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NetEase Wins the Profit Growth Game

By Dan Caplinger – May 16, 2019 at 11:35AM

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The Chinese video game company gave investors welcome news after a tough spell.

It's always difficult for investors to weather slow patches for the companies whose shares they own, and for Chinese video game specialist NetEase (NTES 0.56%), troubles that began early last year have weighed on the stock for a long time. Despite solid growth, NetEase faces immense competition in the lucrative industry, and shareholders haven't seen the results that they've looked for from the video game giant.

Coming into Wednesday's first-quarter financial report, NetEase investors wanted the company to prove that it could keep growing both its sales and profits at a pace worthy of its business prospects. NetEase's report was encouraging, as earnings rose substantially and the video game maker showed that it can keep up with peers in key areas of the industry.

Animation of about a dozen small characters shooting laser weapons at a dragon surrounded by fire.

Image source: NetEase.

NetEase hits a new level

NetEase's first-quarter results were solid. Sales came in at $2.74 billion, and on a local currency basis, top-line growth of 30% compared to year-ago levels was consistent with what most of those following the stock had anticipated. Net income in local currency more than tripled over the same period, and adjusted earnings of $3.48 per share were considerably stronger than the consensus forecast among investors and more than twice what NetEase brought in during the first quarter of 2018.

As we've seen recently, the biggest source of NetEase's growth came from its online gaming business. Net revenue from online game services climbed 35%, and cost controls made the segment more efficient as well, as gross margin climbed more than 1.5 percentage points to 63.7%. The lower-margin e-commerce business also benefited from better conditions, with a 30% gain in revenue and a modest rise in gross margin to 10.2%.

However, there were some weaker performances within the company. The advertising services segment underperformed, with sales declines of 5% and a plunge of close to 10 percentage points in gross margin to 49.5%. The company's innovative businesses segment managed to boost its top line by 5%, but losses widened from year-ago levels.

NetEase cited multiple drivers of its growth. Familiar titles like Fantasy Westward Journey played useful roles, with new expansion packs drawing interest, while newer efforts like Night Falls: Survival and Invincible also helped the company's financial performance. More efficient operations in e-commerce were also notable contributors to growth.

CEO William Ding put the quarter into perspective. "Our heightened emphasis on online games, e-commerce, advertising, online education, and music," Ding said, "allows us to sharpen our focus on areas where we see the most potential for sustainable, long-term growth." The CEO noted that structural efforts internally to make the most of NetEase's biggest opportunities paid off during the quarter and should help in the future as well.

Can NetEase keep winning?

Part of the way that NetEase intends to build its business is through international expansion. The company said that games like Night Falls: Survivor and Cyber Hunter made strong initial showings in the Japanese video game market, and NetEase believes that its brand is becoming more well-known and recognized across the globe well beyond China's borders.

Dividend levels finally staged a complete rebound. The company declared a $0.69-per-share dividend for the quarter under its variable dividend policy, and that was quite a bit above the $0.48 per share it paid three months ago.

NetEase shareholders were happy with the results, and the stock jumped 7% on Thursday following the Wednesday night announcement. China will remain an ultra-competitive market for video game releases, and NetEase can't count on its reputation to ensure that it'll be able to take advantage of opportunities in the industry. However, with its recent efforts, the video game leader has proven that it can keep up with its rivals and move itself toward a more sustainable and faster growth trajectory over the long run. That's what long-term investors in NetEase want to see.

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

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