Competition within the Chinese online gaming space remains incredibly fierce, and our forecast for Netease is bearish.
Sina's pathetic showing came a day after Baidu (BIDU), China's No. 1 search engine, reported a 286% gain in fourth-quarter profit, which only moved shares 5.4% That tells us that amid all this China fever, investors aren't falling to their knees for these stocks.
Netease derives revenues from 2 sources: subscriptions for its games and advertising from its site. Netease should focus on the latter, because rival Shanda (SNDA) recently announced that it'll provide free content (and charge for ancillary services). That could be a death blow for Netease, which charges users for its two basic games.
That's correct: 2 games. Netease's games are wickedly popular, but the company only spits out 2 games a year. That leaves plenty of room for new entrants or existing competitors to put forth better titles.
Moreover, there is regulatory risk we must consider. The Chinese government has already limited the number of hours video game enthusiasts can play each day. That's a revenue-killer, isn't it?
As is piracy, which is eating into Netease's dominance. Miscreants are releasing illicit versions into the underground economy while hackers are breaking into server systems to tinker with the rules of the games. Both of these illegalities are upsetting die-hard purists and sending them to Netease's rivals, like The9 (NCTY) and Tencent.com.
The one front where Netease has excelled is advertising: the market for it in China is poised to double in 06, and Netease is well-positioned.
Still, that doesn't mean Netease is a buy. The firm's competitive advantage is barely visible, and its buiness model clearly needs some fine-tuning, in our opinion. The good news is that Netease's management receives little cash compensation, so it's in their best interest to see this company leapfrog its challenges and see the stock gravitate higher.
We don't doubt that online gaming in China will continue to hit stratospheric levels, but we do doubt Netease will enjoy the same level of success it did over the last 2 years.
As the space for gaming grows, so will Netease's difficulty in maintaining market share and sustaining its hitherto impressive operating margins (50%+).
Risks to our thesis include Shanda's continuing downward spiral (freeing more room for Netease); faster than expected Internet penetration in China; Netease's margin story remaining intact; and governmental control over China's netizens being over-hyped and/or limited to the under 18 crowd (arguably less avid end users).
NTES 1-yr Chart
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