NetEase Update: Back To A Reasonable Valuation (Rating Downgrade)

Summary

• With the stock being up by +50% in just a couple of months, it's worth considering if it's still a good buy.
• The recent financial report demonstrated substantial progress in stabilizing the company's operations.
• In light of the following reevaluation of the stock, I am changing my rating from Buy to Hold.
• With the high reinvestment rate and the dividend, investors can still expect mid-double digits going forward.

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Introduction

NetEase (NASDAQ:NTES) has recently seen a significant increase in its stock value, raising questions about whether it is still undervalued. My previous analysis of a fair valuation of NetEase, taking into account future growth projections, was only published a couple of months ago. The analysis included a review of the company's financials and its future growth projections.

At the time the article was posted, the conclusion reached regarding the valuation of NetEase was as follows:

A return to its 50- moving average would indicate a return of 40%. This would also bring the stock close to its average multiple and slightly above the standard multiple of 15.

Given that the stock price of NetEase has increased more than expected, and that the company has presented Q3 2022 earnings after the article was posted, it's worth taking a look to see, if the company is still a good deal.

Q3 2022 Earnings

In its most recent quarterly earnings report, NetEase earned a sizable EPS beat. Particularly, the business's earnings per share came in at $1.58, exceeding analyst projections by $0.53. The business also stated that it had witnessed an increase in the top line as well as improved margins. The results of the earnings not only exceeded expectations, but also expedited the company's return to its fair valuation.

For the third quarter of 2022, the company's gross profit margins across all major divisions showed strong performance. Games and related value-added services had a gross profit margin of 65.0%, up from 64.9% and 61.3% in the previous quarter and third quarter of 2021. Similarly, Youdao's gross profit margin increased significantly from 42.8% and 56.6% in the previous quarter and third quarter of 2021, respectively, to 54.2% in the current quarter. The gross profit margin for Cloud Music also increased, rising to 14.2% from 13.0% in the previous quarter.

NetEase has further strengthened its financial position by increasing its cash, cash equivalents and short term investments to ¥116 billion, which greatly outweighs its debt of only ¥28 billion.

The company also disclosed that a fresh share buyback program had received approval from the board of directors, which permits the open market repurchase of shares worth up to $5 billion.

To summarize, the company is still in a healthy financial state, its profit margins and return on equity have remained stable, and it has achieved double-digit year-over-year growth in its top line. Overall, based on these factors, the company is very attractive as an investment opportunity, however, the current valuation of the company may be questionable. It may not be undervalued anymore.

Valuation

Currently, the stock can be purchased at a price-to-earnings ratio of approximately 18, which is near its historical average P/E ratio of 18.75 and slightly higher than the typical P/E ratio of 15. As previously noted in my analysis, I believe this to be close to the stock's intrinsic value. Since there have been no significant changes to the company's long-term fundamentals, I continue to hold this view. Therefore, I now believe the stock to be fairly valued rather than undervalued.

Given the company's historical performance of ~17% return on equity and a moderate dividend payout ratio of ~25%, an annual growth rate of ~12.75% can still be expected. With the added dividend, an annual return on investment in the mid-double digits is still worth considering for investors.

Stock Chart

Quick disclaimer: A technical analysis in itself is not a good enough reason to buy a stock, but combined with the company's fundamentals, it can greatly narrow your price target range when you buy.

The utilization of moving averages proved to be a valuable tool in this instance. In my initial analysis of NetEase, I had expressed doubt that the stock would fall to its 200-day moving average, even considering, at the time, the tense political climate in China. Additionally, I anticipated that the stock eventually would return to its 50-month moving average, given its seemingly low valuation at the time.

My conviction that the stock is currently reasonably valued has been strengthened by recent occurrences, such as the stock crossing its 50-month moving average and the absence of undervaluation based on earnings.

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Final thoughts

Despite the company's strong financial position, solid profit margins, and double-digit year-over-year growth in its top line, I believe, it may now be prudent to consider it fairly valued rather than undervalued.

The company's historical performance of ~17% return on equity, a moderate dividend payout ratio of ~25%, and an annual growth rate of ~12.75% can still be expected. With the added dividend, an annual return on investment in the mid-double digits is still worth considering for investors.

The Chinese stock market has experienced tremendous movement as perception toward Chinese equities has started to shift as a result of the nation's reopening. With a company like NetEase reporting strong profitability and growth, it's not surprising that their stock have returned to a fair valuation.

Even though the stock may no longer be inexpensive, double-digit growth is still a possibility in the future. As a result of it no longer being undervalued, I am changing my rating from "Buy" to "Hold".

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.