Summary
- Despite the pressures of an undoubtedly challenging macroeconomic backdrop in China, NetEase, Inc. posted solid Q3 results.
- The macro-environment in China is improving and the termination of the partnership with Activision is likely only a minor headwind to NetEase fundamentals.
- After a 28% sell-off YTD, NetEase is now trading at a one-year forward EV/EBIT of approximately x11 and a EV/Sales of x2.4.
- According to my analysis, which I anchor on a residual earnings model, NetEase stock should be fairly priced at around $115/share.
Thesis
In a previous article on NetEase, Inc. (NTES), I argued that the Chinese gaming company would trade in line with fundamentals - and I assigned a "Hold" recommendation to the stock. But following an approximate 26% selloff since my initial assessment, as well as a stronger than expected Q3 report, I upgrade my NetEase recommendation to "Buy." According to my analysis, which I anchor on a residual earnings model, NTES stock should be fairly priced at around $115/share.
For reference, NetEase stock is down about 28% YTD, as compared to a loss of approximately 20% for the S&P 500 ( SP500 ).
Stronger Than Expected Q3 Supports Bull Thesis
Despite the pressures of an undoubtedly challenging macro-economic backdrop in China, NetEase posted solid Q3 results. During the period from July to the end of September, NetEase generated total revenues of approximately $3.43 billion, which compares to about $3.11 billion for the same period one year earlier (10% year over year increase), and $3.05 billion for Q2 2022 (5.5% quarter over quarter growth).
- Games and related value-added services net revenues were RMB18.7 billion (US$2.6 billion), an increase of 9.1% compared with the third quarter of 2021.
- Youdao net revenues were RMB1.4 billion (US$197.2 million), an increase of 1.1% compared with the third quarter of 2021.
- Cloud Music net revenues were RMB2.4 billion (US$331.4 million), an increase of 22.5% compared with the third quarter of 2021.
- Innovative businesses and others net revenues were RMB2.0 billion (US$276.7 million), an increase of 13.6% compared with the third quarter of 2021.
Although analysts had estimated revenues to be about $54 million higher, the Chinese gaming giant managed to more than offset any sales disappointment with a stellar profitability surprise.
In the September quarter 2022, NetEase operating profit jumped by 25.6% year over year as compared to Q3 2021, to $667 million. Even more notably, net income attributable to shareholders increased by 110.6%, as cost discipline pushed NetEase profit margin to 23.12%. As a consequence, EPS was recorded at $1.58/ ADS, which is 53 cents higher than what analyst consensus had expected (50% beat).
Termination of Partnership with Activision Likely A Minor Headwind
In recent weeks, NetEase stock price suffered from negative investor sentiment caused by the termination of the partnership with Activision Blizzard (ATVI). Together with the September quarter, NetEase disclosed that (emphasis added):
[NetEase has entered into certain licensing agreements covering the publication of several Blizzard titles in Chinese mainland.] These licenses will expire in January 2023 and will not be renewed.
However, investors should consider that the impact on NetEase financials is less severe than what markets are arguably pricing (emphasis added):
Net revenues and net income contribution from these licensed Blizzard games represented low single digits as a percentage of NetEase's total net revenues and net income in 2021 and in the first nine months of 2022. The expiration of such licenses will have no material impact on NetEase's financial results . The co-development and publishing of Diablo® Immortal™ is covered by a separate long-term agreement.
Accordingly, an analyst could likely estimate that the partnership termination with Activision will impact NetEase revenues and net profit by no more than 5%, or approximately 15 cents per share.
From GARP To Value
Reflecting on a strong Q3 quarter, it is not unreasonable to claim that NetEase is slowly approaching value territory. First, I would like to point out that NetEase is now trading at a one year forward EV/EBIT of approximately x11 and a EV/Sales of x2.4. Such multiples are very attractive for a company growing at 10% year over year, and claiming a greater than 20% net profit margin.
Moreover, investors should not forget to look at NetEase exceptionally "rich" balance sheet: $16.3 billion of cash and cash equivalents, against total debt of only $4.1 billion (net cash of $12.2 billion). For reference, cash provided from operations for the trailing twelve months was $3.8 billion.
With such a strong financial positions, it should come as no surprise that for the trailing twelve months, NetEase has paid out slightly more than $1,800 million to shareholders, which implies an equity yield of almost 4% (share buybacks of 1,045 million, and dividends of $790 million).
Valuation: Raise Target Price To $100
Following a strong Q3 report from NetEase, as well as an improving economic environment in China, I update my residual earnings model for NetEase to account for consensus EPS upgrades.
In line with my previous base-case assessment, I continue to anchor on a 3.5% terminal growth rate (approximately between one - two percentage point higher than estimated nominal global GDP growth).
I increase my estimate for NTES fair cost of equity to 9%, from 8.5% prior, to account for globally higher risk premia, partially offset by an improved assessment of NetEase regulatory risk.
Given the EPS upgrades as highlighted below, I now calculate a fair implied share price of $114.24 versus $95.04 prior .
Analyst Consensus EPS; Author's Calculations
Here is the updated sensitivity table.
Analyst Consensus EPS; Author's Calculations
Risks
As I see it, there has been no major risk-updated since I have last covered NTES stock. Thus, I would like to highlight what I have written before :
First, the economy in China is currently pressured by multiple headwinds including inflation, real-estate crisis and COVID-19 lockdowns. If the Chinese economy would slow more than what is expected and priced in, investors should adjust expectations for NetEase's short/mid-term business monetization accordingly.
Secondly, China's internet/tech companies in general, and gaming companies in particular, are strongly exposed to regulatory risk. That said, investors should monitor the regulatory environment very closely.
Third, much of NetEase share price volatility is currently driven by investor sentiment towards Chinese ADRs and risk assets. Thus, NetEase stock price might show strong price volatility even though the company's business fundamentals remain unchanged.
Finally, investors are well advised to not underestimate competitive pressures. NetEase is directly competing with Tencent on multiple segments including game development, live-streaming and online music. Tencent is the world's biggest and most successful game developer with unmatched software-development capabilities and financial firepower. If competition were to intensify, I personally wouldn't want to bet against Tencent.
Conclusion
There are few companies that trade at a FWD EV/EBIT of only x11, while growing 10% year over year and achieving a greater than 20% net income margin - all despite a truly challenging macro environment.
In my opinion, NetEase is now a value stock - with low valuation multiples and a $12.2 billion net cash position. According to my analysis, which I anchor on a residual earnings model, NTES stock should be fairly priced at around $115/share.
For further details see:
NetEase: Now A Buy (Upgrade)