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NetEase.com Upgraded Before Q3 Earnings

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NTES_09Q2_growt_thumbRating BUY (Click HERE for Report in pdf format: CV_NTES_09Q2.pdf )

We recommend a BUY rating on NetEase.com Inc (NASDSQ: NTES). With relatively high profit margin and market shares, NTES is considered to be the most profitable online game provider in the industry. Even though NetEase.com Inc (NASDSQ: NTES) is involved in political risk due to World of Warcraft (WOW) currently, the projected revenue and EPS indicate growing profitability for year 2009. Moreover, a self-developed online game called New Fly for Fun (New FF) will be another profitable game operated by NetEase.com Inc (NASDSQ: NTES). Since the stock is undervalued, we expect a generally growing trend of the stock price.


Potential high risk of WOW

On 19th September, World of Warcraft was commercially operated by NetEase.com Inc (NASDSQ: NTES) without an approval from General Administration of Press and Publication (GAPP). This re-launch took NetEase.com Inc (NASDSQ: NTES) to an embarrassing position. The risk of failure to release Wrath of the Lich King (WLK) expansion pact is very high, combining with the likelihood of requirement to shut down the operation by GAPP.


New revenue source from New FF

NTES spent 4 years in re-developing New FF. On 15th May, the game was commercialized and the number of servers was increased from 30 to 50 within 3 weeks. We expect that PCU (Peak Concurrent Users) of New FF will increase to 500 thousand in the near future. It will be a profitable game like Fantasy Westward Journey, which is the most successful game for NetEase.com Inc (NASDSQ: NTES).


Strong profitability, undervalued stock

Compared to other rivals in the industry, NetEase.com Inc (NASDSQ: NTES) has strong profitability in 2008 with high profit margin and market shares. The net income and EPS for 2009 are projected to be US$291.71 million and US$2.25 respectively. Compared to 19.68% EPS growth rate, P/E ratio is only 16.84, indicating the stock is undervalued.

* Estimates (Dec)





(USD, Millions)

2005

2006

2007

2008

2009E

Net Income

115.49

159.25

173.29

234.03

291.71

EPS

1.06

1.41

1.50

1.88

2.25

EPS growth rate


33.02%

6.38%

25.33%

19.68%

 

NetEase.com Inc.

Key Income Statement Data

2008Q3

2008Q4

2009Q1

2009Q2

(USD, Millions)





Total Revenue

118.80

117.51

114.40

127.68

Total Operating Expenses

-24.25

-24.69

-22.04

-25.59

Operating Income

68.72

68.96

71.87

75.70

Profit Before Taxation

64.65

72.70

70.02

85.43

Tax Benefit/ (Expense)

-18.51

11.71

-9.04

-16.89

Profit for the Year

46.14

84.41

60.98

68.54






Key Cash Flow Statement Data

2008Q3

2008Q4

2009Q1

2009Q2

Cash from Operating Activities

72.98

75.34

83.10

79.70

Cash from Investing Activities

-277.69

-91.14

-83.82

-14.08

Cash from Financing Activities

0.82

-12.81

0.37

5.13

Effect of exchange rate change on cash hold in foreign currencies

-4.37

0.52

0.18

0.98

Net Change in Cash

-208.27

-28.09

-0.18

71.73






Key Balance Sheet Data

2008Q3

2008Q4

2009Q1

2009Q2

Cash & Equivalents

777.46

822.78

882.57

909.37

Total Current Assets

822.42

875.60

925.46

963.67

Property/Plant/Equipment, Total - Net

32.06

37.93

38.06

69.58

Total Assets

870.45

930.14

991.52

1,090.56

Total Current Liabilities

131.42

121.52

121.19

144.94

Long Term Debt

0.03

0.03

0.03

0.03

Total Liabilities

131.44

121.55

121.22

144.97

Total Equity

738.98

808.57

870.30

945.59

Total Liabilities & Shareholders' Equity

870.45

930.14

991.52

1,090.56






Market Comparisons

Company

Industry

Sector

S&P 500

Current Ratio (MRQ)

6.65

2.08

2.09

0.81

Total Debt to Equity (MRQ)

0.15

57.79

29.61

119.11

Return on Assets (TTM)

31.93

3.67

1.63

2.94

Return on Equity (TTM)

36.72

5.37

2.63

7.35

Gross Margin (TTM)

79.3

12.27

15.52

25.67

Operating Margin (TTM)

59.3

5.47

1.42

--

Pre-Tax Margin (TTM)

66.9

5.81

1.23

7.41

Net Profit Margin (TTM)

53.7

4.67

-0.39

5.85

 

Summary

NetEase.com Inc (NASDSQ: NTES) is one of the most profitable companies within internet segment, including online search. Unlike its rivals, NetEase’s revenue depends heavily on its self-developed games. Most of the in-house games from NetEase are high quality, and they assist the company in removing the dependence of earnings upon other online game developers. Therefore, despite high risk in WOW, NetEase still has healthy profitability.


Recommendation: BUY

1. Negative outlook for WOW operated in Mainland.

Since World of Warcraft (WOW) was licensed to NetEase.com Inc (NASDSQ: NTES) on April, it has been a hot topic in game industry. WOW was expected to contribute a large proportion of revenue to NTES as long as it was re-launched successfully, because it was one of the hottest online games in China. On 19th September, NetEase.com Inc (NASDSQ: NTES) finally announced that WOW was commercially operated again in Mainland after a long procedure of seeking approval. However, this action unexpectedly brought NetEase.com Inc (NASDSQ: NTES) into a political risk, which has adversely affected the future of the game. In fact, WOW is only approved by Ministry of Culture. The approval from General Administration of Press and Publication (GAPP) was still in the process when NTES released the announcement.

Since GAPP was ignored by NetEase.com Inc (NASDSQ: NTES) in the event, it is believed that NTES will be penalized by the agency. Even though the probability that GAPP shuts down WOW is small, the future expansion pact such as Wrath of the Lich King (WLK) can be rejected by the agency. If WOW cannot be updated to WLK in mainland in the near period, NTES has to face potential loss of customers because players have alternative. WOW operated in Taiwan is attractive for players from mainland because the game in Taiwan has been updated to the latest expansion pact. The risk of failing to introduce WLK to mainland has a huge adverse impact on profitability of NTES’s WOW.

The policy and responsibility is still unclear for each regulator in the online game industry. As NTES’s WOW contains high risks involving government, we believe that outlook of WOW is negative and doubt the profitability of WOW in mainland China.

 

1. New potential revenue resource from New FF

Among several self-developed online games, New Fly for Fun (New FF) should have investors’ attention. We believe that New FF will be a new important growth source for NetEase.com Inc (NASDSQ: NTES).

New FF is derived from a Korean online game called Fly for Fun (FF). FF was licensed to NTES by a Korean company called Aeonsoft on July 2004. Then it went to beta test on December 2004. The initial game did not meet NTES’s expectation. Therefore, NetEase.com Inc (NASDSQ: NTES) brought the source code and right to re-develop the game. However, they found that the game engine was too limited to support their new ideas. NetEase.com Inc (NASDSQ: NTES) thus determined that they would write a new engine by themselves and re-develop FF. On May 2009, New FF was finished finally. It went to open beta on May 15, 2009. Since New FF is an item-based game, which means game players need to pay for in-game items but free to play, open beta test is equivalent to commercialization.

It is hard to imagine how popular New FF is among young ladies and teenagers. Within 3 weeks, the number of the game servers increased from 30 to 50.

NTES_numberofservers

Figure.1 Number of Servers (New FF)

On 26th April, NetEase.com Inc (NASDSQ: NTES) announced that New FF would go to open beta test on 15th May. Since then, the number of required game servers was increased to satisfy the growth of new players. Compared to NTES’s TX2, which has 37 servers after 1year closed beta, New FF is apparently more successful. In fact, NetEase.com Inc (NASDSQ: NTES) put little expense on the marketing of New FF. Such popularity can be attributed to pubic praise. New FF includes most of elements that are popular in Chinese online game market. It is believed that PCU (Peak Concurrent Users) of New FF will achieved 500 thousand in less than one year.


Strong Profitability, undervalued stock

  1. Revenue/EPS

NetEase.com Inc. (NASDAQ: NTES) has a growing revenue and EPS with US$127.7 million and US$0.53 respectively for second quarter 2009.

NTES_09Q2_profit1

The 11.6% growth of total revenue is attributed to the increase of online game services by US$8.4 million, as well as advertising services by US$4.7 million. Particularly, the improvement of online game services is mainly due to revenue recognized from removing game points from dormant accounts.

NTES_09Q2_profit2

Figure.3 Net Profit vs. Total Revenue

With the economy recovery in China, the revenue of advertising services experienced a sharp increase by 77.5%, from US$6 million to US$10.7 million. At the same time, gross profit margin of advertising services jumped up from -13.1% to 16.6%. However, compared with US$15.2 million in the second quarter of 2008, this revenue is still relatively low.
Although NetEase.com has increased its net profit since the first quarter of 2009, its net profit margin stayed still. It was even worse quarter over quarter. However, EPS has recovered back to the level of second quarter of 2008 at US$0.50.


Competitors

SINA and SOHU compete with NetEase directly in terms of internet portal. SINA (NASDAQ:SINA), as an online media company and information services provider, underwent a downturn in the second quarter of 2009. Its total revenue decrease by 1.1% quarter-over-quarter, and the net income even shrank by 40.9% to US$13.3 million, compared to US$22.5 million in 2008Q2. SOHU (NASDAQ:SOHU), however increased 24.6% in total revenue and 21.6% in operating income. But its net income has a negative growth due to the large proportion of provision for income taxes.

Since online game services contribute 89.6% revenue, obtaining a good position in this competition are more crucial for NetEase to survive. The main rivals include Shanda Interactive (NASDAQ:SNDA), Changyou.com (NASDAQ:CYOU), Giant Interactive (NYSE:GA) and The9 Ltd (NASDAQ:NCTY). Figure 4 and 5 are comparisons of NetEase and its rivals in terms of total revenue and net profit margin.

NTES_competitors

Figure.4 Total Revenue in online game industry

As shown in the sector graph above, NetEase has taken the second large market share in online game industry. Although Shanda Interactive enjoys the largest part of the market, its net profit margin is relative lower than NetEase (Fig.5). Giant Interactive has the highest net margin, but its market share is smaller than NetEase.com Inc (NASDSQ: NTES). Thus, it is believed that NetEase is the most profitable online game services provider with relatively large market share and high net profit margin.

NTES_netprofitmargin

Compared with largest rival Shanda Interactive (NASDAQ:SNDA), NetEase also takes a strong position in terms of financial strength. Relatively high current ratio of 6.6 demonstrates that NetEase is less risky than Shanda Interactive (NASDAQ:SNDA) because liquidity is higher. This is also evident by total debt to equity ratio, indicating that NetEase uses less leverage than Shanda (SNDA).

NTES_09Q2_currentratio

Figure.6 Current Ratios among competitors

NTES_09Q2_debtequity

Figure.7 Total Debt to Equity Ratios

DuPont Analysis

2008Q3

2008Q4

2009Q1

2009Q2

1

Net margin (NI/Revenue)

39.4%

72.8%

53.7%

54.2%

2

Asset turnover (Revenue/ Assets)

0.13

0.12

0.11

0.12

3

ROA (1*2)

5.30%

9.07%

6.15%

6.28%

4

Leverage (Assets/ Equity)

1.18

1.15

1.14

1.15

5

ROE (3*4)

6.24%

10.44%

7.01%

7.25%

Net margin stay at 54% stably during the first half year of 2009. Note that the margin of 2008Q4 is abnormally high because NetEase had US$11.2 million tax refund during that period. We expect the net margin for 2009Q3 will increase to 60% due to the summer holiday and commercial operating of New Fly for Fun.
  1. Asset turnover and leverage are expected to be stable. Based on the expectation of net margin at 60%, ROA and ROE for 2009Q3 are estimated to be 7.2% and 8.3% respectively.

Moderate Valuation

The projected EPS for 2009 is US$2.25, and growth rate is 19.68%. The earning forecast does not include the potential revenue factor from WOW. As shown in figure 8, the estimated P/E ratio is 16.84, lower than the EPS growth rate. This implies that the PEG ratio is less than 1 and the stock of NTES is undervalued.

It is believed that NTES’s revenue will increase faster in 2010 because 8 major online games will be commercialized including StarCarft II from Blizzard Entertainment. The risk of WOW would not influence NTES’s profitability. As long as the risk is well-mitigated, it will even bring higher revenue for NetEase.com Inc (NASDSQ: NTES).

Based on the analysis, we suggest a BUY rating for NetEase.com Inc (NASDSQ: NTES).

NTES_09Q2_growthrate

Figure.8 EPS growth rate vs. P/E

 


NetEase.com Inc - Annual Income Statement, 2005-2008 (USD)

2008A

2007A

2006A

2005A

Total Revenue

452,119

303,414

277,336

199,792

Cost of Revenue

82,024

56,954

48,859

34,105

Gross Profit

370,096

246,461

228,478

165,687

Operating Expenses

Research and Development

30,344

24,777

19,626

11,173

Sales, General and Admin.

59,127

56,411

44,851

33,473

Operating Income

280,625

165,273

164,001

121,041

Add'l income/expense items

-2,525

8,376

12,171

6,254

Earnings Before Interest and Tax

278,100

173,649

176,172

127,294

Interest Expense

0

0

0

43

Earnings Before Tax

278,100

173,649

176,172

127,252

Income Tax

44,071

369

16,976

11,766

Minority Interest

4

10

51

0

Net Income-Cont. Operations

234,033

173,291

159,247

115,485

Net Income

234,033

173,291

159,247

115,485

Net Income Applicable to

234,033

173,291

159,247

115,485

Common Shareholders

 


NetEase.com IncBalance Sheet, 2005-2008 (USD)

Year to December

2008A

2007A

2006A

2005A

Assets

Cash

116,292,843

340,364,218

45,915,773

149,317,924

Other Current assets

759,306,937

267,797,042

148,849

644,343

Total current assets

875,599,780

608,161,260

46,064,622

149,962,267

Non-current assets:

54,542,149

34,185,049

432,081,081

248,660,518

Total assets

930,141,929

642,346,309

478,145,703

398,622,785

Liabilities and Shareholders’ Equity

Total current liabilities

121,516,756

175,037,144

5,839,851

2,356,032

Total long-term liabilities

29,315

1,398,295

99,980,000

99,980,000

Total liabilities

121,546,071

176,435,439

105,819,851

102,336,032

Total shareholders’ equity

808,565,185

465,882,383

372,325,852

296,286,753

Total liabilities and shareholders’ equity

930,141,929

642,346,309

478,145,703

398,622,785

 


Analyst Certification

I, Junqiang Zhang, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.

Copyright, user agreement and other general information related to this report:

Copyright 2009 Chinavestor.com. All rights reserved. This research report is prepared for the use of Chinavestor.com clients and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of Chinavestor.com.

This research report provides general information only. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice. Past performance is not necessarily a guide to future performance.

Fundamental equity reports are produced on a regular basis as necessary to keep the investment recommendation current.




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