NetEase (NASDAQ:NTES) delivered Q2 earnings and revenue ahead of analyst estimates. All of the company's business segments have performed very well. The online games revenue is growing nicely, while the advertising and e-commerce revenue growth have grown considerably both sequentially and on a year-over-year basis. NetEase is investing heavily in sales and marketing and gross margins are lower on higher revenue contribution from licensed games. I am raising my price target to $105 and I believe that there is potential for even more upside in the next six to twelve months.
NetEase's Q2 revenue increased 20.9% Y/Y to $446.1 million. Earnings per share increased 8% to $1.48. Both the earnings and revenue figures were above analyst estimates. The introduction of fresh expansion packs for existing popular content and new original online games contributed to the growth of online games revenue, which was up 13% Y/Y in local currency. The company is investing aggressively in its mobile segment, and has launched several games in the second quarter, with plans for new launches in the coming months. However, revenue contribution from mobile games remains unknown, and management acknowledged that mobile revenue is still quite low. This is perhaps the most disappointing part of the earnings release, and it remains to be seen if the company can ramp up the monetization in the mobile segment in the next couple of quarters.
On the other hand, advertising and e-commerce revenue growth have contributed heavily to the top line growth. Advertising revenue grew 43% Y/Y to $62.7 million. Internet services and food and beverage were the top performing sectors. The advertising services segment benefited from monetization of mobile apps and the soccer World Cup. The company should also benefit from the World Cup in the third quarter, as the tournament lasted through mid-July. NetEase's Mobile News app was ranked by iResearch as number one mobile news app used by consumers in China in terms of time spent. E-commerce revenue was up 201% to $36.5 million. Third-party lottery products were the primary reason for the rapid growth of the segment.
Gross margin for the online games contracted by 330 basis points Y/Y to 77.6% due to increased revenue contribution from licensed games. Gross margins for the advertising services business expanded from 55.5% in Q2 2013 to 60.9%, while the e-commerce gross margin was 37.5% in Q2 2014, compared to a gross loss margin of 21% in Q2 2013. Margin gains in the two smaller segments were not enough to offset the lower gross margin in the online games business, and the total gross margin contracted 250 basis points year-over-year to 67.7%.
It is good to see strong growth across the board, and top and bottom line above estimates. I expect strong growth to continue going forward, and believe that the company is well positioned to capture the growth of the mobile games and apps in China. However, I am somewhat worried about the lack of monetization of mobile games and the fact that the company did not disclose the numbers, which means they are too low to be disclosed. But the efforts that we are seeing in that space and NetEase's experience and expertise in online games are a solid start and the company should focus on increased offerings and building a robust pipeline of future products, and the results will be visible in the next couple of quarters. Building the social component into mobile games with YiChat will also have a positive effect on demand in the future.
Valuation and price target
My previous price target of $87 was based on a 2014 P/E ratio of 15. NetEase is currently trading slightly above that price target. I am raising my price target to $105, based on a 2014 P/E of 17.5. The expectations have moved up since I wrote the article in early April and I believe that there is room for additional multiple expansion based on accelerating growth in the advertising services and e-commerce segments. I also think that online games should continue to grow at a steady pace, helped with higher mobile monetization in the following quarters. NetEase might eventually reach a 2014 P/E of 20, which translates into a $120 price target in the more bullish case.
As I said before, the downside should be limited because of the huge cash position of $3.2 billion and the share buyback program of $100 million. The company did not buy back shares since it authorized the program this year, since it turned out that there is demand for its shares without the buyback. NetEase is already valued as a no-growth company, so the downside should be limited to 10% to 20%, which would bring the company's valuation back to very low levels, even if we do not back out the net cash position. NetEase's ex-cash 2014 P/E is currently around 11, while the 2015 ex-cash P/E is 9.6, notwithstanding an increase in the cash position, which is certain, given the substantial free cash flow. I think that if NetEase goes lower from here, the company should start to buy back shares and may even increase the buyback program.
NetEase is still a strong buy, even after the 30% rise since my last article. The new $105 price target means that there is 20% more upside from the current price, while the more bullish scenario translates into 35% upside. Downside should be limited to 10% to 20% and regarded as a strong buying opportunity. The only cause for concern is the slow monetization of mobile games, but the company is making efforts to correct the issue, and we should see the results from these efforts in 2015 and beyond.
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