NetEase Inc. (NTES) witnessed staggering top line growth during year ended 2016, with revenue touching $5.5 billion as compared to $3.28 billion during 2015. This translates to a growth rate of an astonishing 67%. The growth was a result of increased adoption of online mobile games in China, launch of more than 40 game titles in 2016 and the licensing deal with Activision Blizzard Inc. ( ATVI) . Strong sales of Overwatch along with the release of the new expansion pack for World of Warcraft also boosted the company's revenue.
Primary revenue source for the company is certain online games including PC client MMORGPs, mobile games and games licensed from Activision Blizzard. These games contributed around 77.5%, 72.3 % and 69.2% towards total net revenues in 2013, 2014 and 2015, respectively.
Industry prospects
Mobile games revenue in China is expected to grow at a CAGR of 10% during the next five years. Newzoo expects the Chinese market to grow at a CAGR of 8% during 2016-2020.
However, IDC is a little more optimistic about the growth of Chinese market.
In 2016-2020, "the operating revenue of the China gaming market is expected to grow at a compound annual growth rate (CAGR) of 12.2%," said Neo Zheng, research manager, Terminal System Research, IDC China.
Average revenue per user is expected to grow at CAGR of 6% during 2016-2021; 10% growth is expected during 2017. Overall, online games industry will continue to follow a growth trajectory going forward. The growth projections aren't as rosy as they were in the past yet the market is set for a double digit growth. NetEase, being a dominant player in China, will benefit from this growth going forward. Moreover there are certain reasons to remain bullish on NetEase:
NetEase is dominating the mobile gaming front
The company is one of the leading online games providers in China. According to App Annie analytics, NetEase, as of April, 2017, has three games in the top ten of the top grossing charts. It is worth mentioning that Tencent Holdings (XTER:NNND) (0070.HK) (TCEHY), the leader in online games in China, has two apps in the top grossing segment.
The company is a premium revenue generator
Moreover, the company is generating more per app revenue as compared to Tencent indicating NetEase's games are more lucrative. It also points towards less capital-spend for the development and marketing of new games. See the chart below:
Source: Tencent and NetEase Financials, App Annie, and Focus Equity Estimates
dollars in billion
Tencent
NetEase
Games Revenue 2016
2.6
4.03
Apps as of March 2017
400
267
The company enjoys an extended gaming lifecycle
The table clearly depicts NetEase is more efficient in terms of generating revenue from its games. What's more interesting is that the company is at a fourth position in terms of game downloads during March 2017, yet it holds the second position in term of revenue generated. This indicates that NetEase's games have an extended revenue life cycle. While others are trying to capture revenue from new games, NetEase's older games are assisting in maintaining the company's top line. Note that NetEase consistently had three to four games in top revenue generating charts during the last six months.
NetEase trades at a reasonable valuation
The stock is trading on the low-side according to an EVA based valuation. Consensus earnings for 2017 and 2018 are used as earnings proxy. Earnings are assumed to grow at 5% p.a. during 2019-2022. 1% growth is assumed in perpetuity. Cost of capital is expected to grow in line with earnings growth. Required rate of return incorporates inflation and the risk-free rate.
Projections
2017
2018
2019
2020
2021
Perpetuity
Notes
Amounts in million
Net Income
2061.84
2378.64
2473.79
2572.74
2675.65
2782.67
Cost of capital
r*capital invested
506.8
582.8
606.2
630.4
655.6
681.8
1555.02
1795.80
1867.63
1942.34
2020.03
2100.83
Adjusted Net Income
1555.02
1795.80
1867.63
1942.34
2020.03
2100.83
Discount factor
1.00
0.93
0.87
0.80
0.75
11.52
Economic Value Added
1555.02
1670.51
1616.12
1563.50
1512.60
24201.58
Period
0
1
2
3
4
5
Market value added
32119
Invested Capital
5539
Value of the equity
37658
Perpetual Growth in Residual Earnings
2%
Price Target
285.3
Focus equity estimates
Netease currently trades around $266, which is at a discount to the price target of $285. Valuation reveals an upside of around 7%-10% based on above presented assumptions. Note that, it's improbable that the company can surpass assumptions as 22% growth is assumed for 2017 earnings and 15% growth is assumed for 2018. Given that gaming is set to grow at 12% p.a. during the next five years, it's highly unlikely that NetEase surpasses the estimates during the next couple of year. Therefore, this valuation should be assumed to be the upper bound for NetEase.
Investment risks
Low barriers to entry are a significant risk in the mobile gaming arena. As mobile games can be created in a short period of time without any significant investment, profusion of mobile games can make it difficult for NetEase to outperform competitors consistently. Companies must innovate to keep in top charts in order to generate meaningful revenue.
Final thoughts
NetEase is a mobile gaming leader alongside Tencent in China. Therefore, the company is exposed to the double digit growth in China's mobile gaming market. Expansion in new markets is expected to further boost the company's revenue. Moreover, NetEase generates a higher amount per game as compared to its counterparts. Longer life cycle is also one of the key advantages for the company. Overall, given the prospects in China, NetEase's ability to generate premium revenue and reasonable valuation, the stock is a buy.
Disclosure: I have no position in any stocks mentioned and no plans to initiate any positions in the next 72 hours.
