JPMorgan upgraded NetEase (NTES, Financial) – one of the leading mobile games developers in China – from underweight to overweight Tuesday, citing increasing revenue from new games titles.
Analyst Alex Yao argued that in role-playing games the developer is witnessing stable performance from legacy games and incremental revenue from new titles, putting an end to the downward earnings cycle. The analyst raised the price target from $230 to $290, which translates into upside of 16% over Tuesday’s closing price. The stock reacted positively, up 1.8% in pre-market on July 3, only to erase the gains later during the day.
To put an end to the revenue growth woes, NetEase unveiled 20 new games titles for PC and mobile last month. The China-based games company introduced massive multiplayer online games (MMO) and battle arena games among others. The influx of new games is one of the possible reasons JPMorgan turned bullish on NetEase.
Although JPMorgan is bullish on addition of new games from NetEase, it’s yet to be seen if new games add to the revenue growth of the company. Forward looking analyst estimates look reassuring though. Revenue consensus for the third quarter ending June 2018 stands at $2.59 billion, a potential increase of around 12% sequentially. Top-line growth of 32% is expected on a year-over-year basis.
It is important to note, however, that earnings per share is expected to decline during 2018 despite revenue growth. The Street is modeling for approximately 30% decline in earnings per share during the current year. This means revenue growth might come from low-margin business including e-commerce and email services, rather than games, which is a high-margin business.
While e-commerce and email services revenue grew an astonishing 102% and 101% respectively during the first quarter of 2018, revenue from Online Games – the company's core business – declined 18% year-over-year. Therefore, expected growth in revenue shouldn’t be construed as the potential success of new titles.
NetEase hasn’t been doing quite well on the games side lately, according to analytics provided by AppAnnie. During May 2018, none of NetEase’s apps made into the top-10 downloads charts in either iOS or Google Play, while Tencent (TCEHY, Financial)'s PUBG Mobile took the second place in top downloaded games in iOS during May 2018. In terms of revenue generation, only one game made the top-10 charts of Google Play and iOS combined.
In short, JPMorgan’s bullish comments about the performance of newly released games from NetEase should be received with skepticism as analytics indicate that the company isn’t doing much better than before when it comes to games downloads and revenue generation.
Regarding valuation, the stock isn’t exactly cheap. It has been riding on the success of its games during the last few years. The stock has been up more than 86% during the last three years.
The Chinese online mobile games company is now trading at a forward price-earnings ratio of 27 based on 2018 earnings. As analysts are expecting earnings to shrink by about 2% during the next five years, a high price-earnings ratio isn’t warranted for NetEase.
Moreover, an economic value-added (EVA) approach to valuation also reveals that the stock is trading ahead of its fair value. If consensus earnings hold for 2018 and 2019 and NetEase manages to post 10% per-year earnings during the next five years, the stock is valued around $205.
| Projections | Â | Â | 2018 | 2019 | 2020 | 2021 | 2022 | Perpetuity |
| Â | Â | Notes | Â | Â | Â | Â | Â | Amounts in million |
| Net Income | Â | Â | 1171.46 | 1512.92 | 1664.21 | 1830.64 | 2013.70 | 2215.07 |
| Â | Cost of capital | r*capital invested | 526.7 | 565.9 | 627.9 | 696.6 | 772.6 | 856.6 |
| Dividends | Â | Â | 120.82 | 120.82 | 120.82 | 120.82 | 120.82 | 120.82 |
| Adjusted Net Income | Â | Â | 644.81 | 946.97 | 1036.30 | 1134.06 | 1241.13 | 1358.48 |
| Discount factor | Â | Â | 1.00 | 0.93 | 0.87 | 0.80 | 0.75 | 11.52 |
| Economic Value Added | Â | Â | 644.81 | 880.90 | 896.75 | 912.88 | 929.36 | 15649.71 |
| Â | Â | Â | Â | Market value added | 19914 | |||
| Â | Â | Â | Â | Invested Capital | 7022 | |||
| Â | Â | Â | Â | Value of the equity | 26936 | |||
| Perpetual Growth in Residual Earnings | 3% | Price Target | $205.1 | |||||
Focus Equity Estimates
Note that previous EVA valuation revealed similar results despite revised dividend payout from NetEase. That’s because a more relaxed 10% per-year earnings growth assumption is used in this valuation as compared to 7% per-year earnings growth assumption in the previous one. All in all, NetEase seems overpriced.
Takeaways
- The comments from JPMorgan analyst Alex Yao shouldn’t be considered a positive development unless investors find a backing for the improvement in games revenue of NetEase.
- As it stands now, NetEase’s game titles aren’t doing better enough than before to warrant higher earnings growth during the upcoming quarter.
- Due to rich valuation, investors should stay on the sidelines for now.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
