Is This Gaming Company Primed for a Turnaround?

Chinese online gaming giant NetEase (NTES -2.17%) has been in a state of flux for almost a year now. The company started focusing on its in-house games when Activision Blizzard's (ATVI) World of Warcraft, to which NetEase holds the license in China, started showing signs of decay. But, just as NetEase's self-developed games were gaining momentum, Chinese consumers shifted their preference toward mobile games.

As pointed out by T.H. Capital analyst Tian X. Hou, massively multiplayer online role-playing games, or MMORPGs, are losing out to mobile games in China. The number of MMORPG gamers in China increased less than 1% in 2013 to 338 million users. However, mobile game users jumped an impressive 54% year over year to 215 million in 2013. 

In a state of flux
As such, NetEase was caught in the middle of a difficult transition. On one hand, the company had to focus on its self-developed MMORPGs to keep the top line strong. On the other hand, the company had to kick-start its mobile initiative to keep up the strong pace of growth to which investors had become accustomed.

However, at first glance, it seems that NetEase's initiatives just aren't enough. In the recently reported first quarter, NetEase performed below expectations. Its revenue of $380.5 million, although up 11.6% from last year, was well behind Wall Street estimates of $392 million. The bottom line also came in short of estimates.

The results weren't inspiring and didn't do much to support NetEase's flagging share price performance. However, a closer look at the results and the company's strategies reveals that NetEase is proceeding in the right direction.

Silver linings
The company's gross margin in its gaming business improved to 78.5% in the first quarter, up from 77.8% in the year-ago period. This shows that NetEase is monetizing its games more efficiently now. Also, the company was able to offset weak performance from World of Warcraft in China through its in-house games. NetEase has been aggressively developing its own games for the past year, after it became clear that World of Warcraft is on the decline.

As pointed out by Fool contributor Demitrios Kalogeropoulos, WoW's subscriber base is down 40% after peaking in late 2010. As such, it became important for NetEase to reduce its reliance on the NetEase franchise, and it has made some good progress in this endeavor. The likes of Tianxia III, New Westward Journey Online III, Legend of Fairy, and others have helped NetEase sustain its revenue growth, to some extent. 

The company recently further bolstered its portfolio by introducing an expansion pack for Ghost II. Now, it plans to provide expansion updates to its other titles. This is a tried and tested strategy because new content updates keep gamers coming back, and NetEase is trying to achieve the same with its popular titles.

Pipeline, WoW, and mobile
Going forward, the company has lined up more games to strengthen its portfolio. Revelation, its 3-D Oriental fantasy MMORPG, is currently under development and has garnered positive user feedback in the testing phase. Crisis 2015, NetEase's first-person shooter game, is lined up for release later this year, while the company is working with Activision to bring Heroes of the Storm, a free-to-play online team brawler game, to China. 

Moreover, Activision is trying to inject some life into WoW once again, and it has expanded the game's development team to improve the quantity and quality of new content to be rolled out in the future. Warlords of Draenor, the next World of Warcraft expansion pack, is expected to be out this December, which could help Activision arrest the decline in subscribers and, ultimately, benefit NetEase. 

Finally, NetEase is laser-focused on its mobile initiative. The mobile version of its Fantasy Westward Journey II title has been successful, and NetEase expanded this game's universe by launching Mini Westward Journey, its first mobile card battle game. To enhance the mobile experience, NetEase is adding social networking functions to its mobile games. For example, it is allowing users to log on to mobile games using YiChat accounts to share their gaming experience and achievements. 

The bottom line
All in all, NetEase is making a lot of good moves. Its own games are doing well, while Activision's expansion update later this year should lead to an increase in the number of WoW subscribers. The mobile initiative is also coming along well, and considering that NetEase is trading relatively cheap at 13 times trailing earnings, and carries a dividend yield of 2%, it looks like a good investment.