NetEase: is the gaming company a clear buy?

History

NetEase was founded in June 1997 and the company (from a legal standpoint) was incorporated on July 6, 1999, in the Cayman Islands. However, the principal offices are located at NetEase Building, in Guangzhou, People’s Republic of China.

The story of NetEase is rather synthetic, as it doesn’t yield value to undergo a complete analysis on the story of games published in the years.

Here are the major points:

• 1997: Founding of NetEase
• 1998: Launch of free web-based e-mail services. The business model shifted from software development to internet technology with the launch of NetEase website (“www.163.com”).
  The origin of 163 is historical: in the early days of internet connection, Chinese users had to dial 163 to be able to connect to the World Wide Web.
• 1999: Launches of advertisement services, online platforms, online shopping malls, and other internet services in China
• 30 June 2000: Listing on Nasdaq
• 2001: Introduction of fee-based premium services and online entertainment services, including online games
• 2001: Launch of the first PC-client MMORPG game, Westward Journey Online, a widely popular in-house developed game series
• 2004: Launch of Fantasy Westward Journey series, the second widely popular original game series
• 2006: Founding of Youdao, an education company that now offers learning content, applications and solutions, as well as online marketing services
• 2013: Launch of NetEase Cloud Music, a music streaming platform
• Still during 2013: Launch of first mobile game, the mobile version of Fantasy Westward Journey
• 2015: Launch of the e-commerce platform, Kaola
• 2016: Launch of Yanxuan, a private label e-commerce business
• 2019: Kaola is sold to Alibaba in a deal in the area of $ 2 billion
• 26 October 2019: Listing of Youdao on the New York Stock Exchange 
• 11 June 2020: Listing on Hong Kong Stock Exchange

Structure of the Company

Image source: NetEase 2020 Annual Report

The structure of NetEase is the same that is typical of almost all the Chinese companies: a holding company in a tax haven, to access American stock exchanges, and sub-holdings through which organizations inside China are controlled.

In August 2008, Blizzard agreed to license certain online games to Shanghai EaseNet for operation in the PRC. 

Shanghai EaseNet is a Chinese-resident company, wholly owned by William Lei Ding, the Chief Executive Officer, director and major shareholder. 

This firm, based in Shanghai, has contractual arrangements with the joint venture established between Blizzard and NetEase. This joint venture sees both parties having half of the interest.

The joint venture was established concurrently with Blizzard’s gaming licensing in August 2008 and provides technical services to Shanghai EaseNet.

Management Overview

Mr William Ding is the Founder, Director and Chief Executive Officer. 

William Lei Ding, the founder, has served as a director since July 1999 and as Chief Executive Officer since November 2005. From March 2001 until November 2005, Mr Ding served as Chief Architect, and, from June 2001 until September 2001, he served as Acting Chief Executive Officer and Acting Chief Operating Officer. From July 1999 until March 2001, Mr Ding served as Co-Chief Technology Officer, and from July 1999 until April 2000, he also served as interim Chief Executive Officer. Mr Ding established Guangzhou NetEase and Shanghai EaseNet, affiliates of NetEase, in May 1997 and January 2008. Mr Ding holds a Bachelor of Science degree in Communication Technology from the University of Electronic Science and Technology of China.

Mr Charles Zhaoxuan Yang is the Chief Financial Officer. 

Charles Zhaoxuan Yang has served as Chief Financial Officer since June 2017. Prior to joining NetEase, Mr Yang was an executive director of the China technology, media and telecommunications, and corporate finance team at J.P. Morgan Securities (Asia Pacific) Limited and based in Hong Kong for almost a decade. Mr Yang currently serves as an independent director on the board of So-Young International Inc. (stock code: SY), a company listed on the Nasdaq Stock Exchange. Mr Yang holds a master’s degree in Business Administration from the University of Hong Kong and a bachelor’s degree from Wesleyan University with majors in Economics and Mathematics. Mr Yang is a Certified Public Accountant licensed in the State of Michigan.

Business Highlights

The online gaming sector is having a truly solid expansion, with Tencent and NetEase being the giants that control the largest shares of the market.

Just like the best globally known Tencent, also NetEase can count on several businesses apart from the gaming one.

Let’s see, then, how NetEase is able to produce value for its shareholders.

The management of the company divides the company into three main parts:

• Online Games through which the firm acts as:
  • A developer and operator of self-developed games for internet users inside mainland China and internationally;
  • An operator of licensed games from Blizzard Entertainment, Mojang AB (Microsoft company) and other international developers;
• Online Education: NetEase offers educational services for people of all ages via its subsidiary Youdao, listed on the New York Stock Exchange (NYSE: DAO);
• Innovative Businesses and Others: in this part, the management puts NetEase’s music streaming services as well as news. Another business in which the company is invested is a private-label e-commerce,  Yanxuan, which targets the Chinese middle class, with a strong emphasis on quality of living.

While the online games and innovative businesses are growing at a slow but steady pace, the online education side of the company is growing rapidly, and it’s also expected to continue to do so in the long run.

Online Games

After several blockbuster titles for Personal Computer, NetEase experienced real growth and international recognition with mobile games.

The company now operates over a hundred mobile titles of various genres.

The sale of “game upgrades” inside the apps accounts for more than 71.9% of the revenue generated from the online games business, as of 31st December 2020.

Instead, revenue from licensed games has reached 9.1% in 2020, increasing from 7.5% of the two previous years.

The company actively invests part of the cash generated from operations into R&D, to support the continuous development of new games.

As a consequence of this focus on innovation, NetEase boasts several proprietary gaming technologies:

• Proprietary game engines: NeoX and Messiah enable the company to systematically develop mobile games with the highest quality in lighting, audio, special effects, physics and animation, and other key game features, while a drive for better games, in turn, motivates the development of more powerful engines.
• User profile analytics: NetEase performs an in-depth analysis of users profile by analyzing activities and performances in games, in-game purchasing preferences and other data and information with artificial intelligence. Leveraging the user data on an aggregate basis, the company is able to guide game development and upgrades, marketing and other activities.
• Intelligent non-player characters (NPCs): Enabled by deep learning technology, NetEase has created intelligent NPCs that can join players’ in-game activities, simulate real-life interactions, facial expressions and body language and enable a more engaging gaming experience. The company also deploys multiple reinforcement learning technologies to produce NPCs with diverse styles and difficulty levels, catering to a wide range of player preferences.
• Natural language processing (NLP): NetEase applies NLP technology inside games to enable players to develop their own storyline by carrying out conversations with NPCs and explore hidden elements in the game, creating an immersive gaming experience for players.
• Advanced game graphics: Advanced game graphics enables game players to create unique characters with customized facial features. NetEase also offers automatic character customization based on real-life photographs uploaded by players. In addition, the company deploys high-quality 3D game graphics and automatic scene generation inside the games.

Online Education (Youdao)

Youdao is an intelligent learning company in China with over 120 million MAUs in 2020 and operates in several overseas markets. NetEase founded Youdao in 2006 and launched the flagship Youdao Dictionary in 2007, which remains the top language app in China in terms of MAUs. Youdao experienced rapid growth since its founding and completed its public listing on the New York Stock Exchange in October 2019.

Building on the early success of Youdao Dictionary, the company has attracted a massive user base. Furthermore, the firm built a strong brand, and expanded into a broad range of products and services addressing lifelong learning needs of pre-school, K-12 and college students as well as adult learners, including online learning services and smart devices. Youdao’s smart devices seamlessly integrate advance AI algorithms and data analytics which supplement the online courses and learning products and further enhance user experience and efficiency.

The majority of the revenues produced from this side of the business are generated from the courses’ tuition fees.

Other Innovative Businesses and Services

Innovative businesses’ and others revenues are generated from NetEase Cloud Music, Yanxuan, NetEase CC Live streaming, advertising services, premium e-mail and other value-added services.

NetEase Cloud Music

The group launched the NetEase Cloud Music streaming platform in April 2013. Since then, NetEase Cloud Music has focused on delivering a differentiated and premium listening experience regarding the quality and variety of music offered. NetEase Cloud Music is home to a large number of independent musicians. NetEase Cloud Music operates under a freemium business model in which essential services are free while some enhanced features are available on a paid basis. In addition to providing the main music playback, download and search services, we also offer music social functions, such as song reviews, song list recommendations based on historical playback records.

In 2019, the company also added a new community module, Cloud Village, to further develop a music community that fosters discussion, creation and sharing of personalized expression around music. Also, the firm launched a music-inspired live streaming app, LOOK in 2018 to provide an additional platform for independent musicians and other performers to showcase their musical talents and interact directly with their audience. Fans can leave comments and send virtual gifts to broadcasters while they perform live. In early 2020, NetEase hosted an online music festival where more than 50 artists live-streamed their performances to a massive audience across China. In the newly launched Cloud Music version 8.0, the company focused on bringing young users elevated personalized experiences to express themselves. 

Yanxuan

NetEase’s e-commerce platform, Yanxuan, primarily sells private label products, including consumer electronics, food, apparel, homeware, kitchenware and other general merchandise which is primarily sourced from original design manufacturers, or ODMs, in China. With its slogan Quality Products, for Quality Life, Yanxuan is dedicated to helping consumers build quality yet affordable life by providing selected daily life products with outstanding quality and design.

Under Yanxuan’s ODM model, it establishes close partnerships with selected manufacturers in China to design and manufacture products and sells them directly to customers. The ODM model enables Yanxuan to provide quality goods at lower cost by eliminating brand premium and channel intermediaries such as distributors and retailers. It also utilizes data analytics to help these suppliers enhance their efficiency and product appeal, particularly in terms of merchandise design and production. In addition to the online platform, Yanxuan has also opened several offline stores in Hangzhou and Shanghai, inviting more consumers to discover the popular items on the Yanxuan through experiential retail.

Competitors and Threats

Tencent is the main competitor of the company. However, many analysts believe firmly that NetEase has a competitive advantage over Tencent, for its groundbreaking gaming technologies and its online education division. 

Especially the latter pertains to a hyper-growing sector that allowed the company to see its revenues growing.

While the competition is fierce, the company has all the weapons to continue growing and outperforming Tencent and more players in the market.

Financial Performance

The income statement indicates a growing company with positive gross profit margins.

Revenue figures grew by more than 20% between Q1 2019 and Q1 2020, with a further 24% growth during the last twelve months.

Gross profit margins went from 56.6% in the twelve months ending on 31st of March 2019, to 53.6% a year later and 52.7% in the last twelve months.

Margins are getting thinner, even though NetEase still boasts comfortable levels of Gross Profit as a share of Revenues.

General and administrative expenses followed more than proportionally the revenue figures and the R&D expenses have been carefully augmented, as sales were ramping.

Despite the expenses, needed to maintain the current status of market leader, NetEase has been able to keep its Net Income margin well over positive, ranging from 15.1% in the twelve months ending on 31st of March 2019, 36.2% in the following year and 16.8% in the last twelve months.

This last year, NetEase enhanced its “benchmark” performance tracing back in 2019: the twelve months ending on 31st March 2020 have seen the company register profitability levels in outlier levels, given the effect of restrictions due to COVID-19 that benefited its business.

Due to the characteristics of all the businesses in which NetEase is invested, we can observe a liquid patrimonial structure: most of the assets and liabilities that are recorded in the company’s balance sheet are short-term and highly convertible in cash.

During the last two years, the company had a higher leverage level. Through last year, the management was able to bring it to a safer point.

In particular, as of 31st March 2021, the company presents a healthy capital structure divided into ⅔ of equity and ⅓ of debt.

The cash flow statement shows a company able to reach shareholder’s goals, while preserving investing inside the firm.

In fact, we see a continuous reinvestment of the funds accumulated from operative activities into betterment and improvement of lines of business with high-growth potential (Youdao) and maintenance of the other parts through structural injections of capital.

While the last year presents a negative unlevered free cash flow, we feel confident that it doesn’t constitute an issue to the company’s ability to grow and produce value for the shareholders.

Let’s now see what this value is, through our Valuation!

Valuation

Key Financials

Revenues are projected a cumulated annual growth rate of 12% over the next five years. The underpinning factors for this are the continuing growth in their three major categories of revenue generators Online Game Services, Youdao, and other Innovative Businesses. 

Revenue growth has been healthy; 16%, 15%, 16%, and 24% for years 2017, 2018, 2019, and 2020, respectively. However, Net Income has not been consistent and has had negative growth for the better part of the same time horizon: -8%, -43%, 245%, and -43% for years 2017, 2018, 2019, and 2020, respectively.

While Revenues have experienced an 18% CAGR, Net Income has had a CAGR lower than 1%. This can be attributed to an increase in Operating Expenses: Selling, General & Administration expenses went from 14% to 19% from 2016 to 2020; Research & Development costs went from 8% to 14%. 

From the breakdown, it can be seen that R&D has been significantly weakening operating margins. However, R&D has been the primary driver for the growth of their Online Games Services revenues, which is worth 60% of total revenues. 

If operating expense and cost structures are maintained at the current level, NetEase can see positive growth Net Income in the future as R&D continues to feed back into revenue growth. 

The negative YoY growth on Net Income in the LTM ended March 31, 2021, is a reflection of profits arising from online gaming services during the pandemic and the selling of the e-commerce business Koala to Alibaba from the LTM before, both of which are non-recurring and do not reflect the business during normal periods.

With that in mind, NetEase is still in the position to continue reinvesting into R&D, which has allowed their Online Games Services division to grow at the rate before.

Discounted Cashflow Analysis

The DCF indicated NetEase’s intrinsic value of $124.15 per share; NetEase is currently trading at $117.39 as of May 22, 2021.

Assumptions to the DCF are a 12% CAGR to revenue, 35% effective tax rate, an internal WACC of 5.56%, and an average terminal value based on EV/EBITDA of 15x and a perpetual growth rate of 2%.

 Comparables Analysis

The choice of the multiple to be used is not always easy with a business like the one of NetEase.
However, in our experience evaluating tech platforms, the Revenue multiples, which usually is inaccurate at best, give the best explanation of the results of the price that can be seen in the market. This is because the growth and success of a certain company are strictly tied to those metrics, as the bigger a platform is, the better the number of users and reach.

This analysis gives us a rather scattered output, but the current price seems to be in a middle area between the more rigorous EV/EBIT and EV/EBITDA and the more permissive EV/Revenues and P/Sales.

One thing to notice is that the market has been on a bull run for long years and we believe that specific industries, like the tech/online platform ones, have inflated multiples and might experience a correction.

Youdao

Youdao is currently operating with negative operating margins of -50% for the past three years operating at a net loss, reporting -$268 million in 2020. The segment has been experiencing significant growth since its IPO with revenue YoY revenue growths of 61%, 78% and 143% for the years 2018, 2019, and 2020 respectively, 

Despite Youdao’s spectacular growth, the company is still too small to contribute any significant improvement on its parent company’s financials if they ever manage to turn around their operating margins and begin to generate profits. Youdao will continue to be cash outflow to NetEase and hurt the valuation of its parent company in the foreseeable future.

Youdao’s growth may see a plateau from weak demand for their educational services and devices, primarily from K-12 customer base, as China is witnessing the slowest population growth in decades.

Competition

There is mounting pressure to compete for market share from major competitor Tencent and new tech company entrants implementing aggressive growth strategies to expand their gaming divisions. For example, ByteDance outbid Tencent to acquire Moonton Technology in March, 2020. 

Despite growth in revenues for gaming giants NetEase and Tencent, Alibaba Group’s Linxi Games has stolen a slice of the total iOS game revenues pie as they grew from 0.38% market share to 6.64% from 2019 to 2020.

So is NetEase a buy?

The valuation conducted would suggest so.

From a business point of view, the company is solid and strongly investing towards creating further stream of income other than online gaming.

The online education wave is exciting, with a vast opportunity for NetEase to become a main Chinese and possibly global player.

The target price following our valuation is in an area between $ 120/share and $ 125/share. However, the charts show that, if a bullish movement happens, speculators could try to reach the price of $ 134.52/share, coincident with the second level of weekly resistance.

The price action shows the presence of a possible imminent bearish movement towards one of the major pivot points at $ 109.8/share before resuming an upper trend.

We will, obviously, closely monitor the movements and report them to our readers in our next update of this analysis.

Thanks for reading us, and continue following ChineseAlpha.com!