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Soid Ahmad
Soid Ahmad
Articles (195)  | Author's Website |

NetEase Returns to Growth in Online Games but the Price Remains Stretched

The Chinese massive multiplayer games developer reported double-digit growth across all segments for the second quarter

August 09, 2018 | About:

NetEase (NASDAQ:NTES), a China-based massive multiplayer online games service provider, reported its second quarter earnings yesterday, beating analysts’ top-line and bottom line consensus.

Revenue grew 24.7% year-over-year and 7% sequentially to reach $2.46 billion during the quarter; analysts were looking for revenue of $2.41 billion. Unlike the first quarter, NetEase managed to beat the earnings estimates of the Street comprehensively during the second quarter as earnings per share rose to $3.15 compared to the consensus of $2.09.

While the shares of the online games developer rose by around 3.5% in afterhours yesterday, the stock has erased those gains since then and is down a further 2.1% in pre-market trading today.

What boosted the top line?

During the second quarter, email and e-commerce were the highest growing segments of NetEase followed by online games.

Revenue from e-commerce and email services reached $185 million and $659.7 million, translating into year-over-year growth of 76% and 43%, respectively.

Although NetEase reported 18.4% year-over-year decline in games revenue during the first quarter of 2018, the company rebounded this quarter with a 7.4% increase in online games revenue. During the second quarter, NetEase rolled out 20 new games titles, which helped the company return to growth after a disappointing first quarter as far as the online games segment is concerned.

“During the second quarter, we launched a number of highly successful games in non-MMORPG categories, including Shadowverse, Identity V and QwQ, each of which climbed to the top of the charts in China”, said NetEase CEO and Chairman William Ding in an earnings press release.

In short, NetEase posted revenue growth across all its reportable segments including the online games segment during the second quarter of 2018.

Gross margin remains under pressure.

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While email services and e-commerce segments are adding to the top line, they are putting pressure on the bottom line of NetEase.

The chart shows that e-commerce generated a gross margin of 10% while email services registered a loss-margin of 7.3% during the second quarter. It’s worth mentioning that revenue from online games made up 61% of the total revenue of the company during the second quarter of 2018, compared to more than 70% during the same quarter last year.

As e-ecommerce and email are growing at a very fast rate, NetEase’s gross margin will remain under pressure going forward.

What’s the outlook?

As NetEase generated most of its revenue from online games, its future outlook largely depends on the industry trend. According to Juniper Research, massive multiplayer online games – the core specialty of NetEase – made up 25% of the total digital games market in 2017 and are set to grow at compound annual growth rate of 14.5% until 2021. NetEase seems to be doing better than the industry as the company’s revenue is expected to grow at more than 20% in 2019.

NewZoo, a global games market intelligence firm, said that mobile gaming will grow at 10% per year to make up 59% of the global games market by 2021. NetEase is set to benefit from this trend, as the company generated more than 70% of its revenue from mobile games during the second quarter of 2018.

In effect, the games industry supports a favorable growth environment with massive multiplayer games growing at a faster rate than the overall industry. NetEase is certainly positioned well to benefit from the industry growth.

What about valuation?

NetEase appears to be trading ahead of its fair value, at least according to the economic-value-added (EVA) valuation.

Assumptions:

  • Earnings are expected to grow at 14% per year from 2019 to 2023, in line with the industry growth.
  • One percent 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 grow 5% from 2018 to 2023 and 3% in perpetuity.
  • Dividends are assumed to reduce the cumulative cost of equity.
  • CAPM is used to calculate the cost of equity

Projections

   

2018

2019

2020

2021

2022

Perpetuity

   

Notes

       

Amounts in million

Net Income

   

1139.97

1433.34

1634.00

1862.76

2123.55

2420.85

 

Cost of capital

r*capital invested

526.7

554.1

600.5

657.5

726.4

808.6

Dividends

   

120.82

126.86

133.21

139.87

146.86

154.20

Adjusted Net Income

   

492.50

752.40

900.28

1065.35

1250.26

1458.01

Discount factor

   

1.00

0.93

0.87

0.80

0.75

11.52

Economic Value Added

   

492.50

699.91

779.04

857.57

936.19

16796.27

Period

   

0

1

2

3

4

5

       

Market value added

20561

       

Invested Capital

7022

       

Value of the equity

27583

 

`

Total capital value per share

$210.0

Projections,
dollars in millions except value

2018

2019

2020

2021

2022

Perpetuity

Dividends

 

120.8

126.9

133.2

139.9

146.9

154.2

[email protected]%

 

1.00

0.93

0.87

0.80

0.75

18.28

PV of Dividends

120.8

118.0

115.3

112.6

110.0

2819.2

 
 

Value of Dividends

3395.9

 

Value per share

$3.5

Price Target (Capital value + Value of Dividends)

(210+3.5)

$213.5

Price-earnings relative valuation also seems stretched.

2128788359.png

Takeaways

  • Thanks to new games titles, NetEase successfully reignited growth in its online games segment.
  • While revenue from email services and e-commerce is growing quickly, it’s putting pressure on the margin profile of NetEase.
  • The industry is set to witness double-digit growth, which will benefit the China-based MMO online games company going forward.
  • Much of the growth is already baked into the stock price as is evident from the valuation based on reasonable assumptions.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.

About the author:

Soid Ahmad
Soid Ahmad is affiliated with the Association of Chartered Certified Accountants. He graduated from Oxford Brookes University. He also holds a Master's degree in Economics and Finance from HSRW Germany. He has been working as a technology analyst for several years and has an eye for mispriced technology stocks. He is also affiliated with Focus Equity, an independent equity research firm.

Visit Soid Ahmad's Website


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