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Correctly valued after recent declines. In early September, I advised investors to sell short NetEase (NASDAQ:NTES) shares because the stock price of $40.20 had fully reflected the positive contribution of "Wrath of the Lich King" (WLK) but had not fully reflected the weaknesses of other games. NetEase's stock price has declined 5.6% since then, as investors gradually realized the short-term challenges facing NetEase's in-house developed games. After recent price declines, I believe the market has correctly valued NetEase shares at the current price of $37.94, and my virtual portfolio has exited its short position on the stock for a 5.6% gain.

Recent performance of NetEase's major games. Based on my checks, World of Warcraft's popular WLK expansion is now the single most important growth driver for NetEase for 4Q10, while all other NetEase games are trying hard to maintain their market positions. In the past several months, NetEase has launched major updates/expansions for key games FWWJ, TX2, and DT2, and the results have been mixed based on my proprietary tracking. All three games saw their usage and revenues rebounding during the first several weeks of these updated versions. However, after their initial success, none of these updates/expansions has proven to be sustainable mid-to-long-term growth drivers. These games' usage is now in downward trends again.

Further downside is limited before Q3 earnings release. In my view, NetEase has been successful at revitalizing its in-house developed games in the past several months, at least temporarily. Based on the track record of its recent expansion packs, if NetEase can launch one expansion pack per quarter for every major game, then it will be able to maintain current usage levels for its in-house developed games. As long as the other games maintain stable usage, "Wrath of the Lich King" should be able to drive sequential revenue growth for NetEase for at least two quarters (3Q10, 4Q10). Therefore, despite the heavy reliance on WLK, I believe NetEase shares will be supported by positive near-term outlook before the company releases Q3 earnings in mid-November. Until then, further downside will be limited below the current $37.94 stock price, in my opinion.

Disclosure: No positions

Source: NetEase: Further Downside Limited Before Q3 Earnings Release

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