New Investment – We’d All Like a Few Hundred Million Customers

by Enis February 13, 2014 10:19 am • Commentary

NetEase, the Chinese gaming company, reported earnings last night.  We first profiled the stock in my Deep Dive post in late November, in which I concluded:

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.

Going through the earnings release, NTES delivered another strong quarter.  The gaming portfolio continues to expand, with management clearly focused on investments in the mobile gaming arena, where it is a relatively new entrant.  Its mobile presence is rapidly growing for its portal business, as its mobile news application has been downloaded more than 200 million times.  As a result, advertising services are commanding an increasing proportion of total revenues and revenue growth, which is helping to diversify the company’s exposure from more fickle gaming revenues.

The company announced its intention to pay a $1.40 dividend (after paying $1 last year), as well as a $100 million buyback, which is relatively small for a $9 billion market cap.

The reaction in the after-hours and pre-market has been tepid, but we like the technical situation for the stock here near multi-year support:

[caption id="attachment_36283" align="alignnone" width="600"]NTES weekly chart, 50 week moving average in pink, Courtesy of Bloomberg NTES weekly chart, 50 week moving average in pink, Courtesy of Bloomberg[/caption]


The $65 level is the high from 2012 and mid-2013 that has served as support in late 2013 after the stock’s August breakout.  It also coincides with the 50 week moving average.

Given the stock’s cheap valuation, at around 13x P/E and earnings expected to grow 10% per annum for the next few years, we like the entry today with the stock flat after a good earnings report, and less than 10% away from important support.

TRADE: Bought NTES for $71.72

We simply bought the stock for our investments.  Options are relatively wide and illiquid, and the stock’s valuation has us comfortable with the potential downside risk in the case of broader market weakness.  If the stock does fall to the $65 support area, we might look to add some upside leverage through options to this position, but starting out with just buying the stock for now.