introduction

2021 has been brutal for Chinese tech stocks. Some small cap stocks such as HUYA, DOYU and TME lost up to 88% of their market capitalization. Alibaba Inc (NYSE:BABA) was hammered -47%. And other companies such as Baidu Inc (NASDAQ:BIDU) managed to squeeze in with acceptable losses of just -24%.

However, two big tech players held up pretty well – with only single-digit percentage losses. These companies include JD.com (NASDAQ:JD) and NetEase (NASDAQ:NTES). This naturally aroused my curiosity and I was eager to see the companies up close. I wrote about JD.com here (spoiler: it’s a great company).

In the following article, I will focus on NetEase. First, I will present an overview of the company. Second, I will present a financial overview. And finally, I will apply a DCF valuation to calculate the intrinsic value of NetEase based on a base, bearish and bullish scenario.

For those of you who don’t want to read the whole “analysis“, but only a concise and accurate summary of my research, here it is: I initiate my coverage on NetEase with a buy recommendation and a price target of $215 through 2025, implying a CAGR of 20.1%.

About NetEase

NetEase is a leading Internet company in China, focusing primarily on games, but has also expanded into various services centered on innovative content, community, communication and commerce.

As a leading gaming company, NetEase develops and operates some of China’s most popular mobile and PC games. So far, the company has more than 100 games in operation. In addition to its self-developed game content, NetEase partners with other leading game developers, such as Blizzard Entertainment and Mojang AB (a Microsoft subsidiary), to operate globally successful games in China. Notably, NetEase itself has made major inroads into international markets, including North America and Japan. In 2018, “Knives Out” held the No. 1 spot for 6 months in overseas Chinese mobile game rankings. At the same time, NetEase Games has successfully launched many other internationally popular titles, including Rules of Survival, Identity V, Onmyoji, Onmyoji Arena, Life After.

NetEase is ranked the No. 2 largest game developer in the world, just behind Tencent. And we all know it, the gaming industry is on fire. Whether it’s the future of entertainment, VR/AR, Metaverse, NFTs or another tech trend: the gaming industry is likely to be the battleground for tech giants to realize innovation and seek growth. Looking to the future, in my view, NetEase is well positioned to seize the trend of gaming premiumization with a strong product portfolio, creative ingenuity, and international expansion.

More than game

However, gaming is not NetEase’s only business. In fact, NetEase has expanded into a diverse basket of Internet services and business models. The most important companies are undoubtedly:

• Youdao, AI-based learning platform that provides educational services across all disciplines and for all ages. YouDao (NYSE:DAO) is listed on Nasdaq and currently trades at a market capitalization of $1.83 billion.
• NetEase Cloud Music, is a freemium music streaming service developed and owned by NetEase, and arguably Tencent Music’s (NYSE:TME) ​​biggest competitor. NetEase Music Cloud is listed on the Hong Kong Stock Exchange and currently trades at a market capitalization of $2.29 billion under the symbol 9899.
• NetEase Yanxuan, is a private label e-commerce brand that provides high quality and cost-effective lifestyle products to Chinese consumers. The idea is a new business model, which connects quality manufacturers directly to customers and eliminates unnecessary costs and third-party layers of distribution and retail.
• NetEase CC, is a live streaming service.
• NetEase email, one of the earliest and most popular email service providers in China with over 500 active accounts.

The following graph gives an overview of how the revenue share of different companies is distributed. As you can see, “online gaming services” is by far the largest component at 74%, followed by “innovative businesses and others” at 22%, and Youdao at 4%. Notably, since around 2017, non-gaming businesses have begun to pick up pace and account for an increasingly larger share of revenue growth. As noted by management in various analyst calls, this trend is expected to continue.

finance

When assessing a company’s financial potential, I like to see three key characteristics: revenue growth, strong operating cash flow and a healthy balance sheet. Although the overall conclusion is relatively favorable for NetEase, the financial figures do not necessarily imply an undervaluation reflecting the current market capitalization.

Let’s start first with the income statement. Between 2018 and 2020, revenues grew from $8.3 billion to $11.3 billion, implying a compound annual growth rate of 8.02%. In addition, operating profit growth continued at a perfect pace and increased from $2.0 billion to $2.8 billion. Notably, NetEase’s cyclically-adjusted EBITDA margin is around 24.4%.

The cash flow statement partially confirms what we saw in the income statement — an efficient business. As you can see, operating cash flow is constantly inferior than net income levels, calculating a cyclically adjusted average of 930 million per year. I honestly don’t like this observation, because operating income below net income usually means poor quality earnings.

For reference, the market cap of NTES, as of early February 2021, is just $69.5 billion.

NetEase’s balance sheet appears solid and healthy. At the start of 2022, NetEase had $14.7 billion in cash, roughly 21% of the company’s market capitalization. Additionally, total debt levels at just $9.7 billion imply a leverage ratio of less than 1/2. So, in my view, NTES could absorb some multi-year headwinds, while making significant investments in long-term growth opportunities and new product development.

Finally, I would like to point out that almost no intangible assets are recorded on the balance sheet, although this category is probably the most important asset – and of the highest monetary value.

Evaluation

Now let’s see what a reasonable price target for the company might be. I constructed a DCF valuation with sensitivity analysis of key assumptions. The results of my analysis are called base, bearish and bullish cases. (Some assumptions for the analysis are listed under the respective case).

As you can see, possible valuations for NTES, given current knowledge of the company, could range from US$64.93 per share to US$322.88 per share. I would however note that the probabilistic weights of these targets are not normally distributed! On the contrary, I expect the probabilities to be slightly biased towards the bullish case. I personally estimate the following probability distribution. Feel free to challenge my personal assumption.

• Base case: 25%
• Bear case: 20%
• Bull-Case: 55%

I base my argument for the bullish deal on NetEase’s excellent track record of successful business development and new business incubation, coupled with my favorable outlook on the future of the Chinese economy and industry. international game. Personally, I expect a valuation of around $215 per share by the end of 2023.

However, to give a more balanced assessment on NTES, let’s look at where other analysts set their price target. As you can see, the average is calculated at $136.83 per share, which also reflects a slightly bullish bias.

Some thoughts on the risks

Although the market has probably priced in too much negativity for Chinese stocks in general, NetEase was largely unaffected by the impact of regulatory headwinds and political uncertainty. This does not mean that NetEase enjoys some kind of permanent “immunity”, however.

Regulatory headwinds in China. Perhaps the biggest risk to NetEase stock is continued pressure from the Chinese government. I don’t want to politicize the discussion or portray myself as a China expert, so I would encourage every investor to do some research and assess the situation for themselves.

ADR delisting fears. This risk is closely related to the previous concern of regulatory headwinds. Personally, I’m not afraid of an ADR delisting, but the negative market sentiment and fear could certainly keep the stock price depressed for some time. Notably, NetEase is also listed on the Hong Kong Stock Exchange.

The gaming industry in China is not without competetion. In fact, China’s gambling industry is so popular and financially attractive that it has attracted many gamers. The biggest competitor is obviously Tencent (OTCPK: TCEHY). But, of course, international players such as Activision Blizzard (NASDAQ:ATVI), Take Two Interactive (NASDAQ:TTWO) etc. should also be evaluated when analyzing the industry.

Conclusion

NetEase is definitely an interesting tech company. And as a gaming industry leader, I expect NetEase to benefit from a secular growth narrative that will see the NetEase industry vastly outperform the broader economy. Gaming, for me, will be the battleground for tech companies in the coming decades.

From a fundamental point of view, however, I am not entirely convinced. While NetEase definitely looks like a good company and an attractive investment overall, I personally think the Chinese market has equally good companies at cheaper valuations – with particular reference to Baidu (BIDU).

Concluding with numbers: I expect a target price of $215 through 2025, implying a CAGR of 20.1%.