What to do about NetEase (Nasdaq: NTES ) ?
I recommended the stock to Motley Fool Rule Breakers subscribers nearly three years ago, when it was a fast-growing player in the booming online gaming market in China. It worked out well. The stock's return has been more than triple that of the S&P 500.
So what's wrong? Well, last night's quarterly report has me concerned about the company's growth prospects. Total revenues of $76.2 million came in flat with last year's showing. Earnings of $0.27 a share clocked in below both the $0.30 per share it earned a year ago and the $0.29 a share that Wall Street was looking for. The company's gaming and online advertising subsidiaries held their own, but an operating loss in its dwindling value-added wireless services rocked margins for the period.
NetEase used to be a speedster. It was able to grow its Web-based gaming presence easily on the strength of its bread-and-butter Fantasy Westward Journey title. Its role as the top dog in free Internet email greased the company's way into being a major online portal.
So where is the growth? The gaming industry is the biggest concern, since it accounts for 82% of the revenue mix. NetEase has been stagnant there -- for a few quarters now -- as the market waits to see whether new games like Westward Journey Online III and Tianxia II can take the baton. Government crackdowns on Internet cafes and regulations on minors' playing time could have dented the niche, but NetEase is pretty much the only major player smarting.
Smaller companies like The9 (Nasdaq: NCTY ) and newly public Giant Interactive (NYSE: GA ) are growing nicely in this environment. Even Shanda Interactive (Nasdaq: SNDA ) -- the company that NetEase once displaced at the top of China's gaming market -- has bounced back with an assortment of fee-based and ad-supported casual games.
Other Chinese heavies are also getting in on the fun. Sohu.com (Nasdaq: SOHU ) runs the country's top online gaming portal. China.com parent CDC (Nasdaq: CHINA ) is priming its pipeline of games.
Can NetEase remain a growth stock if others keep crashing the party? Shanda was able to bounce back -- and that's encouraging -- but will lightning strike twice in the same niche?
The interesting thing here is that NetEase's allure as a growth stock may be waning, just as its potential as a value stock is bubbling. The company has earned an adjusted $1.17 per American depositary share over the past four quarters, bringing its P/E ratio into the teens. You don't find too many domestic video game developers fetching that kind of multiple, even before you begin to factor the upside of having a prominent role in China's improving economy.
The company also has more than $3 per share in cash. That cushion may be a long way down, but keep in mind that NetEase is still quite profitable on a deliciously thick 46% in net margins.
Sure, NetEase may not seem like a growth stock at the moment. That doesn't mean that it's a bad investment, especially if the negative reaction to last night's report makes the valuation that much more attractive.
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