NetEase (NASDAQ: NTES) recently reported the results of its first-quarter 2017, beating the consensus again.
The company has been consistent in beating the analyst consensus on every single occasion during the trailing four quarters. My previous article points out the key advantages for NetEase including a long product life cycle and a growing mobile games market in China. Anyhow, let’s dissect earnings to see if the company has any upside left.
Earnings highlights
NetEase reported revenue of $2 billion during the first quarter of 2017, a 73.9% year-over-year increase. The company managed to beat analyst consensus by $280 million. Revenue growth was supported primarily by online game services, which were up 78.5% to reach $1.56 billion during the quarter. Email, e-commerce and others and advertising services contributed $357.4 million and $64.7 million toward the revenue. Games including "Onmyoji," mobile version of "New Ghost" and "Demon Seals," "Overwatch®" and "World of Warcraft®" were the primary revenue drivers.
Regarding the bottom line, net income grew 59.4% – as compared to the same quarter last year – to reach $569.9 million. The company reported an EPS of $4.29 while analysts were modeling for an EPS of $3.99. It is worth mentioning that the company managed to beat analyst estimates by 13% on average during the last four quarters. However, despite an initial spike, the stock is down 5% since the earnings release.
Strong results and negative price action doesn’t add up. Holding on to NetEase might be a better idea. Selling can be explained by opportunistic profit taking as the stock was trading around the price target mentioned in the previous piece. However, the whole premise of the valuation in that article was that NetEase might not deliver on the growth it’s promising. Therefore, the cautious estimate revealed a price target of $285. As Netease is consistently beating analyst consensus, the model is updated accordingly resulting in additional upside; details later. Let’s analyze the key advantages for NetEase going forward.
Extended life cycle and high adoption rate
The international launch of "Onmyoji" has been successful; 200 million downloads has been achieved by February. "Onmyoji" is among the five top grossing mobile games in China for the past several months. After the Japan launch, the game climbed from 29th to 16th position in top grossing since March. "Westward Journey," which was released this quarter, is already in top grossing charts, currently placed at 12th. NetEase still holds the second place in revenue generation, both on iOS and Google Play.
Diverse Portfolio of mobile games
NetEase has many games in its portfolio, which mitigates the risk of revenue fluctuations. Out of hundreds of games, some make it to the top charts regularly leaving the company less prone to top line failure. Popularity of games fade away over time, and most of the games have short life cycles. Having extensive games in the portfolio keeps some of the titles in top grossing. Releasing expansion packs for famous games extends games’ life cycle. NetEase has more than 100 titles in its portfolio and the company periodically releases new expansion packs. This is reflected in the company’s high revenue/game as compared to the counterpart, Tencent Holdings (XTER:NNND, Financial) (HKSE:00700) (TCEHY, Financial). Revenue/game details can be found here.
NetEase is mobile-centric
The company has successfully transitioned towards mobile, which reduces the risk of PC game exposure. As mobile is the dominating platform, revenue generation of more than 70% from mobile bodes well for NetEase.
Valuation is reasonable
As mentioned above, the company is beating consensus estimates; revision in valuation is warranted. Previous valuation accounted for an EPS of $15.62 and $18.02 for 2017 and 2018. However, for the updated valuation, an increment of 10% in earnings is assumed for 2017 and 2018 amid consistent outperformance. See the chart below:
| Â | June 2016 | September 2016 | December 2016 | March 2017 |
| EPS – Consensus | 2.51 | 2.84 | 3.37 | 3.99 |
| EPS – Actual | 2.99 | 3 | 4.03 | 4.28 |
| Average Surprise 13.04% | ||||
Source: Yahoo Finance
Other assumptions
Earnings are assumed to grow at 6% p.a. during 2019-2022. One percent growth is assumed in perpetuity. Cost of capital is expected to grow at 7.5% during 2017-2022. Required rate of return incorporates inflation and the risk-free rate. See the valuation sheet below:
| Projections | Â | Â | 2017 | 2018 | 2019 | 2020 | 2021 | Perpetuity |
| USD in millions except PT | Â | Notes | Â | Â | Â | Â | Â | Â |
| Net Income | Â | Â | 2249.71 | 2597.70 | 2753.56 | 2918.78 | 3093.90 | 3279.54 |
| Â | Cost of capital | r*capital invested | 415.4 | 444.5 | 475.6 | 508.9 | 544.5 | 582.7 |
| Dividends | Â | Â | 435.00 | 435.00 | 435.00 | 435.00 | 435.00 | 435.00 |
| Â | Â | Â | Â | Â | Â | Â | Â | Â |
| Adjusted Net Income | Â | Â | 1399.28 | 1718.20 | 1842.94 | 1974.86 | 2114.37 | 2261.88 |
| Discount factor | Â | Â | 1.00 | 0.93 | 0.87 | 0.80 | 0.75 | 11.52 |
| Economic Value Added | Â | Â | 1399.28 | 1598.32 | 1594.76 | 1589.69 | 1583.24 | 26056.92 |
| Period | Â | Â | 0 | 1 | 2 | 3 | 4 | 5 |
| Â | Â | Â | Â | Â | Â | Â | Â | Â |
| Â | Â | Â | Â | Â | Â | Â | Â | Â |
| Â | Â | Â | Â | Â | Market value added | 33,822 | Â | |
| Â | Â | Â | Â | Â | Invested Capital | 5,539 | Â | |
| Â | Â | Â | Â | Â | Value of the equity | 39,361 | Â | |
| Perpetual Growth in Residual Earnings | 2% | Â | Price Target | $299.8 | Â | |||
Focus Equity Estimates
Valuation sheet reveals an upside around 10%. The stock also yields around 1.2% in dividends. Moreover, PEG is below 1 indicating that growth isn't expensive. Given the growth of China’s mobile games market, NetEase’s diverse portfolio of games and ability to beat consensus consistently, the stock is worth a hold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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