth from the company’s gaming business grew 8% year-on-year in the latest reporting period

By Edith Terry

When a company’s revenue falls, so does its stock price – most of the time. But that wasn’t the case this time for NetDragon Websoft Holdings Ltd. (0777.HK), whose interim results released last week show its revenue fell 13% during the six months through June, while its profit dropped 12%.

Despite that, the market shrugged off the negativity, giving the 24-year-old, Fuzhou-based company a pat on the back with a 9.3% jump in its share price the day after the results came out. Rather than focusing on the declines, investors seemed encouraged by the company’s strong post-pandemic gains for its gaming business. They also probably liked a robust plan for its other main business in education, where the company is seeking to expand its share at the lower end of the market for its educational devices.

A spinoff of its non-China educational business is pending, and could rid NetDragon of residual drag associated with negative sentiment towards China’s edtech sector following a high-profile crackdown two years ago.

NetDragon’s revenue fell to 3.7 billion yuan ($506 million) in the first half of 2023 from 4.2 billion yuan a year earlier, while its profit dropped to 500 million yuan from 565 million. Its education business dragged down the overall results with a 29% revenue decline in the first half to 1.7 billion yuan and a loss of 249 million yuan. NetDragon’s gaming business fared better with an 8% year-on-year revenue rise to 1.9 billion yuan, and a profit of 1.09 billion yuan.

Gross margin for gaming was 97%, far higher than the 24% for education, explaining why the company is so keen to spin off the latter business that is dragging on its profitability.

In its earnings call after the announcement, Vice Chairman Simon Leung joked, “The first six months is kind of like the Charles Dickens story, the ‘Tale of Two Cities.’” The novel, set during the French Revolution, has a happy ending, and investors appear to think the same will be true for NetDragon as it gets set to return to its gaming roots with the education spinoff.

The education business has not only weighed on NetDragon’s profits, but is also hurting its valuation. Gaming giant NetEase currently trades at a price-to-earnings (P/E) ratio of 19, while U.S. giant Electronic Arts EA is even higher at 38. By comparison, NetDragon hardly lives up to its “dragon” name with a P/E ratio of just 10.

The company is quite a veteran in China’s gaming space, founded back in 1999 when the internet and online gaming were just getting started in the country. The company’s move into education looked smart in 2014, when education technology, or edtech, was gaining momentum in China and gaming was showing signs of maturing.

Following that strategic decision, NetDragon quickly massed up in edtech hardware, spending $130 million in 2015 to buy London-listed Promethean World, and following that two years later with its purchase of Los Angeles-based JumpStart, a partner of DreamWorks Animation. In 2022, Promethean acquired Explain Everything, a digital whiteboard app.

But in July 2021, when China began its crackdown targeting many for-profit edtech companies, NetDragon’s education business began to look like an expensive mistake.

Unfairly Punished

Here’s where the market may have started to unfairly punish NetDragon. Unlike its gaming unit, which is largely a software-based China business, NetDragon’s education business is largely international and hardware-based. It sells high-end tablets under the Promethean brand, and is planning a move into software as a service (SaaS) to add higher-margin subscription revenues to its hardware sales.

NetDragon argues that the first-half revenue decline and losses in its education business are temporary. The decline came off a high base in the first half of 2022, when the education business grew by 71.2% to 2.4 billion yuan, and far outpaced the 1.8 billion yuan from NetDragon’s gaming business.

Leung said the U.S. market is now “taking a pause” to digest the high level of equipment purchases educators made in 2022, and added the company’s business continues to grow faster than the overall industry by a “wide margin.” The analyst community seems to like the company’s story, with nine out of 11 who follow it rating NetDragon as a “buy” or “strong buy.”

NetDragon’s profit downturn in the first half owes partly to high expenses related to its education spinoff, which the company is conducting by injecting the business into U.S.-listed Gravitas Education Holdings GEHI in a deal first announced in April. The new company, to be named MYND.AI, will allow the education business to conduct its own fundraising and relieve the company of its Chinese associations.

NetDragon’s administrative expenses rose 22.8% year-on-year in the first half of 2023, partly due to spinoff-related costs. Without those costs, administrative expenses would have been up by a lesser 10%, company officials said. “Our team in the U.S. has been working day and night to complete this,” said Leung said of the spinoff. “We are at the very final stage of the process.”

Powered by a post-pandemic rush of enthusiasm among Chinese gamers, Leung said gaming is once again the “exciting” part of NetDragon’s business, as it uses artificial intelligence (AI) to generate graphic content with a 30% increase in efficiency. The company is also using AI to develop smart “non-player characters” or NPCs, avatars that are independent of users and improve the overall gaming environment.

While AI is breathing new life into gaming, NetDragon’s education strategy could be equally exciting in the future. Instead of focusing on high-end products to maintain profit margin, the company is trying to broaden its appeal by pushing into the lower end of the market with its more affordable ActivePanel LX, which began shipping in June. Boosting its footprint through the sale of more such devices will be crucial to developing the company’s SaaS business providing higher-margin programming services over those devices.

With an installed base of 1.7 million devices, the company plans to roll out software subscription services for its education division under the Explain Everything brand by the end of the year. It is using AI and large language models to help teachers organize classroom material more efficiently and to fast-track market entry to the Middle East, among other markets.