I last covered NetEase (NASDAQ:NTES) in March; at the time, I put out a Buy rating, and since then, the total return on the investment has been -7.09%. However, I believe the long-term upside for the stock remains, and as such, I am reiterating my Buy rating while the stock is modestly undervalued, despite the fact that I think it is unlikely to beat the market over the next 5-10 years. Partly, I am doing this because the company is currently trading at significant contractions from its major valuation multiples. The risk is that the company may fail to attract higher investor sentiment because the Wall Street consensus is that its fundamental growth rates are likely to be significantly lower than over the past 5-10 years. As such, the current contraction of valuation multiples may be warranted, but I believe these to be slightly overextended, opening up some room for short-to-medium-term alpha and just-below-market returns following the stock reaching fair value.
Operational & Financial Analysis
Several factors have contributed to NetEase’s recent contraction in growth rates for revenue & EPS:
Overall macroeconomic weakness and lower spending habits due to high inflation and interest rates following the COVID-19 pandemic and increased competition in the gaming market have led to higher sales and increased expenses. I mentioned in my previous thesis on NetEase that regulatory pressures in China, which are reducing the total available time children are allowed to play games, are likely to have a negative impact on NetEase’s revenue. In addition, broader socialist policy implementations in China are likely to curb more liberal market opportunities that are enjoyed by predominantly Western-serving gaming companies.
There are also growing concerns at this time that the company’s established game franchises are showing signs of maturation, which is leading to slower growth rates. To combat this, management has been increasing marketing expenses, with a 38% increase in the first quarter of 2024, which has been attributed to promotional activities for new and existing games. While this is positive, from my research, I have picked up a growing consensus amongst analysts and critics that NetEase could benefit from more innovation for new hit titles to drive growth. This being said management is aware of this, and it released “Shi Jie Zhi Wai” in Q1 2024, which ranked No.1 on China’s iOS download chart. NetEase has also been developing its pipeline with highly anticipated games, including “Where Winds Meet,” “Justice” mobile, and “Naraka: Bladepoint” mobile.
Almost 100% of NetEase’s revenue comes from China at the moment, so management has been developing the correct strategy to aggressively pursue international markets. It is aiming to generate 50% of its gaming revenue from outside of China and back 25% of global AAA game releases. This is a challenge in developing titles suited to international cultures, but the long-term benefits should give the firm better access to more liberal capitalist markets.
Furthermore, the company is exploring cutting-edge game technologies, evidenced by its presentations at GCD 2024. This technological innovation strategy is likely to help it stay competitive with its most fierce rival, Tencent (OTCPK:TCEHY). In addition, the company’s partnership with Blizzard Entertainment is going to help bring Blizzard’s games back to the Chinese market. This deal covers popular titles like World of Warcraft, Hearthstone, Overwatch, Diablo, and StarCraft. Microsoft (MSFT), which owns Blizzard, has also entered into a broader collaboration with NetEase to bring its titles to Xbox. This collaboration is significant in helping NetEase to achieve its goal of global presence in AAA gaming.
I think that, over the long term, NetEase has the potential to outperform what analysts are currently predicting. However, I do think there are likely to continue to be near-term headwinds as a result of macroeconomic pressures curbing spending on nonessentials. Once inflation is hopefully constrained somewhat and interest rates reduce, the international strategy for NetEase has the potential to expand its growth rates and continue a market-beating CAGR in its stock price.
Further Financial & Valuation Analysis
As I showed above, NetEase has been experiencing a contraction in its revenue and normalized income growth rates. Its revenue growth has been 15.81% as a 5Y YoY average. Its diluted EPS growth has been 39.33% as a 5Y YoY average. However, moving forward, Wall Street analysts are expecting 3.5% normalized EPS growth for fiscal 2024, 9% for fiscal 2025, and 9% for fiscal 2026. Revenue consensus estimates are 7.8% for fiscal 2024, 9.4% for fiscal 2025, and 8.15% for fiscal 2026. These are significant reductions from historical growth rates, and it explains why the company saw valuation multiple contractions recently:
The one area in the chart where this is not the case is the company’s price-to-free-cash-flow ratio, which has actually expanded as a result of its strong free-cash-flow generation over the last year and a half:
The company has largely been able to manage this because it uses high levels of SBC, and it also records large levels of depreciation and amortization, making its free cash flow consistently much higher than its net income. Personally, I am very fond of this because higher levels of free cash flow compared to earnings means more real liquidity, contributing to the company’s ability to remain agile and make strategic decisions more quickly.
Considering analysts’ estimates and the fact that NetEase is maturing as a company now, with heavy domestic restraints growing against the company’s free-market expansion capabilities, I think much of its growth success is going to be supported by international operations moving forward. I think analysts are undervaluing the potential here somewhat. As a result, I think a 9% basic EPS CAGR is possible over the next 10 years. In my opinion, it is likely for the P/E GAAP ratio to contract toward approximately 12 due to slower fundamental growth forecasts as time progresses. The current P/E GAAP ratio is 14.5. However, in the near term, I think it is likely for the P/E GAAP ratio to expand toward around 15 once 2024’s earnings show more significant growth compared to 2023 and in anticipation of 2025. With basic EPS per share estimated by the company for December 2024 of $7.32, if the stock reaches a P/E GAAP ratio of 15 by December, it will be worth $109.80. This implies a 16.86% increase from the present stock price of $93.96. It is worth stating that the market may be slower to price the stock this way, so I believe 6–12 months from now is reasonable for my price target to be met. However, over the long-term, December 2034 could see a stock price of $207.84, implying an 8.37% CAGR because of 9% annual basic EPS per share growth from December 2024’s $7.32 and my predicted P/E GAAP ratio of 12. Therefore, I think it may be worth investors selling around when my price target is neared or met if one is looking solely for alpha.
Risk Analysis
In the near term, I think there could be issues with my prediction if the company misses earnings estimates multiple quarters in a row. If this happens over the next three quarters, I expect the upside from the present price to be more moderate. Factors that could cause this include further issues in the macroeconomic environment and greater CCP restrictions on gaming, leading to curbed demand. In addition, as the company is beginning to focus more on international markets, costs related to this could impact its earnings results if it takes more aggressive strategy measures sooner than anticipated. Higher marketing costs in an effort to drive long-term brand recognition could also deflate short-term results. Therefore, my price target for the beginning of 2025/end of 2024 is optimistic, and there are certain factors that could reduce the market’s sentiment surrounding NetEase stock during this timeframe.
In addition, NetEase’s long-term international expansion strategy could prove more problematic in the medium term than beneficial. While management is doing well by strategically partnering with Western counterparts like Microsoft, the development and marketing team will still need to make sure that the games that are released cater to the correct cultural preferences of target markets. I think there are likely to be growing costs and growth restraints before long-term growth is actualized at management’s ambition.
Conclusion
NetEase is likely undervalued in the near term, but I’m not expecting it to beat the market over the next 10 years. There are issues in the company achieving this with its current level of maturity, and the fact that it is looking to international expansion to maintain growth. I think its long-term strategy is likely to pay off, but there are also likely to be considerable development costs that inhibit the company from achieving long-term alpha in stock price returns in the next 5–10 years. That being said, if management executes well, we could be looking at higher growth rates than currently forecasted by Wall Street analysts, which is likely to expand the valuation multiples or keep them steadier for longer. However, these results are somewhat speculative, so if buying at present levels or at the time of my previous thesis, I think there is some rationale to sell if my December 2024/early 2025 price target is met.
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