Netease: Q1 Earnings Likely to Beat Expectations, Future Growth Uncertain

Netease.com (NTES) reports first quarter earnings today after the market close. The company derives 80% of its revenue from two online games: Fantasy Westward Journey and Westward Online Journey II.

To estimate the company's online game revenues I am continuously tracking the utilization levels of the Netease's game servers. Based on my interpretation of the server usage data, I expect online game revenues to increase by about 8-10% quarter over quarter, driven by the strong performance of Fantasy Westward Journey.

My first quarter estimates based on these statistics are:

Net revenues: $69-71 million. Earnings: $0.29-0.31/share.

The estimates are higher than the average analyst expectations, which predict revenues of $67.8 million and earnings of $0.27/share.

Fantasy Westward Journey Grows in Q1

According to my estimates, Fantasy Westward Journey [FWJ] Q1 average concurrent users [ACU] increased to about 500,000, from 444,000 in the previous quarter. The increase was triggered by the release of a new content pack in January and was further supported by the Chinese New Year Holiday, traditionally a strong period for FWJ.

In terms on peak concurrent users, FWJ established an important milestone in the first quarter. On March 4 the game recorded a PCU of 1.5 million players.

Westward Online Journey II ACU continues to lose players at a slow pace. My estimate for the Q1 ACU is 170,000, 2% lower than the ACU registered in the previous quarter.

Datang continues to struggle.

Netease's Future Growth Uncertain

Netease is likely to post good earnings on Monday. However, I believe that the company is going through a critical time.

The two legacy games are aging. FWJ's server utilization levels for April and May show a decline from the levels registered during the first quarter.

Furthermore, Tianxia II, the most anticipated game in the company's pipeline failed to capture gamers' interest. Netease was forced to postpone the game's release and send the game back to the development department. In an already crowded Chinese gaming market this is definitely not positive.

Some Bright Spots

Netease is expected to update investors on the beta testing and release schedule of Westward Journey 3. The game sequel can be successful in reinforcing Netease's game revenue stream. And although the failure of Datang and Tainaxia II don't give us many reasons to be optimistic, the wildcard for WJ3 could be its massive existing user base that could act as a catalyst for the game.

Also, any positive updates on the development of the company's search engine should be good for the stock.

Valuation

Netease trades at a reasonable valuation compared with other Chinese stocks. However in the absence of any positive new developments, and given the current lack of visibility into the company's future earnings growth, I don't expect the stock to resume its upward trend anytime soon.

Figure 1: Fantasy Westward Journey Daily PCU, ACU and their one week moving averages.

Disclosure: The author of this research has no position in NTES