NetEase.com, Inc. (NTES) will announce its second quarter earnings after the U.S. bell on Wednesday. While the company has strong fundamentals, there are also possible short term catalysts to drive the stock higher. The stock is somewhat insulated versus the macro trends in the U.S. and Europe and has buffers against a large downturn.
NetEase creates proprietary online role-playing worlds; it also provides Activision Blizzard, Inc. (ATVI) a conduit to the Chinese market for two of ATVI's popular games, World of Warcraft and Starcraft II. The company has a relatively low P/E of 16, considering growth has been 25% per year over the past five years. Estimates of its future PEG ratio (.75) continue to drop. The company has no debt and $1.62 billion in cash. The cash equals 25% of the market cap. Earnings have surprised in both of the preceding quarters.
First among possible catalysts is the fact that NetEase launched Starcraft II commercially on April 6th of this year. Real-time strategy games have done well in Asia in the past and there is no reason to expect anything different from this solid release that has done well in U.S. and Europe. At $3 per user per month, the Starcraft launch should be a key positive component in the previous quarter’s growth. Additionally, Activision has already announced its second quarter. The company was very positive in its comments about growth in the Chinese market with regards to World of Warcraft; the Chinese market had recently received the latest expansion pack called Cataclysm and other add-ons.
Second, a new dividend is not out of the question. As mentioned above, NetEase has a large cash reserve. On previous conference calls, the company has indicated that it will not be investing this cash through acquisitions. While many gaming giants are looking to acquire other firms in the social media game arena, both NetEase and Activision have chosen to pass and focus on monetizing their core titles. This has worked and led to a growing reserve at both companies. Activision recently instituted a dividend. With the degree to which the two companies match steps, it would be no surprise if NetEase followed Activision in this regard. Initiating a dividend would also be timely as Chinese firms are fighting a perception of questionable earnings accounting.
Lastly, NetEase will have some role to play in bringing Call of Duty to China. Even if first-person shooter games are not as popular in China as real-time strategy games and role-playing games, Call of Duty will generate large revenues in China once it is approved in some form by the Chinese censors. While there are many questions about Call of Duty in China and NetEase’s role, uncertainty in this area will decrease, not increase, over the short term.
What kind of insulation does NetEase have versus the downtrend in the West or other short term negative shocks? First, NetEase’s beta is .98, low for a Chinese tech company with 25% growth. Additionally, the company provides a service to a dedicated, i.e. addicted, consumer in a growing economy. The service is looked upon by its consumers as a value because of its low cost per hour of entertainment. While future growth is reliant on the censors to approve the content of the games it imports from the U.S., the company has an excellent track record in its work bringing World of Warcraft and Starcraft II to China.
One negative is that NetEase primarily holds its cash reserves in euro denominated assets. Over the reporting period, the euro (-1.5%) did weaken slightly versus the dollar. Another currency conversion loss, similar to what we saw 4th quarter last year, is in the cards. The aforementioned may hurt earnings; but it is a high quality problem when the cash reserve is so large that manageable currency fluctuations are the primary concern.
In summary, NetEase is increasing its content, which is driving both top line and bottom line growth. The company is maintaining a large cash position and is responsible in its acquisition strategy. Considering the outlook, the stock is priced at a reasonable 16 times earnings.