Long before U.S. investors heard about Baidu (BIDU), NetEase (NTES) was one of the first cash generating internet juggernauts listed in the U.S. markets. While NetEase started off as a mix of an internet portal and wireless services company, it was the success of its first self developed game "Westward Journey Online" which provided the enormous cash flow the company would use to expand. With economies of scale starting to kick in for NetEase, both revenues and net income soared to record levels in the third quarter of 2011.
For the third quarter, consolidated revenues grew by 12.9% sequentially and 39.5% annually to $307m. NetEase’s core online gaming business made up the bulk of its revenues with a $275.3m contribution or over 87% of total revenues. The growth and high margin nature (71.5% in Q3) of its gaming unit helped expand operating margin to 47% from 42% a year ago. Unlike peer rivals such as Perfect World (PWRD) that have spent heavily on internal development but have not witnessed equal proportionate revenue growth, scale is significantly benefiting NetEase. U.S. GAAP net income during Q3 grew to a record $129.5m, or 0.99 in earnings per share.
Using any historical gauge, NTES still remains extremely cheap at roughly 11-12 times annualized earnings especially compared to its 41% annual earnings growth. Granted given the extremely pessimistic sentiment overhanging all U.S. listed Chinese stocks in general, NetEase much like other Chinese internet leaders such as Baidu, Sina Corp. (SINA), and Sohu.com (SOHU) actually trade at a premium to smaller peers. Direct Chinese online gaming peers Perfect World and Changyou.com (CYOU) currently trade at only 4.8 and 6.5 times trailing earnings, respectively.
Valuing NetEase solely on earnings is deceiving because the company possesses other assets which arguably reduce its market multiple. After nine years of operation and still amazingly going strong, Westward Journey Online along with succeeding games have generated a cash hoard for the company. At the end of the third quarter, NTES held almost $1.9b in cash equivalents, or roughly 14.50 per share of its stock value is cash vs. zero debt. At a recent share price of 45.00 and subtracting the company’s cash, NetEase’s “enterprise” multiple is further reduced to below 8x annualized earnings.
Perhaps more significant among the company’s assets are not quantifiable. Given the market’s appetite for social media which caused a surge in SINA’s share price in the past year due to its micro-blogging phenomenon Weibo, NetEase is not without a hand in this arena. The company’s own micro-blogging efforts generated a 68.6% sequential surge in user base to 88.5m users in the third quarter. Although well under Weibo’s over 200m user base, its sequential growth is worth keeping an eye on. Clearly given the valuation spread between NTES and SINA, the market is discounting any potential success NetEase may experience in the realm of micro-blogging.
Much like micro-blogging currently, NetEase’s email user base doesn’t contribute much if anything to the company’s bottom line. However at 430m registered users vs. the last official count of 485m total internet users in China, the company has an extremely large reach. If synergies can be created between internet service offerings, higher degrees of realized monetization could occur in the future. Once again with the company’s current valuations barely factoring its successful online gaming division, NetEase’s other initiatives could eventually provide a catalyst for incremental earnings growth moving forward.
While it is currently too early to factor NetEase’s other offerings, they are nevertheless assets which could provide material benefits in the future. With a strong balance sheet and a dominant position in China’s online gaming industry, NetEase remains a conservative play on China’s social media whether it is gaming related currently or micro-blogging related in the future. NetEase’s long operating history has generated retained earnings to date of almost $1.7 billion which has provided a huge war chest for the company’s expansion outside its core gaming business. NTES’s returns may not equal BIDU’s in recent years, but its 1500% move since early 2003 is not bad either and yet due to the company’s growth current valuations still remain attractive.