Shares of NetEase.com (NTES: Charts, News, Offers), a leading Chinese Internet and online game service provider, rallied at the end of last week after it announced strong earnings which shattered analysts’ expectations. The company reported a 31% increase in revenues for its fourth quarter, and earned 24% more than the previous year, despite higher operating costs. The rocket fuel powering NetEase was Activision Blizzard’s (ATVI: Charts, News, Offers) World of Warcraft: Wrath of the Lich King expansion pack in China, which was licensed under the NetEase label to much anticipation, after the title hit an assortment of roadblocks with government censors last year. In addition, NetEase’s own stable of well-received first party online games boosted its revenue.
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NetEase is best known to Chinese Internet users for its popular web portal 163.com, which integrates its search engine and MMORPG businesses. Last year, 163.com was the 27th most visited site on the Internet, higher than AOL (AOL: Charts, News, Offers), BBC, Apple, CNN, LinkedIn, CNet, ESPN, Adobe, Flickr and several other major sites as a testament to the massive growth of the Chinese Internet user base. In addition to licensing World of Warcraft for Activision, the company’s own Fantasy Westward Journey is one of the fastest growing Chinese MMORPGs, with ten expansion packs as of February 2011. Its other first party games – Tianxia II, Heroes of Tang Dynasty and Westward Journey Online II all contributed to its annual gaming services revenue growth of 47% for fiscal 2010. For the fourth quarter, these revenues increased 13% quarter-over-quarter and 31% year-over-year. Combine all of these together – with the largest American MMORPG sharing the same roof as the most popular games in the most populous country in the world, and its no wonder investors are paying close attention to NetEase.
Most Wall Street analysts are predicting a conservative 16% growth for 2011, and shares currently trade with a forward P/E of 13.52 with a PEG ratio of 0.92. NetEase also has $387 million in free cash flow, which exceeds its reported net income by 15%. Gaming revenues account for 88% of its total revenues, and the remainder is earned from its search portal, advertising and wireless services. The company’s wireless services, which only accounts for 1.4% of total revenues, is focused on wireless value-added services (VAS), which can be integrated into the framework of online games. This segment grew 25.9% year-on-year and 11.5% quarter-on-quarter, due to the increased adoption of web-capable smartphones.
Beijing-based NetEase closely resembles an idealized Activision Blizzard, with high operating margins – 48.5% last quarter, and room to grow with a market cap of $6 billion USD. Activision, with a top-heavy market capitalization of $13.4 billion, made headlines lately as well, with its over-diversified product lines, debt and uncertain future sinking its shares. NetEase is far more streamlined than Activision – with only two major revenue components – online gaming and online search, which can be easily combined for mutual assistance. In addition, China’s Internet usage is increasing rapidly with its rising tech-capable middle class. With triple the population of the United States, its no wonder that it 163.com portal site already receives more hits than the top American websites. With American companies showing interest in advertising with China’s top search engine Baidu (BIDU: Charts, News, Offers), it may only be a matter of time before NetEase receives similar funding, especially from the lucrative market of online games. CEO William Ding has also expressed his confidence in the company’s large investments in promotional advertising for its portal and its online games through the sponsorship of international and Chinese national venues and sporting events, which he claims was the reason behind the spike in new subscribers for its first party titles. NetEase advertisements were seen during the 2010 FIFA World Cup in South Africa, the 2010 World Expo in Shanghai as well as the 2010 Asian Games.
NetEase’s purely online multiplayer game business has several distinct advantages over mixed genre publishers such as Activision or Electronic Arts (ERTS: Charts, News, Offers) – firstly, mutliplayer online role playing games relying on a living, evolving world such as World of Warcraft are nearly impossible to pirate – whereas the software may be duplicated, fake online subscription keys can be detected by the company and barred instantly. Secondly, these are the only kinds of games which can become consistent cash generators due to player loyalty through monthly payments. Lastly, production costs are carefully controlled and risks are clearly measured, in contrast to the multi-million dollar productions which American studios have often been producing at a loss. Its closest domestic competitor, Sohu.com (SOHU: Charts, News, Offers), which shares a nearly identical business model of a web portal blended with online games, has an operating margin of 33.14%, 11 percentage points lower than NetEase’s margins. If the company can maintain its market lead, the boost from World of Warcraft will merely be icing on the cake as it shoots to the head of the crowded Chinese video game industry.
Other News About NTES
Analysts are giving NetEase a second look.
Netease.com 4Q net income jumps 25 percent
NetEase’s earnings in review.
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Leo Sun is long-time market follower and finance writer. He regularly contributes to the Stock of the Day analysis.
