NetEase's (NASDAQ:NTES) stock price rose over 50% this year as the Chinese tech giant impressed investors with the resilience of its gaming, online education, and advertising businesses throughout the COVID-19 crisis.

NetEase's recent second-quarter report supported that bullish sentiment by easily surpassing analysts' expectations. Its revenue rose 26% annually to 18.2 billion yuan ($2.6 billion), beating estimates by $130 million.

Its adjusted net income rose 32% to $5.70 per ADS, beating expectations by $1.08. Its adjusted net profit from continuing operations, which excludes the impact of several divestments over the past year, grew 35% to $0.23 per ADS. NetEase's earnings beat was impressive, but does the stock still have room to run? 

A woman plays a smartphone game.

Image source: Getty Images.

Its streamlined business segments are growing

Last year, NetEase sold Kaola, its cross-border e-commerce marketplace, to Alibaba for $2 billion. It also spun off its online education unit Youdao (NYSE:DAO) in an IPO but maintained a majority stake in the company.

Those two deals condensed NetEase's business from four units (online games, e-commerce, innovative businesses, and advertising) to just three (online games, Youdao, and innovative businesses and others) by the third quarter of 2019.

During the second quarter, NetEase generated 76% of its revenue from online games. The innovative business and others segment, which includes its advertising business, Yanxuan e-commerce marketplace, and its music streaming service, accounted for 21% of its revenue. Youdao generated the remaining 3% of its revenue.

All three businesses generated robust growth during the quarter, led by an acceleration in online games and innovative businesses segments:

Revenue Growth (YOY)

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Online Games

11.5%

5.3%

14.1%

20.9%

Innovative Businesses and Others

4.5%

17.9%

28%

38.7%

Youdao

98.4%

78.4%

139.8%

93.1%

Total

11.2%

9.2%

18.3%

25.9%

Source: NetEase.

NetEase's gaming business, which generated 72% of its revenue from mobile games instead of older PC titles, benefited from the strength of its flagship Fantasy Westward Journey games and self-developed games like Invincible, Life-After, and Knives Out.

NetEase attributed the growth of its innovative businesses segment to higher membership and live streaming revenue from NetEase Cloud Music, while Youdao benefited from the expansion of China's online education market, which received a big boost from the COVID-19 lockdowns earlier this year.

Stable gross margins with weaker operating margins

NetEase's gross margins expanded annually across all three businesses, but its gaming gross margin contracted sequentially.

Gross Margin

Q2 2019

Q1 2020

Q2 2020

Online Games

63.1%

64.1%

63.8%

Innovative Businesses and Others

15.5%

15.8%

18.5%

Youdao

32.9%

43.9%

45.2%

Total

53.5%

55%

53.8%

Source: NetEase.

During the conference call, CFO Charles Yang said the gaming unit's gross margin remained "generally stable, fluctuating quarter-to-quarter within a narrow band" based on a shifting mix of mobile and PC games.

The innovative businesses unit's margin expanded as NetEase Cloud Music monetized more users and its advertising business rebounded from the COVID-19 crisis in the first quarter. Youdao's profitability also improved as its increased scale allowed it to cut costs.

Netease's gross margins look healthy, but its operating margin contracted annually and sequentially in the second quarter.

Operating Margin

Q2 2019

Q1 2020

Q2 2020

Total

25.8%

26.3%

22.9%

Source: NetEase.

It attributed those declines to higher marketing expenses for its online games, bigger promotions for Youdao in the competitive e-learning market, a higher headcount, and rising R&D expenses. However, NetEase's robust revenue growth still lifted its operating profit 12% annually, so investors shouldn't fret over its operating expenses unless its revenue growth decelerates.

But don't ignore the headwinds

NetEase didn't provide any forward guidance, but analysts expect its revenue and earnings to rise 24% and 15%, respectively, in USD terms this year. Its stock trades at a reasonable 25 times forward earnings, and it pays a decent forward dividend yield of 1.25%.

However, investors shouldn't ignore NetEase's two biggest challenges. First, it competes against its larger rival Tencent (OTC:TCEHY) in the online gaming, online education, and music streaming markets. A prolonged war with Tencent could throttle its growth and squeeze its margins.

Second, the U.S. Senate recently passed a bill that could force Chinese companies to delist their U.S.-listed shares if they don't comply with new regulations. For investors with access to overseas exchanges, NetEase's new Hong Kong-listed shares might be a safer bet than its Nasdaq-listed shares.

The bottom line

NetEase has wisely streamlined its business over the past year, and its core growth engines are well-insulated from the pandemic and other macro headwinds. Competition and regulatory issues in the U.S. remain long-term challenges, but I firmly believe NetEase's strengths outweigh its weaknesses -- and its stock could easily hit new all-time highs later this year.

 
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.