NetEase Inc.'s (NTES, Financial) second-quarter results registered a revenue and earnings beat. Revenue grew 49.4% to reach $1.97 billion while earnings reached $3.86 per share, translating into 7.8% year-over-year growth. Analysts were forecasting revenue of $1.90 billion; earnings consensus stood at $3.82 per share. NetEase did not provide a guidance update for full-year 2017. Despite impressive results, the stock took a serious hit and is down 11% since the earnings release.
Revenue insights
Online games, email and e-commerce were responsible for top-line growth during the quarter. Online games revenue increased 46.5%, contributing $1.4 billion toward the top line. Email and e-commerce also boosted revenue 68.9% year over year. Note the company generated more than 70% of its revenue from online gaming services.
Online games will fuel top-line growth
Online games in China have been growing at double-digit rates over the past several years. This growth trend will continue going forward. The video games market is expected to grow at 7.4% p.a. in China between 2015 and 2020, according to PWC.
"During 2016-2020, the operating revenue of the China gaming market is expected to grow at a compound annual growth rate (CAGR) of 12.2%," said Neo Zheng, research manager, Terminal System Research, IDC China.
All in all, NetEase is benefiting from the growth of online games in China. The trend can continue in the near future.
High growth creates difficult comps
NetEase has witnessed explosive growth over the past several quarters. Since the industry is only expected to grow in the high single digits, it will be difficult for the company to sustain these high growth rates.
Second-quarter results addressed this concern. The company witnessed a sequential decline in revenue, indicating growth might come under pressure going forward. The company grew at a very high rate over the past several quarters, creating difficult comps for NetEase.
Sequential decline indicates slowing growth
Secondly, the market is reaching a saturation point as growth forecasts cite single-digit revenue growth in the coming years. Moreover, sequential decline is concerning as it is not seasonal. For the comparable quarter of 2016, the company reported revenue growth of 13.9% as compared to a decline of 1.9% this quarter. See the chart below:
As a result, the market did not respond to the earnings report positively.
Although growth will remain high going forward, comps will be difficult to match because the company has three games in the top grossing titles as of June. The number of top games stood at four in March. This development can hurt revenue growth going forward.
It appears revenue growth will come under pressure going forward due to slowing industry growth and the reduction of the number of top-grossing game titles. Moreover, high growth in the past has created difficult comps for the company. Sequential decline in revenue growth can hurt the stock price in the coming quarters.
Earnings insights
Despite 50% revenue growth, earnings grew only 7.8% year over year during the quarter. This is alarming as revenue growth is not translating into earnings growth. In NetEase’s defense, high growth can hurt earnings as the company tries to expand operations.
High revenue and low earnings
Low earnings growth was caused by gross margin decline in online games along with increasing revenue share from email and e-commerce, which supports a gross margin of only 11.3%. Furthermore, operating expenses grew at a higher rate as compared to revenue growth; OPEX increased 49.2% year over year. To review, the declining gross margin in online games, increasing low gross margin business and high OPEX hurt the company's bottom line.
Valuation insights
After falling more than 10%, NetEase's valuation looks slightly cheap. The stock will hover around $300 as this seems to be the fair value of the company according to EVA valuation model. Assuming a 10% CAGR over the next five years, the stock’s fair value is north of $300. Perpetual growth of 1% is assumed for valuation.
While some would argue 1% is quite conservative for NetEase, a slowdown in sequential revenue growth, a maturing industry and low-margin email and e-commerce business support this rate of terminal growth.
The price-earnings (P/E) valuation, based on the three-years median P/E, also indicates the stock is priced around $300.
Nevertheless, if you are convinced NetEase will grow its earning in double digits consistently, then the stock is cheap around $300. In my opinion, NetEase will only manage high single-digit or low double-digit growth going forward due to the slowdown in industry growth and constantly pushing new titles in order to sustain its revenue base. Cost of development results in higher OPEX, which makes NetEase a high-cost business on a variable cost basis. All in all, high double-digit earnings growth is not plausible for the company.
Final thoughts
NetEase is growing its revenue at an impressive rate. Earnings are growing, but not in line with revenue growth. Declining margins, a maturing industry and costs for constant innovation are some of the headwinds for NetEase. The recent decline in the stock price creates a short-term opportunity. However, over a longer term, Net Ease will probably underperform the market as it is trading around its fair value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours
