NetEase: A Hidden Pearl In Chinese Online Gaming Industry

  • NetEase has delivered an exceptional return of 660% in last ten years, outperforming the market significantly.
  • In house developed games and growing Chinese online gaming market will drive NetEase’s future growth.
  • Attractive valuations, dividend history and strong growth makes NetEase a stock to buy.

 

NetEase (NTES), the Chinese Online Gaming company, has been a consistent performer in the last ten years. Its ADRs have delivered a return of around 660% (excluding dividends) compared to 125% gains in NASDAQ since January 2005. NetEase stock price has gone up from $12.97 to $101 in the same period. The key driver for this growth has been NetEase’s ability to grow revenues consistently without compromising on profitability. We have had NetEase on our stocks to buy list since May 2013 returning investors a handsome 63%.NetEase share price has gone up from

NTES-stock-chart_2005-2014
Source:Netease stock chart by Amigobulls

NetEase revenue has grown at a compounded rate of 20% in last three years and 30% in last five years, suggesting a relative slowdown in growth in last two years. However NetEase’s revenue growth has picked up again, and registered a YoY revenue growth of 32% in Q3 2014, allaying investor’s concern.

NetEase_revenue_pearl
Source: NetEase Income Statement by Amigobulls

One thing that makes us love NetEase is its operating margin which has been in the range of 35%-40%. NetEase has three revenue segments: Online Gaming, Advertising Services and Email, Ecommerce and others. In the latest quarter NetEase online gaming segment reported a gross profit margin of 77.2% while advertising segment reported gross profit margin of 66.3%.

NetEase Online Gaming Segment: Future Growth Drivers

Size of Chinese online gaming market stood at 83.7 billion Yuan ($ 14 billion) in 2013. The industry is expected to grow at a whopping Compounded Annualized Growth Rate (CAGR) of 23%, between 2014 and 2017. This presents a clear opportunity for NetEase, which already has a wide variety of online games which are very popular. NetEase’s online game website, 163.com, is ranked 52nd globally and 13th in China by Alexa traffic rank. The popularity of 163.com gives NetEase a strong competitive advantage.

NetEase started its online gaming business by licensing popular games like "Hearthstone: Heroes of Warcraft", from Activision Blizzard (ATVI), which became very popular in China. However, of late popularity of games licensed from Blizzard has gown down, forcing NetEase to foray into in house developing of games. In house developed games like Fantasy Westward Journey II, not only allow more flexibility and creativity, they are also more profitable than games licensed from Blizzard Entertainment. Development of In house gaming is likely to have positive impact on NetEase stock price.

NetEase has also released extensions and upgrades for existing popular games which will increase their longevity. Warlords of Draenor an extension of popular game World of Warcraft registered 3.4 million subscriber within 24 hours of its launch. NetEase has several games in pipeline which we expect to strengthen its revenue growth.

Considering that NetEase draws around two thirds of its revenue from online gaming industry, it is likely to continue its revenue growth in the near future. In last quarter online game segment contributed $400.7 million, almost 74% of NetEase revenue of $541 million.

NetEase will face indirect competition from gaming consoles. The recent decision by Chinese authorities to allow gaming console sales by international giants like Microsoft coupled with slow economic growth may be a dampener for NetEase’s growth to some extent. However it is not expected to pose any serious challenge to online gaming industry which continues to boom in China.

NetEase: Strong Growth Ahead In Advertising Services, Email and Ecommerce

NetEase revenue from advertising segment has been growing consistently over last few quarters. In last quarter its revenue from advertising grew by around 60%. NetEase’s revenue from email, ecommerce and other services, continuing their phenomenal growth, grew at 252.5%.

Its News App is China’s No. 1 news app in terms of time spent. Users spent an aggregated average of 600 million minutes daily in April 2014. NetEase is focusing on monetizing this ad inventory. This will provide a great advertising platform for NetEase. NetEase is also China’s largest email service provider, with more than 650 million registered users. Its online dictionary is also one of the most popular in China. The huge user base and its potential growth will help NetEase maintain its growth rate in FY 2015.

NetEase Valuation

NetEase’s current PE of 17.5 is more expensive than its PE of 15 at beginning of the year. However this slightly higher PE should not worry the investors too much as NetEase’s revenue growth rate was 17% at the end of 2013, and it currently stands at 32%.  Also, NetEase’s PE ratio is considerably lower than industry’s PE of 33, while its revenue growth is higher than industry’s. Based on the strong performance by NetEase in last few quarters and future growth opportunity we expect NetEase will continue to grow between 22% and 25% in FY 2015.

NetEase is also a dividend paying company, with a current dividend yield of 2%. While investors in internet stocks may not be looking for dividends, it’s attractive for investors who want regular income. Given the attractive valuations, dividend history and strong growth, we reiterate our buy rating on NetEase.

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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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