Deep Dive – $NTES, A Chinese Internet Pioneer

by Enis November 29, 2013 8:16 am • Commentary

I termed Chinese internet stocks the “Oasis in the Desert” in this Macro Wrap post in June.  We expect attractive Chinese investment opportunities to remain few and far between in the coming years due to abundant overcapacity in the fixed investment arena.  The exception in such an unappealing investment environment is the Chinese internet sector.

In parsing the sector for investment opportunities, one name recently stood out to me on pure valuation vs. growth – NTES.  NetEase, at first glance, is a 13.5x P/E Chinese online gaming company with $1.5 billion in revenues and more than $700 million in earnings expected in 2013.  It’s a $9 billion market cap company expected to grow earnings by 10-15% over the next 2 years.

The cheap valuation (13.5x P/E for 10-15% expected earnings growth) is what first caught my attention, but I was also surprised to see that NTES is a $9 billion market cap, one of the largest Chinese internet companies around. (Aside from BIDU, the $50b+ giant, and Alibaba, soon to IPO, very few Chinese net companies are worth more than $10 billion.)

So I did some digging on NTES.    

The company was founded in 1997 by William Lei Ding as an early Chinese internet portal.  Mr. Ding still owns almost 45% of the company, and is only 42 years old.  NTES started its first online game in 2001, which is the division that now makes up the bulk of its revenues and profits.  The company’s in-house online games picked up in popularity in 2002 and 2003.

In 2003, the stock moved from $2.86 to a high of $18.00 in October 2003.  From that point, the stock essentially stagnated until early 2009, when it took off on the back of a license agreement with Blizzard Entertainment to bring World of Warcraft and Starcraft to China.  Since early 2009, the stock has quadrupled, in a steady trend of higher highs and higher lows:

[caption id="attachment_33134" align="alignnone" width="600"]NTES weekly, Courtesy of Bloomberg NTES weekly, Courtesy of Bloomberg[/caption]

(Note:  I drew the trend channel to demonstrate the consistency of the stock’s trend, not to suggest that the stock is overextended on the upside.)

Here is NetEase’s revenue breakdown:

1.  88% of revenues are from online gaming.  Part of that is from a license agreement with Blizzard Entertainment to offer World of Warcraft and Starcraft in China (first agreement was in 2008/2009; most recent agreement was a 3 year agreement signed in 2012).  The rest of it is from in-house developed online games, mostly the multi-player version similar to Warcraft that involves players interacting in a fantasy world, developing character traits and obtaining possessions along the way.  Most of the revenues from online gaming come from selling game-time to players on an hourly basis, across a variety of NetEase’s gaming platforms.

2.  9% of revenues are from online advertising.  NetEase operates a popular internet portal in China ( which offers a variety of news, entertainment, and community options for free.  Most of the online advertising revenue is generated off of that platform.  The site obviously caters to the male, 23-35 age demographic (one visit was enough proof for me).  Corporate strategy is to use the various online community platforms to entice new users for NetEase’s online games.  The online platform is quite popular.  It has had over 50 million mobile app installations.  The online translation tool, Youdao dictionary, has had over 300 million installations since inception.

3.  3% of revenues are from E-mail Services, Wireless Value-Added Services, and Other Services.  NetEase operates one of the largest free e-mail services in China, with over 500 million free email accounts registered.  However, only about 400,000 email accounts were of the VIP, fee-paying variety.  The company also offers various other services, like SMS from the internet to phones.

Online gaming is the driver of NTES revenues and profits over the past decade.  The company’s resources are increasingly devoted to innovative game development.  Earnings have increased from $2.09 per share in 2009 to $5.50 per share in 2013, a very impressive growth rate.  In fact, the company has grown earnings in every year over the last 10 years.

For a company with such consistent earnings growth, the stock’s multiple is surprisingly low.  Here is the 10 year chart of its trailing 12 month P/E:

[caption id="attachment_33135" align="alignnone" width="600"]NTES 12 month trailing P/E, Courtesy of Bloomberg NTES 12 month trailing P/E, Courtesy of Bloomberg[/caption]

The multiple has been between 10 and 20 since mid-2006, when the stock was trading around $15.  Since then, the company has increased earnings by almost 5x, and the stock has appreciated by almost 5x as well.  But why such a low multiple?

First, future earnings growth is expected to be much lower than in the past, at only 10-15% in 2014 and 2015.  However, NTES management has been quite adept at making targeted investments in the right areas.  While its World of Warcraft and Starcraft games have lost users in the past couple years, its in-house gaming portfolio has grown, with an increasing percentage of gaming revenues coming from selling items within the games as opposed to just charging players on an hourly basis to play the games.

Second, the company is behind in mobile.  None of its major online games is available for mobile users.  Management has emphasized its focus on mobile games in the future, but it’s a late mover in that arena.

Third, its online portal is a laggard in online video.  While other portal competitors (like BIDU, SOHU, SINA, and Tencent) derive an increasing percentage of advertising revenues from online video, NetEase is still dependent on mostly display advertising.  Online advertising has gradually become a smaller part of overall revenues for NTES, though, lessening the impact from the shift to video.

Fourth, investors likely view the gaming market as fickle, with NTES constantly at risk of competition.  In addition, the online gaming industry faces regulatory risks.  In 2005, the Chinese government ruled that Chinese citizens under the age of 18 are not allowed to participate in online games where players kill other players.  Expansion of such restrictions could be problematic, especially since NetEase’s marketing is targeted at Internet cafes and universities, where a number of players are indeed under the age of 18.

As for NetEase’s advantages, I would put its product diversification and its management expertise at the top of the list.  NTES has become one of the largest online gaming companies in China in the past 10 years, after initially starting out with no gaming focus.  The company has made valuable foreign partnerships (Blizzard), and improved its relationship with the Chinese government as well.  It has introduced a number of new products and features for both its gaming community and its online portal community, with no major hiccups in the process.

Finally, NTES is well placed, right in the middle of a secular trend in favor of online gaming, especially in China where overall online penetration still has plenty of room to grow.  Item-based gaming revenues are likely to dominate the gaming landscape in the future, and NTES has a head start in that area.  If it can introduce its massive community to mobile games as well, its gaming portfolio will continue to be the envy of the Chinese internet sector.

At its current multiple, the risk/reward on the long side looks quite attractive for NTES.  This is a company that has executed its strategy successfully through multiple business cycles.  Even given the various risks, NetEase’s diversification and sector expertise are unique.  We have this stock high on our watch list as a potential addition to our investment portfolio, either through simple long stock or through a longer-dated call structure.