Netease-NTES
China Large Cap Play
Disclaimer: This newsletter is not financial advice; it is for educational purposes only. Please DO NOT take this newsletter as a buy or sell signal.
Netease Fundamentals:
Below is a checklist I normally use in my process when I look at the fundamental health of a company. If the company meets my criteria it will be colour-coded in green and if the company fails to meet my criteria it will be colour-coded in red which means I need to investigate further and ask myself why this is the case.
As you can see below there are 2 red boxes and I am going to explain each one:
Current PE Ratio and Current Price To Free Cash Flow Ratio- Netease currently has a PE Ratio of 19x and a Price To Free Cash Flow Ratio of 20x which might be an indicator that this company is currently trading at a premium to the market since the average stock market PE Ratio is 15x. One thing to remember is if a company can grow over 19% from now until judgment day and it can sustain that growth then the current valuation will look cheap. This goes for the opposite side of the spectrum where if a company was trading at 15x earnings and they are only growing 3% a year that might seem expensive because the company can’t justify its valuation.
Business Overview:
Founded in 1997 by Ding Lei, NetEase is a Chinese gaming company that specialises in internet services and online gaming. One of the company’s most notable features is its extensive portfolio of online games which includes popular titles such as Dead By Daylight and Knives Out. NetEase has also partnered with Blizzard Entertainment to operate well-known games like World of Warcraft and Overwatch in China significantly boosting its gaming revenue. In addition to gaming, NetEase offers a variety of internet services including email, e-commerce platforms, and online education. Its news portal is among the most visited in China providing a wide range of content that covers current events, entertainment, and lifestyle articles.
Business Segments:
Games and Related Value-added Services- NetEase's gaming segment focuses on developing, publishing, and operating a diverse range of online games including both mobile and PC titles. The company aims to create high-quality gaming experiences across various genres including role-playing games (RPGs) such as Fantasy Westward Journey, first-person shooters like Knives Out, and casual games like Identity V. In addition to game development NetEase provides value-added services that improve the user's gaming experience. These include in-game purchases, subscription models, and engaging community features. Netease also works with international game developers to localise and introduce popular titles to the Chinese market. This strategy has significantly contributed to NetEase's revenue growth by helping the company’s expansion in both domestic and global markets.
Innovative Businesses and Others- In addition to gaming, NetEase has made significant efforts to diversify its business particularly in e-commerce and advertising services. This diversification has enabled the company to create multiple revenue streams. In the e-commerce sector NetEase provides platforms that cater to a diverse range of consumer needs from everyday products to digital downloads. By using its strong brand and modern technology the company improves the shopping experience for customers and provides sellers with useful tools to reach their target audience. Advertising services are also a vital aspect of NetEase's strategy. The company utilises its large user base and data analytics to deliver targeted advertisements that help businesses maximise their ad effectiveness. Additionally NetEase offers services such as online education and cloud solutions which are becoming increasingly important in today's digital landscape.
NetEase Cloud Music- NetEase Cloud Music is a popular music streaming platform in China that has rapidly gained popularity since its launch in 2013. It is well-known for its library of songs, user-friendly interface, and strong social features that allow users to share music, create playlists, and follow their friends' listening habits. One of the platform's standout features is its emphasis on music discovery. NetEase Cloud Music uses advanced algorithms to recommend songs and artists based on users’ listening preferences making it easier to find new music that they love. Community engagement is also a key focus for NetEase Cloud Music. Users can comment on tracks and share their thoughts leading to discussions and creating a sense of community among music lovers.
Youdao- Youdao is a subsidiary of NetEase that primarily focuses on educational technology. Initially starting as a translation service Youdao has since expanded into a variety of educational tools and resources. Youdao offers a range of products including online courses, language learning apps, and smart study devices designed to improve its users’ learning experience. One of its flagship offerings is the Youdao Dictionary a widely used tool in China for translation and language study. With the increasing demand for online education particularly during and after the pandemic Youdao has developed live tutoring services and interactive learning platforms.
Management:
When evaluating management I like to judge the CEO based on several factors such as experience, capital allocation skills, and Incentives. In this section I will discuss whether management incentives are aligned with shareholders.
Experience- Lei Ding is the founder and Chief Executive Officer of NetEase( a position he has held since 1997). Lei Ding has played a crucial role in the development of the internet in China. In 1997 he launched China’s first dual-language free email service which significantly contributed to the country’s internet growth. Lei Ding has also held various leadership positions including Chief Architect from 2001 to 2005 and Acting Chief Executive Officer from June to September 2001. Lei Ding holds a Bachelor of Science degree in communication technology from the University of Electronic Science and Technology of China.
Below is an image illustrating the current experience of Netease board members:
Capital Allocation- Capital allocation is very important when judging management because I want them to create value for shareholders not destroy it. So far Netease has done a great job with capital allocation. They are providing value back to shareholders by reinvesting in the business to further expand their business and paying dividends.
Netease currently pays a dividend with a yield of 2.15%. This dividend is sustainable because it only covers 29% of the company’s free cash flow.
Incentive- This is important because if the current board is buying shares of their own business it indicates that management believes the stock is undervalued and is confident in the company’s long-term prospects.
As you can see below we have zero buy and sell orders.
Bull And Bear Case:
Bull Case
Bull Case- The first bull case is Netease's Strong Gaming Portfolio. Netease is known for its successful games both original and licensed that appeal to a wide range of players. Netease offer a variety of mobile games, role-playing games (RPGs), and casual games that attract different age groups. Their original games often have interesting stories, fun gameplay, and great graphics while their licensed games are based on popular films, anime, and other well-known series. This mix helps Netease reach a diverse range of players. They also make sure to keep games updated and listen to player feedback which helps keep players happy and engaged over time.
Bull Case- The second bull case is on Innovation. Netease has a strong focus on research and development. This commitment positions it to stay ahead of market trends and consumer preferences in gaming and other sectors.
Bull Case- The third bull case is User Engagement. Netease has strong user engagement on its platforms which is important for the success of its gaming and e-commerce business. Engaged users are more likely to convert to paying customers further boosting the company's revenue.
Bear Case
Bear Case- The first bear case is Regulatory Scrutiny. The Chinese government has increased scrutiny over technology and gaming companies which has led to strict regulations. These regulations can impact NetEase's core gaming business and limit its ability to grow especially in areas like new game approvals.
Bear Case- The second bear case is Intense Competition. The gaming industry in China is highly competitive with major players like Tencent dominating the market. NetEase faces challenges in differentiating its offerings and maintaining market share against these larger competitors which may impact its revenue growth.
Bear Case- The third bear case is Dependence On Gaming. A significant portion of NetEase’s revenue comes from gaming. Any downturn in the gaming sector or shifts in consumer preferences could affect the company's financial performance.
Valuation:
In this section I will discuss valuation. Using some basic metrics I will compare Netease to its industry rivals and determine whether the company is cheap relative to its peers. Then I will value Netease using a discounted cash flow model to determine a price I am willing to pay based on its expected growth rate and my desired return of 15%.
As shown below when compared to its peer Netease scores 5/5 while Tencent scores 1/5. Netease and Tencent are both major players in the Chinese tech landscape. Netease has successfully carved out its niche particularly in the gaming sector and continues to innovate and expand. On the other hand Tencent has massive scale and business diversification that puts it slightly ahead of Netease. Below, I will highlight the key differences between the two companies:
Business Model - Netease primarily focuses on developing and publishing online games including popular titles such as Fantasy Westward Journey. Additionally it provides services in e-commerce, advertising, and education. Tencent on the other hand is known for its wide range of services including social media, gaming, fintech, and cloud services. It operates WeChat (a messaging and social media app), QQ (an instant messaging service), and popular games like Honour of Kings and PUBG Mobile.
Market Reach- Netease is a major player in the gaming industry that is known for its successful titles and partnerships. Netease has collaborated with Blizzard Entertainment to publish games like World of Warcraft in China. On the other hand Tencent is one of the largest gaming companies in the world by revenue. It holds stakes in numerous gaming companies globally such as Riot Games and Epic Games and has a strong portfolio of homegrown titles.
Product Offering- Netease is focused on its intellectual property and expanding into international markets. The company is also making significant investments in research and development to create competitive and innovative gaming experiences. On the other hand Tencent uses an ecosystem approach by creating connections between its platforms including social media, games, and payment services. This strategy enables cross-promotion and allows for a broader user base.
As you can see based on my conservative assumption Netease is looking to grow at a high single-digit rate over the long run so I went conservative and assumed a 6% growth in the first 1-3 years then the growth will slow down to 3% 4-6 years out. In my assumption I also went with an exit multiple of 15x earnings which is below the historical average at which Netease has traded. Based on my assumption I have come to a buy price of $135.02 compared to the current stock price of $128.63 which means right now Netease is trading below its intrinsic value.
Thanks for reading my newsletter on Netease. Disclaimer: This newsletter is not financial advice. This is for educational purposes only, so please DO NOT take this as a buy or sell signal.
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well written
Thank you for the review. I recently bought into NTES, picked it up on a stock screener . The slow steady growth, divis, and future prospects drew me in. Looking to keep it for a few years.