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Is NetEase in Trouble?

By Harsh Chauhan - Feb 25, 2018 at 1:26PM

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The latest results for the Chinese online-gaming and e-commerce specialist might raise concerns, but there's more to it than meets the eye.

NetEase's (NTES -3.39%) high-flying start to 2018 came to a surprise halt after the company's fourth-quarter financial report fell short of certain expectations. Investors saw the unexpected drop in the company's online gaming revenue and decided that was enough to hit the "sell" button despite a robust performance on the whole.

NetEase beat expectations on revenue and earnings. Its top line jumped 21% year over year to $2.25 billion, while consensus estimates were calling for $2.2 billion in revenue. The Chinese company also sprung a surprise on the bottom line, reporting adjusted earnings of $2.18 per share as compared to the $2.11 consensus forecast.

The problem, however, was a 10.6% drop in the company's online gaming segment, which supplies close to 55% of its total revenue. By comparison, NetEase had reported a massive year-over-year jump in online gaming revenue in the year-ago quarter. So, a drop in video gaming revenue despite the launch of new titles in recent quarters looked like a red flag.

A closer look

NetEase blamed lower contribution from its self-developed mobile games for the weakness in its online gaming revenue. Surprisingly, management didn't get into specifics and failed to address why its games didn't make a strong contribution despite recent content updates and new launches.

Man playing video game on a console.

Image Source: Getty Images.

A look at NetEase's conference call transcript shows that management updated a lot of its games to renew user interest, and launched popular titles such as Minecraft into the Chinese market. New content releases for Onmyoji and New Ghost led to "revised" user interest, and NetEase released Onmyoji in Thailand last November. As a result, the company said, the update saw old users returning to the game, while new players were brought into its ecosystem.

The company also reported that its Knives Out and Terminator 2 titles became blockbusters, clocking 100 million and 80 million registered users, respectively.

So, management's commentary over the latest conference call would make you wonder why NetEase's online gaming revenue fell last quarter. There seems to be a simple one-word explanation: monetization.

Though NetEase didn't specifically say that its newly launched games aren't making money just yet, it did drop enough hints. For instance, the company clearly stated that it kicked off the early phases of monetizing Knives Out and Terminator 2 in December, and will start monetizing Minecraft in the first half of 2018.

NetEase doesn't provide a forward-looking guidance. But if its monetization efforts are correct, then the online gaming business should start picking up the pace going forward. So, investors shouldn't be scared by the recent drop in video gaming revenue, as the company seems to be figuring out how to monetize the millions of users it has scored with its new titles.

More important, NetEase doesn't rely solely on its online gaming business anymore, as evident from the rapid growth of its e-commerce revenue.

E-commerce benefits from recent moves

NetEase's e-commerce business was on fire during the holiday quarter. Revenue from this segment shot up 175% year over year last quarter, driven by the company's efforts to expand its product portfolio. As it stands, the e-commerce business now supplies close to 32% of its total revenue, and it could keep improving thanks to NetEase's recent moves.

The company is focusing on giving users a wide range of items to choose from its e-commerce portals -- Kaola.com and Yanxuan -- and has been investing heavily in the businesses. Last November, NetEase announced that it will be buying $11 billion worth of inventory over the next three years from overseas markets such as the U.S., Europe, and Japan in a bid to attack the e-commerce opportunity in China.

The company is also boosting its infrastructure by opening warehouses in the country to shore up its fulfillment channels. China's e-commerce market could be worth $956 billion in 2022 as compared to less than $500 billion last year, so NetEase preparing itself to make the most of the opportunity in this space.

However, the growth of the e-commerce business will negatively impact the company's margins. More specifically, NetEase's gross margin from e-commerce stood at just 7.4% last quarter, a sharp drop from the 12.5% gross margin reported in the year-ago period.

NetEase's aggressive e-commerce push is coming at the cost of its margins because of the huge investments it's making -- such as the massive increase in selling and marketing outlay -- which is why its earnings fell last quarter. But the company can make up for the drop in margins by keeping up the rapid top-line expansion.

This is probably why Yahoo! Finance analysts expect the company's earnings per share to increase over the next two years despite a deteriorating margin profile. Investors shouldn't overreact, as NetEase is sitting on a number of catalysts that could boost its growth going forward. What's more, the recent crash in its stock price has made the stock cheap -- it trades at just 18.7 times last year's earnings, well below the 47.4 industry average.

The recent drop in NetEase shares could be an opportunity for investors to take advantage of both the growth in e-commerce and video gaming in China.

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