NetEase Inc. (NTES, Financial), one of the leading internet game developers in China, reported its first-quarter earnings last week, beating revenue expectations while missing earnings per share estimates. Revenue increased 3.9% year over year to $2.3 billion; analysts were modeling for $2.18 billion. Earnings per share came in at $1.61, falling well below the consensus of $1.97. The market reacted negatively to the earnings miss as NetEase lost approximately 10% after the announcement.
What affected the performance?
Although revenue grew 3.9% year over year, the company reported a sequential decline of 3% for the quarter. Revenue growth was supported by increases in e-commerce and email services revenue, which was more than offset by an 18.4% decline in online gaming services revenue.
While email services and e-commerce revenue grew 102% and 101% respectively, Online Games – the company's core business – was under pressure. Due to heavy gains in email and e-commerce, however, the company managed to beat expectations.
Despite the revenue beat, NetEase fell short of earnings expectations. Earnings per share came under pressure due to a decline in the gross profit margin and negative foreign exchange movements. NetEase reported a gross profit margin of 62.1% for its core online games business during the quarter, down 1.8 percentage points from the prior-year quarter. The decline was the result of reduced contribution from games like "Onmyoji" and the mobile version of "New Ghost." Moreover, advertising also suffered a declining gross margin amid seasonality, management noted in its earnings report.
Core business witnessed declining growth
In effect, NetEase’s core business – online games – is under pressure. This is not good for the company's future prospects as it generates most of its revenue from this segment. During the quarter, the company generated 61% of its revenue from online games. All in all, declining revenue growth and pressurized margin in the games business doesn’t bode well for NetEase.
Low-margin segments bolstered revenue growth
Although the company registered growth in e-mail and e-commerce, these segments are inherently low-margin businesses.
The chart above shows online games is NetEase's highest margin-generating business. The revenue contribution from online games has declined from 78% in the first quarter of 2017 to 60% in the first quarter of 2018. Moreover, high-growth segments support a gross margin of only 10%. The point is, growth from the non-core business isn’t the same as online games. If this revenue mix trend continues, it will put further pressure on earnings going forward.
There seems to be weakness in top grossing games
The decline in gaming revenue seems to be an industry-wide phenomenon. NetEase had three games topping the charts during the first quarter. Last year, the company also had a similar number of games topping the charts. This indicates the revenue-generating ability of the overall industry is fading to some extent. It is worth mentioning, however, that NetEase's games held a lower ranking during the first quarter compared to last year. See charts below:
Source: appannie.com, [Left: June, 2017; Right: March, 2017]
NetEase had four top games in March 2017; three of them among the top five. In June 2017, the company had three top-grossing games with two making the top five. Things are a bit different this year as there was only one game in the top five in March. The other two games were at the bottom of the top-10 chart.
Source: appannie.com, [Left: January, 2018; Right: March, 2018]
In short, NetEase’s revenue decline can be explained by its deteriorating performance in online games.
Nevertheless, given the fast-changing nature of the industry, the company might come up with new games that may improve its position once again. The gaming industry requires constant innovation, which makes investment in the industry relatively risky.
Valuation reveals no upside
From a valuation perspective, NetEase is priced cheaply compared to competitor Tencent (TCEHY, Financial). Although Tencent is generating more revenue per game, NetEase is cheaply priced based on its price-sales ratio.
| Estimates | Tencent | NetEase |
| Revenue (TTM), in million dollars | 37730 | 8580 |
| Total No. of Apps (Worldwide) | 627 | 346 |
| Â | Â | Â |
| Revenue/App | 60.2 | 24.8 |
| Market Cap/App | 787.0 | 89.8 |
| P/S | 13.1 | 3.62 |
The table shows NetEase is priced cheaply compared to Tencent, which also banks on game sales for its revenue. However, Tencent has multiple revenue streams, while NetEase relies heavily on online games. Therefore, the relative comparison with Tencent might be misleading.
From an absolute value perspective, there might be an upside to NetEase given the recent post earnings selloff.
Assumptions:
- Earnings are expected to grow at 7% per annum from 2020 to 2023, in line with the earnings growth of the most recent quarter.
- 1% earnings growth is assumed in perpetuity.
- Analyst consensus earnings are used for 2018 and 2019.
- Cost of equity is expected to grow in line with earnings growth.
- Dividends are assumed to stay constant over the forecasted period.
- Dividends are assumed to reduce the cumulative cost of equity.
- CAPM is used to calculate the cost of equity.
| Projections | Â | Â | 2018 | 2019 | 2020 | 2021 | 2022 | Perpetuity |
| Â | Â | Notes | Â | Â | Â | Â | Â | Amounts in million |
| Net Income | Â | Â | 1723.5 | 1958.55 | 2095.65 | 2242.34 | 2399.31 | 2567.26 |
| 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 |
| Adjusted Net Income | Â | Â | 873.15 | 1079.04 | 1185.03 | 1298.43 | 1419.77 | 1549.60 |
| Discount factor | Â | Â | 1.00 | 0.93 | 0.87 | 0.80 | 0.75 | 11.52 |
| Economic Value Added | Â | Â | 873.15 | 1003.76 | 1025.44 | 1045.18 | 1063.12 | 17851.43 |
| Period | Â | Â | 0 | 1 | 2 | 3 | 4 | 5 |
| Â | Â | Â | Â | Â | Â | Â | Â | Â |
| Â | Â | Â | Â | Market value added | 22862 | |||
| Â | Â | Â | Â | Invested Capital | 5539 | |||
| Â | Â | Â | Â | Value of the equity | 28401 | |||
| Perpetual Growth in Residual Earnings | 3% | Price Target | $216.4 | |||||
Focus Equity Estimates
Valuation reveals the stock is trading above its fair value despite the recent selloff. The sharp decline in economic value added can be attributed to the downward revision by analysts. To review, although NetEase is trading at a discount to Tencent, it’s not cheap on an absolute basis.
Final thoughts
NetEase’s revenue decline coincides with its deteriorating position in top games. The company’s top-grossing games are sliding to the bottom of the top 10. With declining gaming revenue, the margin will come under pressure as the revenue mix shifts toward non-core businesses, including email services and e-commerce. Valuation also doesn’t reveal any upside despite the recent selloff. Given the risks surrounding gaming revenue, pressure on margins and expensive valuation, investors should stay away from NetEase for now.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
