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World of Warcraft’s Decline Cannot Hold This Company Back

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NetEase's (NASDAQ: NTES  ) performance so far this year has been nothing short of impressive. 2012 wasn't a great year to be a NetEase investor as the stock's performance tapered off toward the end of the year on the back of weak earnings reports.

NetEase has gained close to 75% year-to-date. Moreover, its recently released earnings report and upcoming strategic moves indicate that more upside is in store for NetEase investors. So, even though analysts at Nomura Securities have downgraded the stock, a look at the company's prospects and strategies will tell us that there are solid reasons to stick with NetEase.

In the second quarter, NetEase's revenue jumped almost 20% to $369 million (excluding sales tax), beating the consensus estimate of $363.5 million. Diluted earnings came in at $1.37, well ahead of the consensus estimate of $1.24 and significantly up from last year on the back of NetEase's share repurchase program and higher revenue.

Avoiding the drop
Most importantly, NetEase's focus on developing its own games helped it mitigate the decline in subscribers of Activision Blizzard's (NASDAQ: ATVI  ) World of Warcraft. NetEase has the exclusive license to operate the game in China, but of late, the subscriber count of the popular game has dropped significantly.

In the previous quarter, Activision reported that WoW had 7.7 million subscribers, a drop of 600,000 on a sequential basis and the lowest ever count in the last six years. What's more worrying is that the majority of this drop is coming from China, where NetEase operates the game. Activision Blizzard's cult game has been on the market for long, and as such, the precipitous drop in the subscriber count can be expected as players look for a new experience.

But, Activision is still trying to infuse some life into the game, like it has done so far through expansion packs. It has been trying to move to a free-to-play model and promote in-game purchases. Such moves on Activision's part may or may not benefit its licensing partner NetEase, depending on the outcome of such strategies, but NetEase has already been switching gears so that it doesn't have to depend much on Activision Blizzard.

Playing with a good strategy
NetEase's self-developed games seem to be doing really well. The company has already brought out a few games this year, such as Heroes of Three Kingdoms and Dragon Sword. Going forward, NetEase plans to go on a marketing blitz to attract more gamers to its stable and as such, it might incur higher expenses. But, the company can benefit from the long-term success of these games through expansion packs and newer content.

Like many others in the industry, NetEase is also looking to keep gamers interested by releasing fresh content. As such, it introduced expansion packs for Ghost II and Fantasy Westward Journey II recently. This strategy of introducing expansion packs is a tried and tested one and can help game publishers enjoy revenue for long periods of time. For instance, Activision Blizzard has kept World of Warcraft running with four expansion packs in eight years.

So, it's not surprising that NetEase is also moving in the same direction as it intends to release a couple of expansion packs for its games next month apart from the two it released last month. Going forward, NetEase has a first-person shooter game and Legend of Tibet, a massively multiplayer online role playing game, in the works.

Looking at mobile
In addition, the company is also looking to make its presence felt in mobile games, and smartly moved into the platform introducing a mobile version of Fantasy Westward Journey II. Management says that NetEase will be launching "several mobile games" in the next few months. NetEase will be looking to leverage the popularity of its existing self-developed titles by introducing them for mobile devices, and it will release new mobile games as well.

The push into mobile is important, as mobile gaming in China is estimated to grow at a brisk pace of 26.3% annually through 2015, according to Sino Market Insight. As such, NetEase is making the right move by focusing on developing its mobile portfolio. But, competition is expected to be intense in this space, with the likes of Tencent (NASDAQOTH: TCEHY  ) betting big on mobile.

Tencent is one of the biggest game operators in China and is the provider of the popular WeChat service. Recently, it introduced a new feature for WeChat that would enable users to play freemium games (free to play but users need to pay for in-game purchases). Moreover, management says that Tencent won't spare any expense in buying game developers and developing more free-to-play content, as told to Reuters.

But, the mobile gaming market is a pretty big one in China and it could easily accommodate more than one company. If NetEase's mobile games click, then there would be even more upside in store for investors.

The bottom line
Even after appreciating strongly this year, NetEase still trades at a reasonable trailing P/E of 15, and a forward P/E of 12 indicates that analysts are expecting earnings growth. Moreover, the way management executed the strategy of building its own games and trim down dependence on World of Warcraft is laudable, and there are some solid reasons for investors, as outlined above, to expect NetEase to perform even better in the future.

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