NetEase: Undervalued As Gaming Regulations Don't Detract Much From The Great Business

seekingalpha03-27

NetEase, rivaling Tencent, appears undervalued via discounted earnings, despite risks from China's economic shifts and gaming regulations.With over 75% of revenue from gaming, restrictions on minors ...

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superior financial management and growth potential position it strongly against Tencent.   lovenimo/iStock via Getty Images NetEase (NASDAQ:NTES) is a rival to Tencent, and I think it may be the more compelling investment of the two at the time of this writing. Additionally, based on my discounted earnings model, the firm is significantly undervalued. There are risks related to Chinese economic shifts and competition that could inhibit overseas expansion, but nonetheless, the stock is a Buy based on my analysis. Overview & Operational Analysis, Including Gaming Restrictions NetEase is one of the largest internet technology companies in China, and its services include gaming, music, education, and e-commerce. Its core business segments can be broken down as such:   Online Gaming (77.3% of Operating Revenue): NetEase is a key player in the online games market in China and internationally, developing some of the most popular PC and mobile games in the region. Additionally, it has helped bring Blizzard's titles to the Chinese market, but the partnership is set to end. As a result, NetEase will be focusing more intently on in-house development and international expansion.   Music Streaming & Entertainment (9.3% of Operating Revenue): NetEase Cloud Music is one of the top music streaming platforms in China, with a wide range of content, including user-generated audio. It competes directly with Tencent Music.  Education (8.2% of Operating Revenue): Venturing into online education, it offers professional courses and language training through a subsidiary called Youdao.  E-commerce & Others (5.2% of Operating Revenue): NetEase operates an e-commerce platform called Yanxuan, selling a variety of affordable and quality products.  From looking at the game portfolio, it is quite clearly very structured, with titles including Harry Potter and Lord of the Rings games, but also unique titles like Lost Light and Vikingard. These seem to play well on popular trends in entertainment at the moment, namely in military and Viking aesthetics. But this is not all; it has numerous Marvel titles and various games that are quite clearly catered specifically to the Chinese market preferences. It must be noted that recently, the Chinese government has imposed new gaming restrictions to address concerns over gaming addiction among minors. These regulations are actually quite shocking and severe, in my opinion. While I agree that gaming can be a serious impediment to real-life productivity, the authoritarian elements of the Chinese government come through in that minors are only allowed to play online games for one hour a day on Fridays, weekends, and public holidays. Additionally, online game companies have been required to enforce a gaming curfew for minors, with gameplay prohibited between 10pm and 8am. Additionally, the most severe part is that game developers and platforms must implement real-name registration and login systems for all users, and some companies have introduced facial recognition to enforce these rules. One positive is that games have been mandated to not include any content, like virtual rewards, that could be seen as encouraging addictive behaviors. Obviously, as over 75% of NetEase's operating revenue comes from games, it is going to be negatively affected somewhat by this. I do not think that the CCP has bad intentions here, but the effect of those intentions is perhaps too severe, and NetEase shareholders may be wise to understand that a more intense shift toward a socialist agenda and away from free market capitalism could result in reduced shareholder returns for NetEase over the long term. Competition From my research, the main publicly traded competitors to NetEase include Tencent (OTCPK:TCEHY), Electronic Arts (EA), Ubisoft (OTCPK:UBSFY), and Take-Two Interactive (TTWO). While these have varying market caps, these are the peers I will be using for my competitive analysis, as I believe they are of the highest competitive threat. One firm I will not be using in my charted analysis or financial analysis is Activision Blizzard, as it is a subsidiary of Microsoft, and hence analyzing the data becomes less meaningful, although I consider it to arguably be of the highest operational threat other than Tencent, and I will discuss this. First of all, consider each of these firms compared on market cap: Seeking Alpha From this chart, we can already see who is the largest competitor, namely Tencent, and we can also ascertain that this is the largest threat to NetEase because of Tencent's entrenched operations in the Chinese markets. The rivalry between these two Chinese internet titans spans the full breadth of offerings, but it is most concentrated in gaming. Tencent has much higher financial capabilities than NetEase, so it poses a threat based on technological advances and potential strategic acquisitions, which could, over time, reduce NetEase's market share. Tencent has stakes in some of the world's most prominent gaming companies, like Riot Games, Supercell, and Epic Games, and within China it operates some of the most popular games. What I think makes Tencent stand out against NetEase is its ownership of WeChat and QQ, which provides a ready-made audience for its gaming products. Undoubtedly, Tencent's ecosystem is stronger than NetEase, and this is where I believe it has the higher long-term value. Tencent's global expansion efforts are also more aggressive than NetEase, showing that there could be more growth to be had for Tencent shareholders. Key Financials There are many things that I like about NetEase. Starting with the balance sheet, its equity-to-asset ratio at the time of this writing is 0.67, and its debt-to-equity ratio is 0.16, which includes lease obligations under debt. This is slightly stronger than in the past, as over the past 10 years, the company has had an equity-to-asset ratio of 0.63. While this is strong, we should note that the company issues debt every year, but it has evidently kept this well-managed, paying it off regularly. As this is the case, I am pleased to see on the cash flow statement the repurchase of common stock almost every year over the past 10 years, at often very high amounts. My initial analysis of the firm's financial health leaves me thinking that I like the way this company is financially managed, and I trust its management as it has operated a stable capital structure over the long term. We should, however, of course also compare NetEase to its peers on other financial metrics. To start, what is its net income margin like in comparison to some of its major competitors? As we can see from the following chart, it lags Tencent over the long term, but at this moment, it is the leading firm in terms of profitability: Author, Using Seeking Alpha And on revenue growth, the firm is far and wide better than all peers, apart from EA, which it moderately beats: Author, Using Seeking Alpha From my analysis, NetEase seems to be a very strong investment indeed. I plan to become a shareholder because I believe that its operational profile, coupled with a very strong financial track record, places it at an exciting place as perhaps China's most compelling internet investment at the time of this writing. As an underdog to Tencent, I think it may be winning in many regards in terms of the quality of the investment at the moment. Valuation For the purpose of this analysis, I have chosen a discounted earnings valuation model as opposed to discounted cash flow. While I consider discounted cash flow to be the more reliable method in ascertaining intrinsic business value, I tend to believe earnings more accurately correlate to market sentiment in real time. In a sector that is prone to high levels of positive sentiment in the markets, I wanted to account for this as much as possible. Over the past 10 years, NetEase has had an annual net income growth of 20.8%. Moving forward, considering the high levels of digitalization underway in global economies, I believe it is quite likely for at least a 20% net income annual growth rate to resume for the next 10 years. Readers should consider that over the past 5 years, the rate has been 36.74%, and over the past three years, 34.6%. For my discounted earnings model, I used 20% as my growth stage rate, 2% as my terminal stage rate in line with the long-term normal inflation rate in China, a 10% discount rate, which is my low-end expected annual total portfolio return over the period, and a starting normalized EPS value of $4.67. I did not add tangible book value, and my estimated fair value for the stock is $153.07, indicating a 31.03% margin of safety at the time of this writing. Author's Calculation Risk Reiterated To reiterate my risks on this one: I believe that the company could face significant growth inhibitions as a result of a growing shift in Chinese economics away from capitalist ideals and leaning further toward socialism. I do not believe this is a bad thing for its economy, but it could be bad for NetEase shareholders seeking the most supreme alpha. Additionally, investors should be aware that the company faces a significant rivalry with Tencent, and it is much larger than it. Additionally, in the US, Activision Blizzard, which is owned by Microsoft, has such large saturation, as do other Western peers, that I do not see it likely for NetEase to have much success in the Western markets other than through equity stakes in international peers. Conclusion  I admire NetEase as a company, and I am seriously considering an allocation as I do not have any Chinese-centered investments in my portfolio at this time. I believe that NetEase is an exceptional firm operationally and one that could also be considered significantly undervalued at the time of this writing. 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