Saturday, February 24, 2018

A current AIM International Fund Holding: NetEase, Inc. (NTES) by Arsh Salwan. "Let's Take it Ease-y"

NetEase, Inc. (NTES, $300.11): “Let’s Take it Ease-y”

By: Arsh K. Salwan, AIM Student at Marquette University

Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.


NetEase, Inc. (NASDAQ:NTES) provides online services to consumers in mainland China. NTES operates through 3 segments: Online Game Services, Advertising Services, and Email/E-commerce/Others. The Online Game Services segment accounted for 73% of total revenue in FY17.  

• NetEase has been continuously improving their online games services segment as they have released popular games such as Fantasy Westward Journey, Speedy Ninja, and Rules of Survival.

• The company recently announced a new blockchain sharing platform, “Planet”, that serves as a sharing platform amongst users along with a decentralized value exchange. Blockchain will be an important focus of NetEase in 2018.

• In FY17, Online Game revenue had decreased 10% YoY while E-Commerce revenue had increased 175% YoY.

• The YTD stock price change for NetEase has been -13.5%.  

Key points: For the past couple of years, NetEase has been one of the top video game developers in China. NTES has depended heavily on revenue generated from iconic games created throughout the years. There was a decline in revenues and a weaker gross margin for online games in the previous 3 quarters, and this may be a concern moving forward.
The biggest competitor of NetEase is Tencent Holdings Limited, a world class tech company with almost 1 billion users on its social network, WeChat. In late 2017, Tencent announced that it would be adding in-chat mini games which would make it easier for users to play games within the chat. Due to the convenience of Tencent’s mini-games, NetEase’s gaming segment could decrease.

Management recognized the “mini-game” this threat early on and decided to release 14 new games in Q4 FY17 and to focus more on E-Commerce. NTES opened their E-retail business, Koala, which has plans to spend about $11 billion over the next three years on inventory from Europe, Japan, and the U.S. The purpose of this is to attract customers and bring a global presence of goods into China.

NetEase recognized that moving into the E-commerce space would be dangerous because China’s other tech giant company, Alibaba, would become an immediate competitor. To mitigate the competition risk involved, Koala implemented a new strategy to bypass local middlemen and buy inventory directly from international companies. Another advantage that Koala has compared to Alibaba is the delivery time. Delivery for Chinese consumers has averaged about 15-20 days for international orders but Koala has lowered that to 2-3 days. The introduction and growth of Koala could push NTES back towards its 52-week high.

What has the stock done lately?

After meeting earnings expectations in Q3 FY17, it was expected that the company was on a road to turn it around after missing Q2 FY17 earnings. On February 7, 2018, Q4 FY17 earnings were released and the stock price dropped from $314 to $285 in 2 trading days. Since earnings were released, NTES has been up ~5%.

Past Year Performance: In one year, NTES is up ~15%. In the month of August 2017, NTES dropped 11% from $308 to $275. This was due to the fact that the company’s Q2 earnings did not meet the expectations of investors. That may seem worrisome, but the stock later jumped to $371 in mid-December representing an increase of 35%. With average performance in the previous 3 quarters, Q1 FY18 will be very significant in regards to where the company will be heading and if adjustments have been made.

Source: FactSet

My Takeaway

William Deng Lei, NetEase’s CEO/Founder, has run NetEase with expertise in a variety of  areas. Gaming has always been the main focus, but management recognizes that Tencent has new plans to expand so NTES has begun to explore into other areas of business. With NetEase’s e-commerce platform, Koala, there have been changes to the main focuses of the company. With the increased use of e-commerce to purchase international products in China, Koala could have a very bright future. NTES must capitalize on any slip-ups from Tencent and improvements must be made in the gaming segment- if this is done, NetEase could have a promising future. However, with the previous quarter’s missed earnings and increased competition, I am recommending a “hold” for NetEase, Inc.

Source: FactSet