NetEase: 30% Upside Behind Expansion Into Mobile And Self-Developed Games

Nov.21.13 | About: NetEase, Inc (NTES)

There is a lot to be excited about NetEase (NASDAQ:NTES) in the upcoming months. This Chinese software and game developer is looking to expand its gaming segment and boost advertising revenue by tapping into new markets. Even though shares have appreciated almost 60% in value year to date, we believe NTES can reach up to $88 per share in the next 12 months, behind a promising game pipeline and expansion into the mobile smartphone market.

Why We Are Bullish

There are three contributing segments to total revenue: Online gaming services, advertising services and e-mail, wireless plus other services, which accounted for 84%, 13% and 3%, respectively of total revenue as of fiscal year 2012. Improving and innovating online games will have the greatest impact on revenue growth moving forward. We think NTES currently has a solid gaming offering and promising upcoming games in its pipeline.

NTES has the sole license to operate some of Blizzard's most popular titles in China. Legendary games that have been around for more than a decade like Starcraft and Warcraft have drawn millions of users worldwide. World of Warcraft has played an essential role in topline growth for NetEase in the last few years. However, according to the last two quarters, revenue generated by Warcraft has decreased, signaling that popularity for this title has possibly peaked. And that's okay with us.

We see future growth potential coming from self-developed titles, as opposed to licensed ones. Out of the top revenue contributing online games currently offered by NTES, six are self-developed and only one is licensed, namely World of Warcraft. We favor the company pushing for in house produced games, as these offer better profit margins due to lower costs of game development. We believe NTES has the financial and technical capabilities to produce high quality games as shown by the company commitment to research and development. Since 2008, r&d spending has constantly increased, most recently growing by 54% from 2011 to 2012. As a percentage of revenue, 9.41% is spent on r&d, the highest amount up to date. We believe the additional spending will prove fruitful in the upcoming 12 months, as the company expects to release two big online game titles in 2014, namely Crisis 2015 and Revelation, which will boost revenue and improve margins as well.

The next catalyst that could generate growth not only for the gaming segment, but for advertising as well is the expansion into mobile. The number of mobile phone users is expected to grow around 360 million for 2013 and that number is expected to jump to 450 million by 2014. The company's flagship website, www.163.com is the 5th most visited site in China, according to Alexa. NTES looks to build on the high user traffic by offering mobile versions of its most popular sites. NTES also looks to capitalize on mobile games, as some of its popular titles like Fantasy Westward and others have been developed for mobile. Much of the research and development is dedicated to expanding the mobile games pipeline. We believe NTES is making the right moves to take advantage of this booming market.

Valuation

Company

Ticker

NetEase

Shanda Games (NASDAQ:GAME)

Giant Interactive (NYSE:GA)

Perfect World (NASDAQ:PWRD)

P/E

13.28

6.15

12.41

14.37

Forward P/E

10.82

4.93

9.13

9.88

PEG

0.91

0.72

0.78

1.19

Click to enlarge

Data provided by Finviz.com, as of November 19, 2013. Trailing twelve months data.

We can see most of the industry is currently trading at a discount, as investors do not seem willing to pay a premium for Chinese internet and gaming market at the moment. This is due to fierce competition in the Chinese gaming industry. There are numerous companies, small and large that are constantly developing new games to gain users and market share. The industry offers little barriers to entry, as small companies with a popular game can quickly acquire market share from competitors with similar titles. Nevertheless, the industry is still growing and offers high profit margins, as the table below shows.

Company

Ticker

NetEase

Shanda Games

Giant Interactive

Perfect World

Gross Margin

71.50%

64.40%

86.50%

77.60%

Operating Margin

46.20%

27.20%

71.20%

11.90%

Net Margin

45.80%

25.10%

47.80%

14.20%

FCF/Sales

49.33%

30.32%

61.05%

22.83%

Click to enlarge

Data provided by Finviz.com, as of November 19, 2013. Trailing twelve months data.

Gross margin for NTES has been constantly improving since 2010. While it currently trails GA and PWRD, we believe gross margin for NTES will improve in the next 12 months with the release of more self-developed titles. As for operating margins, even though the company is aggressively spending on r&d, NTES still offers a high operating margin relative to its competitors. In terms of cash flow, NTES is second most efficient behind GA, turning almost half of revenue into free cash flow. Overall, NTES offers good value relative to its competitors.

DCF Analysis

In our model, we projected operating income to grow by 15% in 2013 and an additional 10% in 2014 behind solid top line growth and improving margins due to mobile penetration and gaming pipeline. Between 2015 and 2018, we assume further growth of 6%-10% in operating income. We factor in a tax rate of 20% and residual growth rate of 4%. In terms of capital expenditures, we project 20% annual increase through 2014, followed by 9%-15% growth through 2017. As for depreciation, we projected 5%-8% annual growth between 2013 and 2017. When we factor in these figures, we come up with a price target of $88.

Conclusion

The price reflects our expectation for NetEase in the next 12 months, fueled by a booming market and innovative upcoming developments. Self-developed games and applications will further fuel revenue and mobile will offer a strong medium for growth moving forward. We believe NTES is a Buy opportunity, as shares have the potential to grow an additional 30% in the next 12 months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by Adrian Moraru, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.