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Victor Selva
Victor Selva
Articles (150) 

Opportunities in the Tech Segment: NetEase Profitability and Capital Analysis

February 17, 2014 | About:

There aren’t many Internet portals that can pride themselves on successfully climbing the industry ladder in only a decade. But, NetEase Inc. ADR (NASDAQ:NTES) is one of them. Ever since the Chinese gaming market exploded into a multi-billion dollar business, this online game operator has managed to reach its competitors SINA Corp. (SINA) and Sohu.com Inc. (NASDAQ:SOHU), via an extensive brand portfolio of in-house and licensed games. Some of the core online games include Fantasy Westward Journey, Westward Journey Online II and Ghost II.

With Founder and CEO William Ding holding the reigns, this company has taken flight, in particular with its efficient game publishing initiatives and in-house research capabilities. In this article I analyze NetEase Inc.'s past profitability, debt, capital and operating efficiency. I will also take a look at which institutional investors have recently bought stock shares in the last quarter, and based on this information, we will get an understanding of the company' revenues, operating metrics and quality of earnings.

Profitability Analysis

Profitability is a class of financial metric used to analyse a business’ ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section I will study several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues. By analyzing these four metrics, we will be able to elucidate if the company is really making money.

In addition, I always compare a company's revenue growth and operating cash flow growth. Over the past three years, the company's operating cash flow has increased by 4%. The company augmented its operating cash flow from $4.073 to $4.224. I advise looking for companies with strong cash generation profiles.

ROA - Return on Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets, and shows how efficient management is at using its assets to generate earnings. In simple terms, ROA tells you what earnings were generated from invested capital (assets).

I do not like the fact that NetEase Inc.'s ROA decreased from 23.93% in 2010 to a current 20.95%. I am always looking to invest in companies that generate increasing ROA. However, the firm’s ratio is evidence of the company generating less from its assets than it did in 2010. The fact that the revenue growth has outpaced the assets growth (-0.13% growth) on a percentage basis, indicates that the company is making money on its assets.

Quality of Earnings

Quality of earnings is the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies — such as inflation of inventory. NetEase Inc. augmented its profits at a rate of 23%, but the growth of cash flows was higher, which shows that profits aren’t being created through anomalies, such as inventory or accounting practices.

Working Capital

Working capital is a measure of both a company's efficiency and its short-term financial health. This ratio indicates whether a company has enough short-term assets to cover its short-term debt. Anything below 1 indicates negative W/C (working capital), while anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.

In order to appreciate a company's working capital structure, we need to analyze its current ratio growth. NetEase Inc.'s current ratio has decreased from 6.34 in 2010 to 5.00 in 2012. This shows that the company´s balance sheet was stronger in the past.

Revenue on the Rise

Competing in the gaming market can often-times be complicated, due to low switching-costs and unpredictable gamer preferences. However, NetEase has earned its differential value thanks to a combination of expansion packs, unique gaming experiences and smart marketing, which have contribute to the company’s large customer base today. Furthermore, the firm has done a good job at appealing to female gamers, which are growing in volume, by also offering a variety of casual and social games.

This well-spun strategy has ensured that 90% of revenue derives from the gaming market, with the rest attributed to online advertising and wireless value-added services. And although this business model could be risky if the firm’s next game launch is unsuccessful, the impressive revenue growth curve of an annual 28% over the past five years leaves me confident in NetEase’s profitability.

Gross Margin: Gross Income/Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. Investors tend to pay more for businesses that offer higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.). Over the past three years, this company’s gross margin has increased. The ratio rose from 67.5% in 2010 to 73% in 2013. An increasing margin indicates that the company has, in fact, gained efficiency.

Institutional Sponsorship

It’s important to check which hedge funds bought the stock in the last quarter and at what price they did so. I assume that if a prominent institutional investor puts money into NetEase Inc., the stock will pass the strict fundamental standards. In this case, I feel encouraged by the fact that Jim Simons (Trades, Portfolio) bought the stock in the past months at an average price of $68.26, because it shows confidence in the stock’s value and profitability.

Analyst Outlook

Currently, many analysts have a good outlook for NetEase Inc. Analysts at MSN Money are predicting that the firm will retrieve EPS of $6.06 for fiscal year 2013 and EPS of $6.83 for fiscal year 2014. Analysts at Bloomberg are estimating the Internet company’s revenue to be at $1.76 billion for fiscal year 2013 and $1.99B for fiscal year 2014.

Bottom Line

While selling and marketing expenses have been flat compared to the last fiscal year and operating margins have shrunk slightly, I’m still optimistic about NetEase’s future in the gaming industry. With several expansion packs in its pipeline, and management’s promise to upgrade its marketing efforts on future PC and mobile games, the company should be ready to stay for the long haul. China’s fast-growing gaming market, where the firm holds the second-largest position as online game operator, will undoubtedly be the future growth catalyst.

Furthermore, this might be just the right time for investors looking to buy NetEase shares, as the company is currently trading at an about one-third of the industry average valuation (14.6x P/E vs. 43.9x P/E). For instance, one of the company's main competitors, Sohu.com Inc. (NASDAQ:SOHU), trades at 125 times the firm´s earnings, almost 10 times NetEase's valuation. And with the potential for growth at hand, I feel very bullish about this investments profitability.

Disclosure: Victor Selva holds no position in any stocks mentioned.

Rating: 5.0/5 (4 votes)


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