- Slowing revenue growth in online gaming segment is a concern.
- Monetization of mobile games will be critical to the long term success of NetEase.
- We reiterate our positive outlook given the earnings potential of in-house games and growth potential on account of the mobile platform.
NetEase (NTES), a leading Chinese online gaming company announced its Q1 2014 earnings yesterday (May 15) after market close. The quarter saw the company launch new games across mobile and PC apart from expansion packs for its Fantasy Westward Journey II. We today take an in-depth look at the results and update our outlook on NetEase post the Q1 2014 results.
Netease performance in Q1 2014
The table below compares the Q1 2014 performance against the year ago Q1 2013 performance.
|2013 Q1||2014 Q1||Y/Y growth|
|Net revenue ($ in millions)||346.59||380.53||9.8%|
|Gross profit ($ in millions)||248.94||274.72||10.4%|
|Operating profit ($ in millions)||175.57||184.04||4.8%|
|Net profit ($ in millions)||171.23||180.79||5.6%|
|Earnings per share (EPS)||1.32||1.38||4.5%|
Source: NetEase Income statement
The company saw topline growth of 10% on a Y/Y basis. The growth in revenues was driven by growth across all segments with online games segment (+6.3% Y/Y), online advertising services (+47.9% Y/Y) and the e-mail, e-commerce and internet segment (+81% Y/Y). The growth on a constant currency was 10% Y/Y. The revenue growth outpaced the growth in profits as the company saw margin compression on account of increased investment & promotion activity. The margin contraction is clearly understood after a comparison of the Q1 2014 margins against the Q1 2013 margins.
|2013 Q1||2014 Q1||Y/Y change|
|Gross profit margin||71.8%||72.2%||0.4%|
|Operating profit margin||50.7%||48.4%||-2.3%|
|Net profit margin||49.4%||47.5%||-1.9%|
The gross margin saw a Y/Y expansion of 40 basis points. The expansion in gross margins was on account of greater revenue contribution from in-house developed games like Hearthstone, Fantasy Westward Journey II and New Westward Journey Online II.
Moving on to operating margins, the 2.3% drop was driven by increased staff related expenses (+22% Y/Y) and substantial increase in the research and development expenses (+29.3% Y/Y). The Net profit margin for the quarter contracted in-line with operating margin, 1.9% down from the net profit margins in Q1 2013.
While the slowing growth in the online games segment is a cause of worry, the fact that the company is diversifying into mobile platform provides a hedge to the inherent risks of the gaming market, largely dependent on the tastes of the customers. The minor contractions in profit margins is no cause of worry as the company remains extremely healthy with the operating profit and net profit margins exceeding 40%.
Let's now take a look at the cash position of NetEase at the end of Q1 2014.
Netflix Cash Analysis
|($ in millions)||2013 Q1||2014 Q1||Y/Y growth|
|Cash, cash equivalents and investments||2,797.6||3,311.2||18.4%|
|Cash from operations||249.2||265.5||6.5%|
|Free cash flow (FCF)||243.5||260.5||20.3%|
NetEase saw a 6.5% Y/Y increase in cash flow from operations. The free cash flow margin for the quarter, down 1.8% over Y/Y, was more than comfortable at 68.5%. The healthy cash flows during the quarter helped the company end the latest quarter with cash and cash equivalents of $3.3 billion, an increase of 18.4% over Q1 2013.
Netflix Company Valuation
We now move on to take a look at the valuation multiples of NetEase post the latest results. The table below represents the company’s valuation multiples based on the closing price of May 15.
Netflix Valuation Multiples
|LTM earning per Ads ($)||5.70|
Netflix valuations continue to remain attractive considering its earnings and given its huge profit margins on account of in-house developed games and revenue growth potential from its thrust and focus on the mobile platform as mentioned in our earlier article.
Actuals v/s Estimates
The company beat analyst estimates on revenue and missed consensus EPS estimates. Netflix reported quarterly total revenue of $405 million, 3.6% higher than the consensus estimate on streetinsider.com. However, the reported EPS of $1.38 per ADS was 1.4% lower than the consensus estimate of $1.42.
The Q1 2014 performance was largely along expectations with the slowing growth in online gaming revenues being a concern. The monetization of the mobile games will be a key point on the management’s radar as we head deeper into 2014. The revenue contribution from the mobile platform will be critical to drive growth over the coming quarters.
The company has been on our positive watchlist and we continue to hold a positive long term outlook on the company. Considering the future potential from self-developed games and the attractive current valuations, we reiterate our positive outlook for Netflix with a current rating of 4.2/5. Do you agree with our rating? Feel free to leave a comment below.