NETTF - NetEase: I Am Buying The Sell-Off

2023-12-27 07:18:10 ET

Summary

• On December 23rd, the Chinese government published a first draft of guidelines aimed at curbing excessive spending and time commitment in online gaming.
• Although I understand that the regulatory announcement will rekindle fears of a broader crackdown on gaming in China, I believe the intent of the government is less aggressive than feared.
• Looking beyond the new regulatory guidelines for gaming in China, whose long-dated impact on the sector remains uncertain, I argue that NetEase remains an attractive, structural growth story.
• I argue that an EV/EBIT of about 10x suggests a clear buying opportunity for long-term focused investors.

I am buying the sell-off in NetEase (NTES) shares (-16%), after Beijing introduced new guidelines aimed at curtailing online gaming content consumption on both time spent and money invested. Although I understand that the regulatory announcement will rekindle fears of a broader crackdown on gaming in China, I believe the intent of the government is less aggressive than what investors may fear. Moreover, I continue to view NetEase as a structural growth opportunity; and I argue that a EV/EBIT of about 10x suggests a clear buying opportunity for long-term focused investors.

For context, NetEase stock has performed strongly YTD. Since the start of the year, NTES shares are up close to 15% (despite the 16% sell-off), compared to a gain of approximately 24% for both the S&P 500 ( SP500 ) and a loss of 12% for the broader Chinese internet/ technology sector, respectively (PGJ).

What Happened - Why NTES Shares Sold-Off Sharply

On December 23rd, the Chinese government published a first draft of guidelines aimed at curbing excessive spending and time commitment in online gaming. Specifically, according to the draft, online game publishers will be restricted from offering incentives due to daily logins or in-game spending. One potential consequence of the regulation, if enforced, could be that there will be time-indexed spending limits, as well mandated pop-up warnings for irrational spending patterns. Additionally, there will likely be more stringent controls proposed for minors' access and duration of online gaming. Lastly, the rules also prohibit game content promoting obscenity, pornography, gambling, violence, or instigating crimes.

Following the publication, Tencent (TCEHY) suffered a -12% share price drop in its stock, while rival NetEase plummeted by -21% (both stocks reference HK trading, HK.0700 for Tencent and HK.9999 for NetEase, respectively). Including the consequential loss of market value for Bilibili (BILI), Huya (HUYA) and some Korean game publishers, the regulatory announcement led to an approximate $80 billion wipeout in market value.

Although I understand that this broadly unexpected regulatory move echoes the 2021 crackdown on the Chinese tech sector, I argue that market participants overreacted to the announcement. Firstly, I point out that the new guidelines are still "drafts", with no impact on game publishers for now. In fact, the Chinese government actively encouraged feedback from the public on the proposed rules, saying that it will "earnestly study expressed concerns and views". Accordingly, there is still a probability that the new rules won't be enforced in their current outline. Secondly, I also point out that the primary aim of the proposed rules is to safeguard users' rights, protect minors' mental and physical well-being, and foster a healthy development environment for the sector, not cutting the structural growth outlook of the sector. Supporting the thesis that the new regulation is not aimed at stopping the structural growth, I highlight that only one day following the publication of the draft rules, the Chinese government approved new 105 games, including NetEase's Firefly Assault.

Still A Growth Story

Looking beyond the new regulatory guidelines for gaming in China, whose long-dated impact on the sector remains uncertain, I argue that NetEase remains an attractive, structural growth story.

In Q3 2023, NetEase revenues reached RMB27.3 billion (US$3.7 billion), marking an 11.6% YoY growth compared to the same period one year earlier. In that context, games and related value-added services accounted for RMB21.8 billion (US$3.0 billion) of the company's revenues (approximately 81% of group sales), and showed a growth of 16.5% YoY compared to the third quarter of 2022. On a broader topline growth perspective, NetEase growth is leading the expansion rate of other Chinse tech/ internet companies, including Tencent (TCEHY), Baidu (BIDU), JD (JD) and Alibaba (BABA).

I bullish on NetEase game pipeline for the next 12-24 months, which may drive 10-15% revenue CAGR through 2025. In Q1 2023, NetEase is poised to release (1) Where Winds Meet, (2) Shediao, and (3) Naraka Mobile, while (4) Condor Heroes, (5) Mission Zero, and (6) Once Human may be released later the year. Meanwhile, Eggy Party (Q1 2023 released) has successfully reached critical mass with over 30 million daily active users and a 100 million monthly active users base (30% DAU/MAU) (Source: Morgan Stanley research note dated 5th December: China Online Entertainment and OTA).

Lower Target Price; But Still Upside

After a year has passed since I last valued NetEase stock, it is time for me to update my NTES valuation framework: Specifically, I am updating my EPS projections for NetEase based on analyst consensus projections, drawing from Refinitiv estimates. My revised EPS for FY 2023 now stands at $7.1, compared to the previous estimate of $5.9. Additionally, I am raising my EPS projections for 2024 and 2025 to $7.4 and $7.7, respectively. My valuation model maintains a 3.25% terminal growth rate, slightly higher than the anticipated nominal global GDP growth. However, I've increased my cost of equity estimate by a significant 100 basis points, now at 10.0%, reflecting the amplified regulatory risk.

Taking these adjustments into account, my calculated fair implied share price for NetEase estimates $96.41.

Below also the sensitivity table, which tests different assumptions for cost of equity (row) as well as terminal growth rate (column).

A Note On Risks

Investors should not forget to note the risks associated with investing in NetEase stock: Firstly, I point out that the broader spectrum of China's internet and tech companies, specifically gaming entities, faces substantial exposure to regulatory uncertainties (as evidenced by the most recent regulatory announcement). Secondly, the current fluctuations in NetEase's stock price are largely influenced by investor sentiment toward Chinese ADRs and overall risk assets. This volatility might persist despite the company's unaltered business fundamentals. Lastly, it's crucial for investors not to underestimate the competitive landscape. NetEase engages in direct competition with Tencent across various segments, such as game development, live-streaming, and online music.

Conclusion

While the recently published regulatory guidelines targeting online gaming may reignite concerns about a broader gaming/ tech/ internet crackdown in China, I argue that the intentions of the government might be less aggressive than suggested. Moreover, I believe NetEase presents an appealing narrative for sustained structural growth. Looking past the uncertain long-term impact of these gaming regulations, I think that NetEase's valuation around 10x EV/EBIT suggests a compelling buying opportunity. Lastly, on updated valuation assumptions, I now calculate a fair implied share price for NTES equal to $96.4. "Buy".

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