NetEase: Further Potential Upside From This Chinese Game Developer

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The Chinese online gaming industry, in the midst of rapid growth, is expected to report a staggering growth of 32% in 2013. The huge opportunity ahead has resulted in a number of Chinese gaming companies springing up in every part of China. The interest of the Chinese gaming community and its future potential can be gauged from the fact that the dying internet cafe business experienced marginal stability for two consecutive years as gamers played online games from these cafes.

At Amigobulls, NetEase (NASDAQ:NTES) has been one of our favorite stock picks from the internet industry for close to 3 quarters. NetEase saw a one year stock price gain of 80% in 2013. Today we take an in-depth look at the company to see where the company is headed over the coming quarters. But even before we move ahead in time, let’s see what has resulted in a turnaround for the company in 2013 and what were the right moves made by the company which bode well for 2014.

NetEase revenue trend in 2013

NetEase has seen a remarkable improvement in its fundamentals in FY 2013. We refer to the revenue growth and margin expansion which were a result of some smart moves made by the management.

Netease revenue growth

Based on the numbers as reported in NetEase SEC filings

Netease had entered into a partnership with Activision Blizzard in 2008 to exclusively market and distribute the latter’s World of Warcraft title in mainland China. The revenues from World Of Warcraft sales contributed a lion’s share to the overall revenues of Netease. However the game has seen interest fading over the last year which had an adverse impact on Netease revenue growth in 2012. The chart above clearly displays the turnaround in revenue growth since Q4 2012. The revenue growth had slowed down as the demand for games licensed from Activision began to decline in 2012. However, Netease released its in-house developed games like Kung Fu Master, Heroes of Tang Dynasty II and Soul of the Fighter late in 2012. The in house developed games immediately gained acceptance in the gaming community. As a result, the revenue growth has been put back on track inspite of the falling demand for the games licensed from Activision Blizzard.

The company’s partnership with Activision Blizzard to market and sell the latter’s game titles in China gave the company the understanding and time required to develop quality games of its own. Moreover the hugely popular titles like World of Warcraft generated significant revenues for the Chinese company. The success of Netease’ in-house games could not have come at a better time considering that the interest for the Activision games had been waning all over the world and even more rapidly in China.

In-house games drives revenues

The company’s focus on in-house developed content has led to two benefits for the company. The first was that the revenues from these games have driven growth in 2013 as has already been pointed out above. The second result was an improvement in the company’s profit margins as the share of revenue from in-house games increased in proportion to licensed games. The company saw its margins improve by close to 1.5% Y/Y in the Last twelve months (LTM). The chart below shows the Operating profit and Net profit margins of the company over the last two years.

NetEase profit margin

Based on the numbers as reported in the company’s SEC filings

Focus on the mobile platform

Q3 2013 saw the company deliver on two fronts in the mobile space. The first was the successful launch of the mobile version of its popular game ‘Fantasy Westward Journey II’. The second positive from the quarter was the launch of ‘Yichat’ in combination with China mobile. The company also plans to develop mobile versions for its other games in order to reach out and leverage the fast growth of the Chinese smartphone user base.

NetEase: Expectations in FY 2014

Based on the industry outlook for the Chinese Online gaming industry as well as the company’s growth rate over last few quarters, we see the company generating revenue growth of 20% - 22% in FY 2014 mainly on account of new games in the pipeline to be launched in Q4 2013 and in 2014. The company also plans to release expansion packs for its successful titles following the success of its expansion packs for Heroes of Tang Dynasty and Fantasy westward journey II, both launched in Q2 2013. The focus on in house developed games will continue the margin expansions into FY 2014 The average Net Income margins for the last twelve months was in excess of 45% and this will see marginal increase with higher proportion of revenues contributed from self-developed games. However, on a conservative basis we assume the margins to stay at 45% for the purposes of our calculation. The table below sums up our FY 2014 expectations from the company. We estimate the one year forward price using a P/E multiple of 14 against the company’s current P/E multiple of 15, which is a conservative estimate considering the company’s growth potential and margin expansion over the coming year.

Revenue (in millions of $) 1,848.58
Revenue growth 22%
Profit margin 45%
Earning per ADR ($) 6.38
CMP, Jan 13 closing price ($) 78.39
Forward P/E 12.29
1 year target price at P/E ratio of 14 ($) 89.32

Our one-year target price represents a gain of 14% over the last closing price on January 13, 2014. We would like to remind our readers that we strictly adhere to the concept of ‘margin of safety’ and hence while our estimates may come across as too conservative, we continue to hold our positive long term outlook on the stock.

To see NetEase’s latest stock price movement, click here (NASDAQ:NTES)

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Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice. Buying and selling of securities carries the risk of monetary losses. Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions. Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.

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