Shares of NetEase (NTES -2.23%) popped last week after the Chinese tech giant posted its second-quarter earnings. Its revenue rose 15% annually to $2.73 billion, but that marked its slowest growth in five quarters and narrowly missed estimates by $20 million.
However, its adjusted earnings surged 20% to $4.09 per share, crushing expectations by $1.40 a share. NetEase mainly attributed that big beat to stable gross margins and lower marketing expenses for its online gaming and e-commerce businesses.
NetEase's stock rose less than 10% over the past 12 months, but that stability was impressive relative to other Chinese tech stocks, many of which were battered by worries about the trade war and the economic slowdown in China. So should investors consider buying shares of NetEase?
Image source: Getty Images.
The key numbers
NetEase generated 61% of its revenue from online games during the second quarter. About 28% came from its e-commerce business, 8% came from its innovative businesses segment, and the remaining 3% came from online ads. Here's how its four core businesses fared over the past year.
|
YOY revenue growth |
Q2 2018 |
Q3 2018 |
Q4 2018 |
Q1 2019 |
Q2 2019 |
|---|---|---|---|---|---|
|
Online games |
7% |
28% |
38% |
35% |
14% |
|
E-commerce |
75% |
67% |
44% |
28% |
20% |
|
Innovative Businesses |
43% |
32% |
14% |
5% |
23% |
|
Advertising |
7% |
2% |
3% |
(5%) |
(8%) |
|
Total |
22% |
35% |
36% |
30% |
15% |
YOY = Year-over-year. RMB terms. Source: NetEase quarterly reports.
The second quarter is usually a slower one for NetEase's gaming business, but older games like Fantasy Westward Journey, Invincible, and Onmyoji retained gamers, while newer games like Identity V and Knives Out (a battle royale title similar to Tencent's (TCEHY 3.68%) PUBG Mobile) expanded its reach into new markets like Japan.
NetEase's biggest rival in gaming is Tencent, which owns five of the top 10 highest-grossing iOS games in China, according to App Annie. NetEase's Fantasy Westward Journey, which ranks third, is the company's only top 10 game.
NetEase's e-commerce business consists of two platforms: Kaola and Yanxuan. Kaola is a cross-border e-commerce site that sells foreign goods to Chinese consumers. The unit was reportedly in talks to merge with Amazon China earlier this year, but no deal has been announced yet.
Yanxuan, which is growing at a much faster rate than Kaola, mostly sells generic "unbranded" copies of brand-name products. However, the platform's reputation as a "knockoff marketplace" is problematic and could attract regulatory scrutiny.
Image source: Getty Images.
The growth of both platforms decelerated over the past year due to the economic slowdown in China and competition from bigger peers like Alibaba, JD.com, and Pinduoduo. The growth of NetEase's advertising business also continued to decelerate due to competition and lower ad spending from companies.
However, NetEase partly offset those slowdowns with the growth of its innovative businesses unit, which includes NetEase Cloud Music (the second-largest streaming platform in China after Tencent Music (TME 4.63%)), its CC live video streaming platform, and its Youdao online education unit.
Rock-solid margins
NetEase's gross margin contracted both annually and sequentially to 43.3%, as improving margins in its e-commerce and innovative businesses were partly offset by lower margins in online games and ads.
|
Gross margins |
Q2 2018 |
Q1 2019 |
Q2 2019 |
|---|---|---|---|
|
Online games |
64.3% |
63.7% |
63.1% |
|
E-commerce |
10.1% |
10.2% |
10.9% |
|
Innovative Businesses |
(7.3%) |
(13.1%) |
1.4% |
|
Advertising |
67% |
49.5% |
55.5% |
|
Total |
44.5% |
44.1% |
43.3% |
RMB basis. Source: NetEase quarterly reports.
NetEase attributed its improved e-commerce margins to its supply chain improvements and higher sales volumes, while stronger sales growth and tighter cost controls boosted its innovative business margins -- which indicates that its highest-growth business is finally a profitable one.
Its gaming margins were weighed down slightly by higher royalty fees and revenue-sharing costs for certain games, and its ad margins were weighed down by lower revenue and higher expenses.
Meanwhile, a 5.5% year-over-year reduction in operating expenses boosted NetEase's operating margin 430 basis points to 18.6%. That improvement, along with share buybacks, helped it easily beat earnings expectations with 20% growth.
Robust growth at a reasonable price
Analysts expect NetEase's revenue and earnings to grow 16% and 13%, respectively, next year (in USD terms). The stock trades at a reasonable 18 times forward earnings and pays a forward yield of 1.2%, which is much higher than Tencent's paltry yield of 0.3%.
Its business model isn't perfect -- it relies too heavily on clone versions of hit games, Yanxuan's business model is vulnerable to regulation, and its ad business will remain a dead weight. However, its strengths outweigh those weaknesses. Its gaming business is faring well against Tencent, its innovative businesses are growing (particularly Cloud Music, which grew its subscribers by 135% annually during the quarter), and its tight cost controls and buybacks will support its future earnings growth.
Therefore, NetEase looks like a promising investment in China's tech sector, even as tough headwinds rattle the market leaders. However, investors should only nibble on NetEase at these levels, since trade war jitters could spark an irrational sell-off in the near future.
