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.
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.
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
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
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
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.
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
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.
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.
Figure.3 Net Profit vs. Total Revenue
With the economy recovery in
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.
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.
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.
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).
Figure.6 Current Ratios among competitors
Figure.7 Total Debt to Equity Ratios
- 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.
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).
Figure.8 EPS growth rate vs. P/E
NetEase.com Inc - Annual Income Statement, 2005-2008 (USD)
NetEase.com Inc – Balance Sheet, 2005-2008 (USD)
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.
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