China's Woes Create Opportunities For New NetEase Investors

| About: NetEase, Inc (NTES)

Summary

NetEase is currently a victim of the hate everything China sentiment in the market.

NetEase is dirt cheap based on virtually any metric investors wish to apply.

A growing consumer class in its home market of China indicates exceptional growth potential for years to come.

Baron Rothschild of the famous Rothschild banking family is credited with coining the phrase: "The time to buy is when there's blood in the streets."

It's an easy quote to remember. It's much more difficult to actually put into practice. Why is that? When considering a hypothetical concept, it is purely an intellectual exercise. It is very easy to leave the emotions of greed and fear aside until real money is on the line.

No matter how compelling the numbers might be, most investors cannot overcome the fear of the price falling further and open a position when everyone around them is screaming "SELL!"

One of the key aspects of successfully implementing the advice of Baron Rothschild is to learn to separate the emotion from investing decisions and to make capital allocations based purely on the numbers and facts rather than fear and greed.

If we think about it logically, bargains in stocks rarely occur when things are going well and the outlook is positive. Bargains are presented because some aspect of the business is causing concerns and fear among investors. The key to making outsized profits is to recognize when those fears are driven more by emotion than fact and have created a substantial gap between the long-term value of a business and the short-term price.

I believe I have found such a situation today in the shares of NetEase Incorporated (NASDAQ:NTES).

What Is NetEase?

NetEase operates an interactive online community in the People's Republic of China. The company has three operating units. These are made up of Online Game Services, Advertising Services and E-mail, E-commerce and Others.

Its Online Game Services offers multi-player, online, role-playing games and mobile games. It distributes its point cards to gamers across China through wholesalers, Internet cafes, software stores, supermarkets, bookstores, newspaper stands and convenience stores primarily in Guangzhou Province, Shanghai and Beijing.

The company's NetEase Websites provide Internet users with Chinese language online services comprising content channels that offer news, information, and online entertainment. It also offers community and communication services, such as photo albums, instant messaging, online personal advertisements, open courses, mobile news applications, online video and community forums. These include various search functions, dictionary and cloud note-taking applications. It also offers online advertising services that include banner advertising, channel sponsorships, direct e-mail, interactive media-rich sites, sponsored special events, games, contests and other activities.

E-mail services are provided to individual and corporate users and value-added wireless services. The company also provides e-commerce services through various online platforms. It also offers cloud based music and other popular products with rapid growth potential.

What Created The Opportunity?

Anyone who has spent time reviewing financial and stock information lately will be keenly aware of the problems China is currently experiencing with slowing economic growth.

China's economic issues were created by both internal and external factors. Most of us who live under elected governments are well aware of their tendency to overdo anything they touch and overdo it in a very inefficient manner. And these are people who are at least somewhat accountable to the voters.

In China, the government has virtually no accountability to anyone who is not in prison or still alive. Just imagine how much excess and how many bad decisions that can create. And it has.

China has rapidly built the world's second-largest economy by creating a massive domestic industry based almost exclusively on exporting products it manufactures. The second leg of that economic boom was created by an unprecedented build out of a huge domestic infrastructure. Whether it was needed or not.

It is easy to find stories of entire cities in China that were built with no demand. Sort of a giant version of Alaska's "bridge to nowhere." The empty cities that have been built in China are now commonly referred to as "ghost cities." Massive government spending on the construction of unnecessary projects provided lots of reportable growth but growth that did nothing to add real value to the Chinese economy.

China also is now finding out that there is a large risk in having an economy that's based heavily on exports. If the world demand slows, it can quickly destroy a large part of your gross domestic product.

They also are finding that in building an economy that sucked up the world's jobs based in a large degree on cheap labor they exposed themselves to vicious completion from other countries that would eventually offer many of the same products produced by even cheaper labor.

The first cracks began to appear a few years ago. Now those cracks have become fissures and are clearly seen by all. This has caused the Chinese market to become one of the most hated in the world.

Much of the current investor disdain is well deserved. But, what many overlook is that China still has a massive population of consumers who wish to have a better way of life. This means businesses that cater to the domestic population and provide them with desirable goods and services should have a bright future in the long term.

NetEase is one of those businesses. Just imagine what the average consumer would do to maintain their access to email and online gaming. Yet, its stock has been hammered right along with the rest of anything China.

NetEase Is One Cheap Stock

Earnings Est

Current Qtr.
Dec 15

Next Qtr.
Mar 16

Current Year
Dec 15

Next Year
Dec 16

Avg. Estimate

2.20

2.15

7.56

9.35

No. of Analysts

5.00

4.00

14.00

15.00

Low Estimate

1.90

1.26

7.00

7.51

High Estimate

2.71

2.61

8.65

11.40

Year Ago EPS

1.45

1.44

5.44

5.44

Click to enlarge

There are more ways to value a stock than most people can imagine. When reviewing the past performance and future projections for NetEase, it is hard to find any valuation metric that doesn't just scream cheap!

On February 12th, the stock closed the day trading at $138.43. The average estimate from the 14 analysts covering the stock for 2015 earnings is $50.42/share. These numbers produce a price to earnings multiple of 18.3 against the year ended on December 31, 2015. In line with the broad market but for much faster growth.

Now, we all know that analysts providing earnings estimates for businesses change those estimates on a regular basis so their latest revision will at least be close to the actual results. Over the last 90 days, the analysts covering NetEase have been very busy doing just that.

The thing is, they have been busy raising them… and raising them a lot. As shown in the table below, the projected earnings estimates for the 2015 and 2016 fiscal years have been increased by 16% and 20.5%, respectively.

EPS Trends*

Current Qtr.
Dec 15

Next Qtr.
Mar 16

Current Year
Dec 15

Next Year
Dec 16

Current Estimate

14.67

14.34

50.42

62.35

7 Days Ago

14.67

14.34

50.42

62.35

30 Days Ago

14.76

13.47

50.23

61.89

60 Days Ago

13.92

11.51

49.64

60.92

90 Days Ago

11.62

10.99

43.40

51.71

Click to enlarge

*Numbers shown are in Yuan. Current exchange 6.67 yuan/$

So, despite the very real issues and concerns over serious problems in some areas of China's economic growth, there are some businesses and sectors that are still well positioned to grow and prosper.

This is not a situation that is unique to China. There are almost always some businesses and sectors that do well in any kind of economic environment. Just look at the record number of millionaires created during the Great Depression.

Unlike some businesses in China that have seemingly solid pasts but somewhat questionable future prospects, NetEase appears to be well positioned for continued future growth.

It is important to remember the massive population of China and the fact that all economies go through periods of mal-investment but eventually get themselves back on track. So, while China may continue to struggle with its existing problems for a while, it will eventually put those issues behind it and get back on track.

NetEase appears to not have those issues today or in the foreseeable future as shown by the forward long-term estimates for earnings growth.

Growth Est

NTES

Industry

Sector

S&P 500

Current Qtr.

51.70%

32.60%

N/A

2.40%

Next Qtr.

49.40%

12.50%

173.80%

12.80%

This Year

38.90%

12.40%

6.90%

3.00%

Next Year

23.70%

18.40%

28.80%

9.10%

Past 5 Years (per annum)

17.56%

N/A

N/A

N/A

Next 5 Years (per annum)

23.40%

21.26%

17.32%

4.88%

Price/Earnings (avg. for comparison categories)

18.04

6.67

8.31

23.02

PEG Ratio (avg. for comparison categories)

0.77

40.38

18.58

1.37

Click to enlarge

Even if the forward growth estimate is off by 50%, this stock would still be fairly priced based on its current earnings and current broad market valuation.

Some Icing On The Cake

I always like to see businesses that are making an effort to reward shareholders for their confidence in the company. While it is still a bit early for me to assign much value to it, the company did begin paying one dividend in 2013 and has paid one each quarter beginning in 2014. I'm not assessing any real value to this aspect of the business because the dividend payments don't have a long track record and I want to see more proof of commitment. However, it should not go recognized as a step in the right direction.

But, for those, like me, who want lots of icing, we can refer to the NetEase balance sheet. For the quarter ended September 30, 2015, NetEase had cash and short-term investments of $4.322 billion and receivables of $306 million on their balance sheet.

Against those liquid assets, the company listed total liabilities of only $1.568 billion.

This means the company could satisfy all of its liabilities from its current highly liquid assets and still have $3.06 billion ($23.41/share) of liquid assets left over. This is equal to 16.9% of the total market capitalization of the business.

Final Thoughts And Actionable Conclusions

The problems with China's broader economy appear to have presented brave investors with a spectacular opportunity in shares of NetEase today. Can the price fall further and present an even more compelling opportunity in the future? Absolutely. No one is capable of picking exact tops and bottoms in stock prices.

For investors who are capable of holding shares for the long term and ignoring the day-to-day insanity of market prices, NetEase possesses every characteristic of a grossly undervalued business today.

As one last measure of quality, the stock has outperformed both the U.S. markets and the Chinese market over the past years and moved higher while the markets have moved lower. With a rock solid balance sheet, exceptional projected earnings growth and a huge and growing customer base in China, this looks like a hard stock to beat for those with the stomach to withstand the short-term volatility.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.