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Why NetEase's Dip Is an Opportunity in Disguise

By Harsh Chauhan - Aug 16, 2017 at 9:46AM

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NetEase's post-earnings stock price drop doesn't dilute the long-term opportunity. Mobile games are set to keep growing.

Shares of NetEase (NTES -0.34%) are down about 12% since the company reported terrific second-quarter results on Aug. 9. The Chinese video gaming giant easily surpassed Wall Street's expectations on both revenue and earnings, but its shares fell as part of a broader decline in Chinese stocks.

But investors shouldn't get bothered by the post-earnings stock price drop. NetEase's latest quarterly report shows that it is pulling the right strings to tap the massive opportunity in the Chinese mobile gaming market, while also harboring international ambitions. Additionally, the company has built a strong pipeline of new games that should act as long-term catalysts.

Here are some of the key takeaways from NetEase's second-quarter report that show why it is built for growth.

A young woman smiling and looking at a smartphone.

Image Source: Getty Images

Mobile will get better

Mobile gaming now supplies 72% of NetEase's overall revenue as compared to 61% in the second quarter of 2016. This impressive growth was driven by the company's shrewd strategy of using the popularity of its PC games to gain more users on the mobile platform. Additionally, NetEase has kept refreshing its legacy games with new content to keep players engaged.

Looking ahead, NetEase's mobile business is set up for stronger growth thanks to the impending launch of the highly popular Minecraft franchise. The PC version of this game is already in the beta-testing phase, and the mobile beta-test phase is expected to start soon.

The company expects to commercially launch this game in the current quarter, paving the way for stronger top-line growth as this game is played by more than 100 million registered users. What's more, over 50% of Minecraft players in the Asia-Pacific are on mobile, so it won't be surprising if the game turns out to be a hit in the Chinese market.

But the good news for NetEase investors is that it is looking to expand beyond China into markets such as Europe, North America, and other areas of the Asia-Pacific region. The company's Onmyoji title has already gained impressive traction in Japan and Southeast Asia, clocking a record number of downloads last quarter.

NetEase is now optimizing this game for the other international markets mentioned above. This sets the company on its way to tap a $50 billion-plus mobile gaming opportunity in North America and Europe combined. So, NetEase's mobile gaming growth won't run out of steam anytime soon if it manages to make a dent in these new areas.

The margin decline continues

NetEase's increased contribution from mobile games has a downside in the form of weaker margins. The company's overall gross profit margin fell to 55% last quarter as compared to 59% in the prior-year period as mobile games have a relatively lower gross margin profile. More specifically, NetEase's gross margin from the online gaming business was down 3.1 percentage points year over year.

Looking ahead, the decline in NetEase's gross profit margins should continue on the back of its growing mobile gaming business. But as has been the case so far, rapid top-line growth should help it mitigate the lower margin profile and lead to a better earnings performance.

NTES Gross Profit Margin (TTM) Chart

NTES Gross Profit Margin (TTM) data by YCharts

Cheaply valued

NetEase shares continue to remain cheap despite the company's rapid growth. The company trades  at 21.6 times last year's earnings, which is significantly cheaper than the industry median of 33. Additionally, a forward price to earnings (P/E) ratio  of 17 signifies that its bottom line is expected to keep growing.

Consensus estimates  indicate that NetEase's earnings could jump to $16.02 per share in 2017 from $13.06 last year. The momentum is expected to continue next year as well, with projected earnings of $18.57 per share.

Harsh Chauhan has no position in any stocks mentioned. The Motley Fool owns shares of and recommends NetEase. The Motley Fool has a disclosure policy.

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