NTES - NetEase: A Strong Defensive Stock In China's Intensely Bearish Landscape

2023-12-20 00:45:41 ET

Summary

• NetEase is a lesser-known company in the China KWEB Internet ETF, but has strong fundamentals and potential for recovery.
• The company is a global market leader in mobile gaming and has diversified into other areas such as music streaming and online education.
• NetEase's valuation is currently discounted, but has the potential for a modest lift as China's economy slowly heals and consumer confidence improves.

Searching for the Outperformers within China's Bearish Landscape

One of the top weighted companies inside the China KWEB Internet ETF is a lesser known company named NetEase ( NTES ) which is the #5 company in the ETF. Many people outside of China actively use their products to some degree, but the company has maintained a very low profile among retail investors.

As discussed in a previous post on JD.com ( JD ), China's stock market has been mired in despair as the confluence of falling property values, weak consumer confidence, and ongoing technology export curbs from the U.S. strangle investor psychology. Objectively speaking, the Hang Seng has been stuck in an enduring and painful bear market since March 2021 when it offered 31,000 and now trades almost 50% lower (now 16,000).

In a conversation with one of my family friends when I visited Hong Kong earlier this Fall, he told me that " he didn't know one person in his network who could make any money in the Hong Kong markets in 2023 ." To say that the investing environment has been difficult for H-Shares is an understatement.

My understanding is that the popular retail stocks HK-9988 ( BABA ), HK-9961 ( JD ) and HK-700 ( OTCPK:TCTZF ) essentially capture all of the investor attention due to their brand recognition and there is much less focus on other opportunities in the marketplace that are actually performing quite well - like NetEase.

Our core view on NetEase has a technical premise that it is now near at the bottom of its rising trend channel formed from November 2022, and that its relative strength against the Hang Seng and Hang Seng Tech Index (HS Tech) gives it the opportunity to recover faster and more durably than other H-Shares in the event of a Hong Kong recovery. Its high correlation with the Hang Seng means that it cannot fully break out of Hong Kong's bear market, but upon any reprieve, NTES may recover faster than other names.

This technical premise is supported by the company's fundamentals which are among the best in terms of growth within the Hong Kong/China stagflationary quagmire at this moment in time.

Another bonus is that the Founder and CEO is a major shareholder in the company with an estimated 45% stake. Founders who have such significant skin in the game - while not a perfect predictor - are a good sign that they have a vested interest in seeing the company succeed.

That said, if NetEase is to rebound, we believe the bounce has to happen soon or the rising channel may be invalidated.

The Catalysts for NTES and Fundamental Outlook

Given that most people may be unfamiliar with this company, I wanted to write a brief background on the firm. This way, in future research pieces I write about NTES, I can link back to this one here.

In 1997, NetEase started as a Chinese software developer and has now become the second largest mobile game company globally. It created Fantasy Westward Journey (image below) and this game has become a mega hit among Chinese gamers.

NTES has worked hard to focus on mobile gaming and now focuses on high quality games which have become very popular such as Identity V and Knives Out. The company has successfully produced popular games in every genre.

On top of working on games developed internally, NetEase also works with Activision, Microsoft, and Marvel to collaborate on popular titles such as Diablo Immortal and Lord of the Rings. Its gaming segment maintains a high level of profitability and the company funnels free cash flow from steady releases to develop new concepts and franchises.

Over time, NetEase has expanded into music streaming, online learning, and e-commerce. These side bets have actually grown substantially, for example, Cloud Village (the music streaming business) had over 180 million MAUs (monthly active users) in 2021 and was the 2nd largest streaming platform in China.

Even in a difficult operating environment in China, the Sell Side has modeled NetEase to grow revenues at a compounded annual growth rate of 8-12% in the coming fiscal years. The company's business model allows it to command a gross margin that is gradually approaching 60-65% and that will allow the Street to assign NTES a higher multiple in the future.

For quick reference, here is a breakdown of their business segments in percentage terms for Revenue

1. Games & related value-added services (GVAS): 77%
2. Youdao: 5%
3. Cloud Music: 9%
4. Innovative Businesses and others (IB): 8%

For the foreseeable future, the most important focal point among analysts will be the health of the gaming business so they will watch the regulation landscape in China closely.

Risks, thoughts on Entry & Valuation

NetEase is a global market leader in mobile gaming, and a less hawkish gaming regulation environment in China during the 2023 calendar year allowed NTES to greatly outperform the Hang Seng and even match the performance of U.S. Big Tech companies.

The biggest risk for NetEase would be unexpected setbacks in gaming regulation or shifts in gaming preferences and weakness of in-game sales. China's macroeconomic slowdown tends to affect e-commerce companies more than gaming companies because Chinese teen youth view gaming as a necessary part of their social fabric, which ironically categorizes NetEase's products to be more along the lines of consumer staples products rather than discretionary items.

NetEase's valuation on an earnings basis and EV/EBITDA trades at about a 50% discount relative to its heydays in 2021 - rightfully so as China's macro landscape coupled with an uncertain operating environment makes investor caution merited. Valuation expansion back to 2021 levels is highly unlikely but a modest lift from here is a reasonable expectation.

Many signs point to China's economy going through slow -albeit choppy - phases of healing in consumer confidence as the property market muddles through a long term bottoming process.

Given NetEase's market leadership position in the mobile gaming space, a slowly healing Chinese consumer narrative, and a reasonably priced valuation setup, there is the confluence in place that NetEase can begin consolidating at current levels and then bounce off the bottom range in its current upward rising channel. For long-term investors, knowing that the Founder also has a significant stake in the business is also an additive piece of information for shareholders.

The company's outperformance relative to the other KWEB stocks means that share price gains may be more modest than beaten down names such as BABA, JD, BIDU, or TCTZF in the event of an intense H-Shares Hang Seng short squeeze.

Due to stronger fundamentals and a more desirable market positioning compared to China's e-commerce platforms, NetEase's share price intermediate-term advances are most likely more durable and perhaps may not be as prone to the sudden reversals/bearish capitulations that investors in JD, BABA, and KWEB have had to contend with for much of 2023.

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