NetEase (NTES 0.17%) has lost its wheels in recent quarters. Massive growth of the low-margin e-commerce business, as well as a slowdown in the video gaming business, has eroded the Chinese internet giant's earnings power, and the situation was no different last quarter.
NetEase's net income plunged 22% year over year in the second quarter even though revenue rose by the same percentage, driven by massive cost increases. Not surprisingly, NetEase shares plunged once again, and rightly so, as the company seems to be stuck in a vicious cycle of reporting weak margins quarter after quarter, as it is now relying on low-margin businesses for growth.
However, there is a silver lining that could work in NetEase's favor in the long run.
Today's pain, tomorrow's gain
NetEase's e-commerce business is growing at a very rapid pace and now accounts for a fourth of its total revenue. It supplied $660 million in revenue last quarter, an increase of 75% from the prior-year period. But at the same time, the segment's gross margin fell from 12.6% last quarter to 10.1% this time thanks to promotional offers that it had to run to capture more market share.
NetEase management made it crystal clear during the latest conference call that its target is to achieve scale in the e-commerce business at a "reasonable" gross margin. So the company is willing to compromise its margins in a bid to sustain the rapid growth, which is the right move, in my opinion, given the opportunity and competition.
NetEase is going up against well-established e-commerce giants such as Alibaba and JD.com, which is why it is busy spending billions to shore up its offerings and corner a bigger slice of China's e-commerce pie. For instance, the company will be spending $11 billion over the next three years to purchase foreign goods to sell in China.
This will help it satisfy Chinese consumers' thirst for foreign goods, as eMarketer estimates that 25% of the country's population will purchase foreign goods by 2020 through cross-border transactions. NetEase's Kaola platform reportedly commands nearly a quarter of Chinese cross-border e-commerce at present, and because this niche is expected to generate $75 billion in sales by the end of the decade, the company needs to sustain its impressive market share by adding more goods.
Assuming that NetEase manages to hold even 20% of China's cross-border e-commerce market by 2020, and it manages to maintain a 10% gross margin, its earnings will get a big shot in the arm. So NetEase's strategy of attaining a bigger e-commerce scale at the expense of margins right now is a smart one from a long-term perspective.
Gaming gets back on track
NetEase's online games revenue was down 19% during the first quarter of the year, but it turned around in Q2 as sales increased 7% annually. More importantly, the segment's gross margin inched up 1 percentage point year over year to 64%, even though mobile games supplied 75% of the total revenue as compared to 72% last year.
The fact that higher mobile gaming revenue didn't affect NetEase's online gaming margin negatively is a step in the right direction, as it indicates that the company is becoming better able to monetize its titles. For instance, NetEase's mobile gaming titles are striking a chord with gamers in foreign markets such as Japan. So it can now generate more revenue without having to incur a substantial increase in development costs and enjoy stronger margins.
NetEase is now looking to expand into more markets such as Europe and North America, and success there could help shore up its online gaming gross margin further. What's more, the company's online gaming business can gradually shift into a higher gear, as it has recently launched new PC and mobile gaming titles that have helped boost revenue.
Patience will pay off
NetEase is attractively valued right now. The stock's trailing price-to-earnings (P/E) ratio of 27 is significantly lower than the 42 industry average, while a forward P/E ratio of 18.9 indicates that bottom-line growth is in the cards. What's more, NetEase is undervalued on a price-to-sales basis as well, with a ratio of 3.7, which is nearly half the 7 industry average, so investors can get to enjoy its rapid sales growth on the cheap.
Now, there's no denying that NetEase has burned investors badly this year, but it might be a good time to accumulate its shares despite the recent headwinds as success in the e-commerce business and a recovery in online gaming should eventually help NetEase reclaim its mojo.