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Why Did NetEase Move Higher After a Bad Report?

By Rick Munarriz – Sep 1, 2021 at 10:05AM

Key Points

  • NetEase fell short of analyst profit targets in its latest quarter.
  • Regulatory agencies are cracking down on the time that minors can spend on online games, but that has never been a major part of NetEase's business.
  • Its e-learning business is in another segment that has come under fire by regulatory agencies, but it also had good news this week.

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The Chinese online gaming pioneer has a sloppy quarter, but the stock still moves up. Don't worry. It makes sense.

The headlines haven't been kind to NetEase (NTES 3.40%) this week. We woke up on Monday with news that China was cracking down on the amount of time that minors can play online games in the country, a pretty big deal since gaming represents the lion's share of NetEase's business.

NetEase went on to post its second-quarter results after Monday's market close, and it was another nugget of unimpressive news. Net revenue rose 13% to $3.2 billion for the three months ending in June, in line with expectations. However, earnings per share fell to $0.98 on an adjusted basis, below what analysts were expecting and below the $1.25 a share it posted a year earlier. 

NetEase has missed Wall Street's profit targets in two of the past three quarters. And now, regulators are making it harder for NetEase to do business on two fronts. However, the stock still managed to be one of Tuesday's biggest winners with a 9% gain. Let's take a closer look at why NetEase stock bucked the bad news during an earnings season when even companies delivering blowout results have come undone. 

A PC gamer in a neon room celebrating.

Image source: Getty Images.

Playing at a different level

NetEase has been refreshingly consistent as a growth stock over the years. It has posted positive top-line growth every single year since going public 21 years ago. It has managed to clock in with double-digit annual revenue growth for the past 13 years. 

Online PC and mobile app gaming has been the core business at NetEase. It's been slowing in the current climate, rising just 5% to $2.3 billion to account for 72% of the revenue mix in the latest quarter. However, one thing that factored into Tuesday's pop is that investors don't need to read too much into the troublesome news of Chinese regulators restricting usage among China's youth -- and leaning on real-name authentication measures to make sure gaming companies and minors play by the rules.

For starters, this week's move didn't come out of nowhere. Back in 2019 -- concerned about minors getting addicted to online gaming and disconnecting from school and family responsibilities -- China introduced measures that would limit youngsters to just 90 minutes a day and three hours on holidays. Monday's move does clamp down on the earlier initiative, limiting minors to enjoying online diversions between 8 p.m. and 9 p.m. on Friday, Saturday, and Sunday or any other holiday day. 

The big reason why the stock is moving higher following problematic restrictions on playtime and an iffy quarterly report is that it's not going to make much of a dent in NetEase's business. During this week's earnings call, NetEase explained that minors on its platform accounted for just 1% of the revenue. Naturally it's not great for NetEase shareholders to see regulatory agencies meddling in the industry, but the latest move won't really move the needle the way many investors feared.

There's also good news on another front. NetEase operates an e-learning platform called Youdao (DAO 17.16%). NetEase took it public in 2019, but it continues to own a controlling stake in the business. The for-profit educators have been slammed since regulators cracked down on that market earlier this summer. If you thought that NetEase had a good day on Tuesday, the much smaller Youdao soared 20%.

For starters, Youdao had a great quarter with revenue soaring 108%. It contributes just 6% of the revenue mix at NetEase, but it did play a starring role in pushing the 5% increase in the bread-and-butter online game services to a 13% year-over-year total top-line increase. Youdao also discussed how pushing into adult learning services -- a market that hasn't come under regulatory fire in China -- in March is helping. It now accounts for 22% of Youdao's business. Growth at Youdao will start to deteriorate at this point as the new regulations and restrictions in tutoring China's advantaged youth kick in, but at least the business is finding ways to diversify into new growth markets. 

Boiling down the ascending NetEase stock to "it could've been worse" is fair, but ultimately NetEase is a survivor. Its business is being tested on a couple of fronts, but it's still positioning itself to succeed. It also continues to return money to its shareholders. It declared a quarterly dividend of $0.24 a share -- in line with its policy to return between 20% and 30% of its anticipated after-tax profits to investors through cash distributions. NetEase's board also announced a new $50 million stock buyback campaign. 

Rick Munarriz has no position in any of the stocks mentioned. The Motley Fool recommends NetEase. The Motley Fool has a disclosure policy.

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Stocks Mentioned

NetEase Stock Quote
$71.12 (3.40%) $2.34
Youdao, Inc. Stock Quote
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$4.78 (17.16%) $0.70

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