Shares of NetEase (NTES +0.36%) tumbled more than 30% this year, due to escalating trade tensions, a depreciating RMB, and a temporary freeze on new gaming approvals in China. However, NetEase also rebounded more than 10% over the past month, and the company posted solid third-quarter numbers that easily beat analyst expectations.
But will that recovery last through 2019? Let's take a closer look at NetEase's core businesses to find out.
Image source: Getty Images.
How fast is NetEase growing?
NetEase generated 61% of its revenue from online games last quarter. Its e-commerce platforms (Kaola and Yanxuan) were responsible for 27% of it, 8% came from email and other services, and the remaining 4% came from its online advertising business. Here's how those four businesses fared over the past year.
| Business Segment |
Q4 2017 |
Q1 2018 |
Q2 2018 |
Q3 2018 |
|---|---|---|---|---|
|
Online games |
(11%) |
(18%) |
7% |
28% |
|
E-commerce |
175% |
101% |
75% |
67% |
|
E-mail and other |
55% |
102% |
43% |
32% |
|
Advertising |
11% |
4% |
7% |
2% |
|
Total |
21% |
4% |
22% |
35% |
Year-over-year revenue growth, RMB terms. Data source: NetEase quarterly reports.
NetEase attributed the recovery of its gaming business to the popularity of internally developed mobile titles like Chu Liu Xiang, Knives Out, and Identity V; as well as popular PC games like Justice and Fantasy Westward Journey Online. NetEase currently publishes four of the top 10 highest-grossing iOS games in China, according to App Annie, while its rival Tencent (TCEHY 0.80%) publishes the remaining six.
Those games were all approved prior to the gaming approval freeze, which could last until the first half of 2019. Mobile games accounted for 68% of NetEase's online gaming revenue during the quarter.
NetEase's e-commerce growth, primarily supported by the explosive growth of its off-price marketplace Yanxuan, is decelerating. However, investors should note that Yanxuan uses a controversial strategy of selling "identical" unbranded versions of pricier products -- which leaves it vulnerable to crackdowns on counterfeit goods.
Image source: Getty Images.
The growth of NetEase's email and other business is buoyed by the growth of NetEase Cloud Music, the second largest music streaming platform in China after Tencent Music. However, its advertising business remains weak due to intense competition from market leaders like Tencent and Baidu (BIDU 1.76%).
Mixed profit margins
The growth of NetEase's core business units looks solid, but only the gaming business' gross margin improved year over year.
| Business Segment |
Q3 2017 |
Q3 2018 |
|---|---|---|
|
Online games |
62.5% |
65.1% |
|
E-commerce |
11.5% |
10% |
|
E-mail and Other |
13.1% |
(3.3%) |
|
Advertising |
68% |
63.6% |
Gross profit margins, RMB basis. Data source: NetEase quarterly reports.
NetEase's e-commerce margin contracted as it used bigger discounts to expand Kaola and Yanxuan, while its email and other margin dropped as it paid higher content licensing costs for NetEase Cloud Music. Its advertising margin contracted on higher staff expenses and content acquisition costs.
NetEase's operating expenses also rose a whopping 60% annually to 5.4 billion RMB ($792 million) as it expanded its businesses. This caused its operating margin to contract from 20.4% to 12.5%, and for its non-GAAP net income to decline 23% annually.
That's troubling when we compare NetEase's operating margin to the margins of Tencent, Alibaba (BABA 1.22%), and Baidu, which lead China's gaming, e-commerce, and advertising markets, respectively.
| Company |
Operating Margins, Most Recent Quarter |
|---|---|
|
NetEase |
12.5% |
|
Tencent |
35% |
|
Alibaba |
16% |
|
Baidu |
16% |
Data source: Quarterly reports.
NetEase is the underdog in all three markets, but it has lower margins than the market leaders. If it aggressively boosts its spending to keep pace with the market leaders, its earnings could continue to decline. That's why analysts expect NetEase's revenue to rise 25% this year, but for its earnings to fall 42%.
Stick with the market leaders instead
NetEase faces uphill battles in 2019, its expenses are rising, and the stock isn't cheap, at nearly 30 times forward earnings. I think Chinese tech stocks will eventually rebound, but I'd stick with market leaders like Tencent, Alibaba, and Baidu instead of this unbalanced underdog.
