NetEase (NTES) downgraded

Apr.26.05 | About: NetEase, Inc (NTES)

From The China Stock Blog (permission granted):

Pacific Growth Equities analyst Jason Brueschke downgraded NetEase (ticker: NTES), a Chinese Internet, online game and wireless
value-added services company. NetEase reports Q1 2005 earnings results tonight. Here are details of the downgrade:

Main Points:

  • Expect strong Q1 results driven by online gaming revenues - BUT beware negative catalysts.
  • Management guidance could be optimistic.
  • Recommendation: Downgrade to "Equal Weight". 

On Online Gaming:

  • Expect a strong quarter.
  • Driven by results from Fantasy, Westward Journey (WWJ), its female-demographic / cartoon genre game.
  • Fantasy ended Q1 at or near the top of China's gaming league tables for peak concurrent users.
  • WWJ also had strong results - but not nearly the success of Fantasy.
  • Pacific Growth ("PacGrow") is estimating $28.6 million in gaming revenues - with upside potential.
  • Outlook: Increased competition.


  • The9's (ticker: NCTY) World of Warcraft (WoW).
    • Scheduled for open beta launch today in China.
    • The9 reported over 1 million gamers applied to be part of the closed beta.
    • PacGrow believes that 1.5+ million could eventually participate in the open beta.
    • PacGrow believes that The9 intends periodically to release peak
      open beta concurrent user numbers, which are likely to be negative for
      most other Chinese gaming stocks.
    • While NetEase's Fantasy is not as vulnerable to WoW because Fantasy is a cartoon and female focused, it could suffer.
    • Coca Cola (ticker: KO) plans to market WoW heavily in second and
      third tier cities where NetEase games are traditionally strongest. This
      creates the risk that Fantasy could see some of its male gamers turn to
      WoW, impacting Fantasy's growth in the second half of 2005.
  • New Female Focused Games from Shanda (ticker: SNDA) and The9 (ticker: NCTY):
    • Shanda is planning to launch a new game, called Magic Land - targeting women.
    • Game is slated for open beta on April 29th.
    • Shanda has announced a marketing campaign with Pepsi (ticker: PEP),
      which could give this game greater early traction than normal.
    • PacGrow believes that NetEase has enjoyed the female demographic
      largely to itself over the past year. So new competition from Shanda,
      together with a new female-focused game (Joyful Journey West) from The9
      scheduled for launch in Q3, could hurt NetEase.
  • Additional Delays in Fly4Fun:
    • Concerns that
      NetEase may once again delay the commercial launch of Fly4Fun, its 2.5D
      game, or possibly abandon the game altogether.
    • The failure of Fly4Fun will put added pressure on Da Tang, its
      martial arts game as well as its new (as yet unnamed) 3D game that are
      both slated for release in the second half of 2005.
    • If The9's WoW is as successful as it has been in other countries in
      the world, the tastes of Chinese gamers could move decidedly towards 3D
      games, which could impact NetEase's 2D games, Fantasy and Westward
  • Additional Regulation of the Chinese Gaming Industry:
    • Last
      week, the General Administration of Press and Publication (GAPP)
      announced it will revise its online game publishing policies.
    • These new regulations could lead to more government regulation of
      the online gaming industry in China in the second half of the year.
    • It could force gaming companies to restrict content or the number of hours that gamers play games each week.
    • Results could be similar to the impact of greater regulation of the SMS industry in 2003.
  • Management Changes:
    • PacGrow believes that management changes could be upcoming.

PacGrow on NetEase's Wireless Business:

  • Expect continued deterioration of wireless revenues.
  • Expect wireless revenue essentially in line with its estimate of $2.2 million.
  • MMS revenues were weaker than expected in January and early
    February as further changes to China Mobile's (ticker: CHL) billing
    practice for non-delivered MMS messages significantly impacted
  • SMS revenues were likely flat to lower - with WAP performing better.
  • This business is no longer a focus for NetEase, and accounts for only 6% of revenues.

PacGrow on NetEase's Advertising Business:

  • Expect an in-line quarter in a seasonally weaker quarter.
  • Expect a modest 5% quarter-over-quarter decline in advertising revenues to $4.8 million.
  • NetEase is benefiting from an up-tick in spending by other Internet companies, including US Internet firms.
  • Expect a strong Q2 - due to seasonality.
  • Also expect continued competition in the Chinese Internet sector to lead to further ad spending.

PacGrow's Valuation:

  • NTES trades at 21x its 2005E EPS of $2.47, 8.2x its 2005E revenues of $177.0 million and 7.2x EV/Sales.
  • With revenues expected to grow at 60%+ year-over-year in 2005 and
    50%+ in 2006, and with earnings growing at 150% year-over-year in both
    2005 and 2006, PacGrow views NTES shares as trading at fairly value.

In Summary:

  • Expect strong Q1 results.
  • Expect management optimism about Fantasy and Westward Journey.
  • BUT: NetEase has been the best performing Chinese Internet
    stock in the past 3 and 6 months. With the company trading at a very
    high valuation relative to its peers, any negative catalysts could be
    negative for the stock.

Comment: Kudos to Jason Brueschke for releasing a note prior to earnings.

See here
for The China Stock Blog's write-up of NetEase's Q4 2004 results. The
write-up includes Q1 2005 guidance that the company provided. The
guidance will be useful later today when NetEase reports Q1 2005
quarterly results.

NetEase's Stock Market Performance: