NetEase: 'Emperor of online gaming'

by Timothy Lutts, editor Cabot Stock of the Month

NetEase.com (NTES) is one of the Big Three among China's Web portals; its big focus has been online gaming, particularly massively multiplayer online role-playing group games.

In fact, 85% of revenues in the first quarter came from online gaming, and there’s little chance that percentage will shrink in the quarters ahead.

What is changing, however, is the company’s reliance on outside developers. Its biggest efforts in recent years have been on developing its own games that center on themes from Chinese history and legend.

These games not only provide more independence and higher profit margins, they are also specifically tailored to the Chinese market.

What’s really impressive are the profit margins on these games. While advertising brought a gross profit margin of 19.8% in the first quarter, and value-added services lost money, the gross profit margins for online gaming hit 73%, up from 70% the year before.

Looking forward, competition will be a factor for NetEase; there’s no guarantee it will be the leader forever. But China’s growth is lifting all boats, and the great growth trends of revenues and earnings in past quarters are likely to continue.

Revenue growth was just 8% in 2007, but hit 53% in 2008, 23% in 2009, 49% in 2010 and 39% in 2011. Earnings per share have grown every year since 2002.

The company’s balance sheet is superb. It has no debt, and current assets at the end of the fi rst quarter were a healthy $2.4 billion (twice the past 12 months’ revenues). Valuation-wise, the current P/E ratio is 15, lower than the midpoint of the low of the past fi ve years (9) and the high (24).

NTES has been in a long-term uptrend for years, which is normal for a growth company. But there have been long corrections in that time. The last big correction ran from March through December of 2011, when the stock declined from 55 to 36 and then tightened up in the mid-40s.   

The start of 2012 saw the uptrend resume, taking the stock up to 59 by the end of March. And since then, as the broad market has stumbled and recovered (several times), NTES has traded fairly tightly around 60 (with excursions as high as 64 in June).

The stock, though, did suffer a recent shakeout, with shares dipping as low as 55 before recovering smartly.

While it might need some time along with everything else, we think NTES -- China's emperor of online gaming -- will be a leader of the next upmove. We think it’s a good buy now.

Learn more about this financial newsletter at Timothy Lutts' Cabot Stock of the Month.

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