China Literature Group: As Web Novels Decline, Can Short Dramas Extend Its Life?

After the Hong Kong stock market closed on March 18th Beijing time, $CHINA LIT(00772.HK) released its full-year performance for 2023. In order to observe short-term marginal changes more conveniently, Dolphin Jun will mainly analyze the performance in the second half of the year.

Overall performance is mediocre, especially compared to the market expectations that have already been lowered due to the delayed broadcast of "With the Phoenix" (Bloomberg's expectations have errors and do not reflect the impact of the company's previous guidance adjustment. The market's actual expectations are lower. The following actual versus expected comparison also includes the expectations of top investment banks). The main shortfall below expectations is in the gross profit part, with the market underestimating the cost estimates for the copyright operation business.

On the revenue side, there are no surprises, basically meeting expectations. The online literature segment is still in a painful period, but the revenue from copyright operations increased by 25% year-on-year, with the non-Xinli Media segment shining even more with a 38% year-on-year growth. Dolphin Jun believes that this may be closely related to IP authorizations related to games, short dramas, and revenue sharing relationships.

Specifically:

1. Online Literature: Returning to Paid Content, but Trend of Contraction is Hard to Conceal

Since the second half of 2022, the company's strategy has shifted towards focusing on premium paid content, with a focus on combating piracy and shrinking distribution channels (reducing free reading within Tencent's self-operated channels, while temporarily suspending third-party channels with low customer acquisition efficiency). At the same time, different platforms under the company have implemented varying degrees of price increases, resulting in a decrease in the overall user base and an increase in the payment rate trend.

However, due to weak new user payments, this ultimately reflects in the overall decline in online literature revenue year-on-year, with a slight slowdown in the first half of 2023. The online business revenue in the second half of 2023 was 1.9 billion, a 7% year-on-year decline, slightly lower than the top investment bank's expectation of 1.96 billion.

Dolphin Jun has split the online business into two parts: a 32% decline in free reading revenue (advertising), which is not only due to competition but also the impact of the company's own strategic adjustments. A 3.7% decline in paid revenue, which seems stable, but considering the low base effect and the price increase at the end of 2022, the performance of the paid revenue part is also not good. Therefore, overall, online literature cannot avoid the industry's downward trend.

2. Copyright Operations: Gradually Holding Up Half the Sky

Copyright operations have always been the core of Yuewen's IP stories. In the decline of online literature, maintaining stable copyright operations has supported half of the group's revenue. Over the past three years, due to the impact of the epidemic and industry regulations, the downstream industries of the IP, games, and film and television have all experienced pressure and turbulence. Therefore, as an upstream player, Yuewen naturally finds it difficult to thrive alone.

However, during this period, Xinli Media, which excels in creating quality content, has had popular dramas and films released, thus barely supporting the revenue from the copyright part. However, a good sign in the second half of 2023 is that excluding Xinli's revenue, the remaining IP authorizations, self-operated games, and other business revenues grew by 38% year-on-yearDolphin believes that although some of the revenue sharing from game licensing contributes, considering the increasing Matthew effect in the gaming industry, after excluding the normal game revenue, what remains may be the contribution of short dramas that emerged in the second half of the year. Previously, the company disclosed that it will cooperate with its parent company Tencent (mini programs, video accounts) to launch 100 to 160 short drama contents in the next two years, seizing the short drama dividend.

3. New Classics: Fluctuations in schedule, but excels in quality

In the first half of last year, New Classics suffered a sharp decline year-on-year due to the high base of "Hi, Mom" in 2022 and the impact of filming progress during the epidemic lockdown period. However, in the second half of the year, despite not starting from a very low base, it maintained a 9% growth with several high-quality dramas.

Dolphin predicts that New Classics will continue to perform well this year. A drama "Hot and Spicy" started off well during the Spring Festival, the costume drama "Phoenix Walks" which was not aired in the second half of last year began airing today, and there are still 4-5 high-quality dramas waiting to be broadcast. In addition, the long-delayed "Joy of Life", "The Exorcist's 2nd Meter", and the problematic drama "The Long Ballad" are actively being produced and reshot, with the possibility of being scheduled for release this year.

4. Marketing spending recovery, efficiency improvement mainly through layoffs

Compared to the second half of 2022, there was no epidemic impact in the second half of 2023, the operating environment returned to normal, and with the release and broadcast of new content, the corresponding marketing and promotion expenses increased accordingly.

However, overall sales expenses remained basically flat year-on-year, indicating that the main cost reduction was in employee costs. In addition, the combined management and R&D expenses also decreased by 8% year-on-year. In 2023, the total number of employees decreased by about 100 for the whole year, and employee welfare expenses in the second half of the year decreased by 15% year-on-year.

Dolphin's Viewpoint

China Literature still finds it difficult to escape the overall trend of the decline of online literature. Despite the "user purification" at the end of last year, which temporarily slowed down the decline, two core obstacles still exist: competition from outside the industry (short videos, long videos, and now short dramas), and competition from within the industry (free reading). In the current economic weakness and prevailing cost-effectiveness era, the attractiveness of online literature payment, even for loyal users, may gradually decrease.

Dolphin is not pessimistic about the short drama that was hyped repeatedly last year, especially for China Literature. It is a logical and long-term growth story for its copyright operation business. Although copyright operation's revenue share is not as high as online literature, it is a key area where most of the funds are placed.

Due to the significant differences in the development trends of different businesses, their impact on the group is opposite. Therefore, we tend to combine the current valuation position and fundamental expectations to assess the current opportunities and risks. In the short term, China Literature's current valuation is in a neutral range, not significantly undervalued (for now, not too optimistic about short drama revenue, expecting 24e Non-IFRS net profit 20x), although there is the concept of short dramas, the speculative sentiment of Hong Kong stocks is relatively weak compared to the mainland market, and it is unlikely to skyrocket (especially after a round of speculation), investors will expect to see signs of performance realizationOtherwise, it is still dominated by fluctuations.

Dolphin believes that the turning point for the true valuation reversal of Yuewen depends on when online literature can emerge from the pain and reverse the downward trend, at least no longer dragging it down. Otherwise, as a short drama as a substitute for consumption, if the incremental value it brings is only enough to fill the gap in the online literature business, it will still be futile. We expect that at least in the first half of this year, online literature may still face pressure risks (high base, offline cultural and travel activities are popular, short dramas diverting traffic), and in the second half of the year, with the increase in new user payment cultivation and the expectation of increased spending on in-app purchases, we can hope for a return to growth in online reading revenue.

Detailed interpretation of this financial report

I. Returning to a focus on paid content, industry trend contraction is inevitable

Starting from the second half of 2022, the company's strategy shifted towards focusing on paid quality content, emphasizing the fight against piracy and contracting distribution channels (reducing free reading within Tencent's self-operated channels, while temporarily suspending third-party channels with low customer acquisition efficiency), and implementing varying degrees of price increases on its platforms. This is reflected in the trend of "reducing total user base while increasing payment rate".

Looking at the second half of 2023:

(1) Overall monthly active users continued to decline to 200 million, mainly due to the company actively reducing free content, thereby shrinking the distribution of online literature content on Tencent's self-operated channels. However, the rate of decline slowed down compared to the first half of the year.

From third-party data from Questmobile, while Yuewen is losing users, the two top free reading platforms, Fanqie and Qimao, still have high growth vitality. Although Yuewen's platform revenue remains stable, free reading is consuming potential incremental users, affecting the current market share of Yuewen's online reading business in the existing market.

(2) Paid users increased by 12% year-on-year, still in the period of the effectiveness of combating piracy. In the second half of 2023, the average number of paid users reached 8.6 million, with the payment rate slightly increasing to 4.3%Due to the weak monetization of new users, the average revenue per paying user (ARPPU) has been lowered, resulting in a continued year-on-year decline in overall online literature revenue. However, the decline rate has slowed down compared to the first half of the year, with online business revenue in the second half of 2023 amounting to 1.9 billion, a 7% year-on-year decrease, slightly below the top investment bank's expectation of 1.96 billion. The decline rate has only slowed down due to the low base.

Looking at the distribution channels, Tencent's self-operated channels (part of free reading) and third-party channels (with lower customer acquisition efficiency) that the company actively shrunk have experienced a significant decline in distribution revenue. Within the entire self-operated channels of Yuewen, over 90% of the revenue comes from the core reading platforms (such as QQ Reading, Qidian, Hongxiu, and Xiaoxiang).

From the perspective of revenue categories of free and paid reading, one can clearly see the changes in the company's strategy and market competition. In the second half of the year, advertising revenue from free reading accelerated by 32% year-on-year, while revenue from paid reading remained relatively stable.

II. Copyright Operations Support Half of the Sky

In Yuewen's copyright operation business, nearly half of the performance relies on Xinli since its acquisition. Xinli represents the first step of Yuewen's IP monetization - IP visualization. Xinli itself has good production capabilities, and after focusing on high-quality content in the past two years, the rate of explosive hits has also increased.

However, in the second half of 2023, the delay in the broadcast of "With the Phoenix" (starring Zhao Liying and Lin Gengxin) under Xinli's banner affected the current period's revenue, with only a slight 9% year-on-year growth. Meanwhile, revenue from game IP licensing and short drama revenue sharing contributed the main net increase, excluding Xinli, the growth in copyright authorization operations alone increased by 38%, which is quite impressive.Looking ahead to this year, Dolphin believes that New Classics can still perform well. First of all, during the Spring Festival, the drama "Hot and Spicy" got off to a good start. The costume drama "With the Phoenix" that was not aired in the second half of last year started airing today. At the same time, there are 4-5 high-quality dramas waiting to be aired. In addition, the long-delayed dramas "Joy of Life", "The Excessive Wife", and the problematic drama "The Long Ballad" are actively being produced and re-filmed, and it is not ruled out that they will be scheduled for release this year.

In addition to New Classics, Dolphin is also quite optimistic about the growth of short dramas. Although the competition is fierce, the industry is still in a period of rapid growth overall. Therefore, as a company with a large IP library like Yuewen, it should be a major participant in the industry. At the beginning of the year, the company also disclosed that it will jointly launch 100 short drama content this year with its parent company Tencent (mini-programs, video accounts), and 160 next year.

According to market research, in terms of profit distribution in the current industry chain, simply doing IP authorization has a profit sharing space similar to long videos, still very low (1%-2%), unless the IP itself has a great influence. However, high-quality IPs are often more valuable when made into long videos. Novels of medium quality are more suitable for short dramas, closely following a few key traffic tags (romance, light novels, rebirth, etc.), focusing on compact character conflicts in the content.

Therefore, to get more of the cake in the industry chain, it is necessary to extend downwards to production, distribution links, and save costs on platform traffic. Yuewen + New Classics + Tencent, this is a relatively complete closed-loop ecosystem. And with the help of the current popular "literature-to-video" and other AI technologies, it helps optimize video production costs and more efficiently obtain the dividends of industry growth.

In the second half of the year, efficiency improvement mainly relies on layoffs.

Compared to the first half of 2022 and the first half of 2023, marketing and promotion expenses in the second half of 2023 began to increase again with the launch of more new content projects. However, due to continued layoffs in 2023, employee welfare expenses decreased by 15% year-on-year, leading to a slight overall decrease in operating expenses.

However, the deviation from market expectations in the second half of the year mainly lies in the gross profit margin of copyright income, which dropped to 45%, while the market generally expected it to be above 50%. The gross profit margin of the online reading business barely remained stable, offsetting the impact of the decline in high-margin distribution income and free reading advertising income on the overall gross profit margin through a price increase strategyAfter excluding other gains and losses, the operating profit of the main business in the second half of the year decreased by 22% year-on-year, with a core operating profit margin of 6.5%. The recovery of profit in the future will mainly rely on the expansion of copyright operation income, as relying solely on online literature is not very promising.

In terms of cash situation, currently, Yuewen has a stable cash flow, with nearly 1 billion in free cash flow in 2023, nearly 2.8 billion RMB in available cash, 1 billion in short-term deposits, and 2.4 billion in short-term investments. At the same time, the external borrowing balance is not high, totaling 10 million, resulting in a net cash of 6.2 billion, accounting for 24% of the current market value of 27.9 billion HKD.

Dolphin Research on Yuewen Group Historical Articles:

Financial Report Season

March 17, 2023 Conference Call "Management: Returning to High-Quality Paid Content, Returning to ROI (Yuewen 2H22 Conference Call Summary)"

March 16, 2023 Financial Report Review "Yuewen Group: Does the Eastern Disney Still Have a Chance?"

August 16, 2022 Conference Call "Yuewen Group: Continuing to Reduce Costs and Increase Efficiency in the Second Half of the Year, New Movie Screenings are Impressive (1H22 Conference Call Summary)"

August 15, 2022 Financial Report Review "Let's Talk About Yuewen's Performance in the First Half of 2022"

August 17, 2021 Conference Call "Yuewen IP Monetization Enters the Second Phase | Conference Call Summary"

August 16, 2021 Financial Report Review "Yuewen Group: The Story of the 'Eastern Disney' is Too Difficult!"

March 24, 2021 Conference Call "Yuewen's Unexpected Rise Today - Annual Report Conference Call"Financial Report Review on March 23, 2021: "Dolphin Research | Don't Count on Online Reading, IP Operation is the Hope of Yuewen"

In-depth Analysis

December 28, 2021: "Yuewen Group (Part 2): Unlucky is not Wrong, 'Eastern Disney' Deserves Long-term Attention"

December 20, 2021: "Yuewen Group (Part 1): Is Online Literature Too Old to Make a Living?"

Risk disclosure and statement of this article: Dolphin Research Disclaimer and General Disclosure