With the market at all-time highs, it can be tough for investors to find stocks with much upside potential. But if you look closely enough, you'll still find plenty of lesser-known stocks that offer compelling growth at reasonable valuations.
One company that fits that description is NetEase (NTES 2.85%), a Chinese gaming and internet-services company that rallied nearly 60% over the past 12 months. Today, we'll examine NetEase's business model, growth rates, headwinds, and valuations to see why it's a smart buy at current prices.
NetEase's Tome of the Sun. Source: Google Play.
What does Netease do?
NetEase publishes PC and mobile games, develops social, news, and media apps, provides online services like email and note-taking services, and runs the e-commerce site Kaola.com. It also licenses games from Activision Blizzard.
The lion's share of NetEase's revenue comes from its gaming business. Its games -- which include Fantasy Westward Journey, Onmyoji, and Ghost Story -- mainly target Chinese gamers. According to Newzoo's latest numbers, NetEase's games claimed four of the top 10 spots (in terms of revenue) in the iOS app store in China in June, and three of the top 10 spots on Android in May.
How fast is Netease growing?
The popularity of Netease's games is reflected in its rapid growth. Its revenue surged 68%, to 38.2 billion yuan ($5.5 billion U.S.) in 2016, with gaming revenue accounting for 73% of that total. Analysts expect 41% sales growth this year.
Its other two business segments -- advertising and "email, e-commerce, and others" -- respectively posted double-digit and triple-digit sales growth last year. Both units posted double-digit sales growth during the first quarter.
NetEase is also highly profitable. Its non-GAAP diluted earnings surged 73%, to $14 per American depositary share in 2016, while its GAAP diluted earnings rose 72%, to $12.63 per share. Wall Street expects its non-GAAP earnings to grow 22% this year.
NetEase's hit game, Onmyoji. Source: Google Play.
NetEase's biggest competitors
NetEase's biggest rival is Chinese tech giant Tencent (TCEHY 1.91%), the biggest video game company in the world. Tencent published five of the top 10 Chinese iOS games in June, and four of the top 10 Android games in May. Its top title, King of Glory, is the top game on both operating systems.
Tencent owns Supercell, which produces the popular Clash of Clans and Clash Royale titles. Tencent is also a threat to NetEase on PCs, since it owns Riot Games, the publisher of League of Legends -- one of the most popular e-sport games in the world.
Nonetheless, NetEase is one of the few Chinese video game publishers that has withstood Tencent's blitz on the mobile-gaming market. Earlier this year, HSBC analyst Chi Tsang noted that NetEase continues to extend the life of its top titles and improve the monetization of its games. The company also has a pipeline of 17 new mobile games for the following two years, which should help it keep pace with Tencent.
What headwinds will it face?
The biggest near-term headwind for NetEase is the threat of new regulations on online gaming. The state-run People's Daily recently called Tencent's Honor of Kings digital "poison" that fueled game addiction among minors. Tencent responded by introducing daily time limits for younger users, but there are still concerns that an official crackdown could hurt Tencent, NetEase, and other mobile-gaming companies.
Another concern is that NetEase's shift from higher-margin PC games to lower-margin mobile games is reducing its gross margin. That long-term trend is easy to spot in the following chart:
Source: YCharts.
On the bright side, those margins remain high and should stabilize as NetEase finds its ideal balance between PC and mobile titles.
The valuations and dividends
NetEase trades at just 21 times earnings, which is lower than the industry average of 37 for internet information providers and its projected earnings growth this year. It also pays a forward dividend yield of 1.4%, and its low payout ratio of 22% indicates that it has plenty of room to raise that dividend.
Those figures make NetEase a rare find -- a tech company that's posting double-digit sales and earnings growth, yet trades at a discount to its peers and pays a solid dividend.
Should you buy NetEase today?
NetEase isn't a stock for queasy investors, since it's volatile and often stumbles on headlines about China or potential regulations on the mobile-gaming industry. But I believe that the rewards outweigh the risks, since NetEase has strong growth, a widening moat, and a low valuation -- which are all solid qualities for a long-term investment.
