It is true expectations can motivate performance. However if you keep performing well, increasing future expectations could catch up with you. Netease (NASDAQ: NTES), one of the leading online gaming companies in China has been on our positive watchlist for over three months now. The company reported its Q3 2013 performance yesterday (November 13th) after market close. The company saw an increase in revenues as well as margin expansions. However the good performance fell short of expectations resulting in a 7.8% fall in NTES stock price in after-hours trading following the earnings release. The after-hours fall probably had a bit to do with the current negativity surrounding Chinese tech companies following the NQ mobile controversy. Let’s take a look at the Q3 2013 numbers.
Q3 2013 performance: A story of growth and margin expansions
The company saw impressive movement in metrics of growth as well as profitability. The topline grew by 23% over Q3 2012. The online gaming segment contributed 84% of the company’s revenues with the segment registering a 21% growth on a Y/Y basis. The company saw widespread enthusiasm among the gaming community for its westward journey II upgrade, released in early July 2013. The June 2013 launch of expansion pack for Heroes of Tang Dynasty II was also well received by audience contributing to revenue growth in the quarter. The increased revenues from in-house developed games offset the decline in revenues from World of Warcraft, a game licensed from Blizzard entertainment. The growing popularity of in-house games and the company’s focus on these games is a move in the right direction. However it will be important to see if the company can replicate its success across the world, a possibility which was discussed in the earnings concall. While revenue growth remained strong, primarily driven by in-house game revenues, the profit margins increased significantly compared to the year ago quarter. The operating margins increased by close to 4 percent while the Net Income margin improved by 2% over Q2 2012. The margin expansion was primarily due to increasing profit margins in the company’s gaming and advertising revenues. The increasing margins and impressive revenue growth contributed to a 33% jump in the earnings per ADS (EPADS). The table below shows the Q3 2013 metrics.
Actual performance v/s Analyst estimates
According to streetinsider.com, the consensus analyst estimate for Netease’s Q3 2013 EPADS was $1.37, while the actual EPADS was $1.31 missing the consensus estimate by 4.4%. However, the EPADS of $1.31 represents earnings growth of 33.7% over Q2 2013. The company came out on top of the revenue consensus estimate of $391.9 million. The actual revenues of RMB 2514.3 million ($410.8 million) were 5% higher than the consensus estimate.
The quarter saw impressive growth in revenues which translated to a higher growth in earnings on account of margin expansions. The future growth will be driven by further expansion into mobile gaming while the successful release of in-house games and expansion packs will lead to higher margins over the coming quarters. Though the quarterly performance fell short of expectations leading to a 7.8% fall in the stock price in after-hours trade, we view the stock as a safe long term investment. The current valuation multiples, price-to-earnings (P/E) multiple of 13.27 (based on November 13th closing price) and a PEG ratio of 0.58 make the stock an extremely lucrative investment. However the risk of the gaming business is huge as it depends on the tastes of the audience which can change at a very short notice. Also the Chinese gaming industry now faces the risk of console gaming eating into the share of online gaming as the Chinese government lifted its decade long ban on sale of gaming consoles in China. The company’s move into mobile messenger services through the launch of Yichat is therefore a move in the right direction as diversifying of revenue sources will hedge the company against the inherent risks of the online gaming industry.
To see Netease’s latest stock price movement, click here (NASDAQ: NTES)