Miss This Stock and You’re Missing Great Returns

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2012 was a forgetful year for NetEase (NASDAQ: NTES), as the Chinese online gaming giant was beaten down badly in the second half of the year after a string of awful quarterly reports. But, I knew that the company’s business was strong enough and it would be just a matter of time before it bounces back. As expected, this year has been great so far for NetEase investors as the stock has gained more than 40%.

A closer look at the company’s just released quarterly report further tells us that NetEase has been going about its business in a very strategic and methodical manner. It has been reducing its dependence on licensed games and is instead focusing on its in-house games.

Smart moves

Thus, despite a steep decline in the number of subscribers in Activision Blizzard’s (NASDAQ: ATVI) World of Warcraft, which NetEase operates in China and derives licensing revenue from, the company managed to post year-over-year top-line growth of 13%. NetEase’s revenue came in at $363.6 million, comfortably ahead of the analyst estimate (Yahoo! Finance) of $348 million. Earnings came in at $1.32 a share, well ahead of the $1.20 consensus estimate and 13% higher from last year.

The company’s self-developed games, such as Fantasy Westward Journey, Westward Journey Online II, Heroes of Tang Dynasty II, and Kung Fu Master performed well and helped offset the outflow of 1.3 million subscribers (with most of them being from China) from Activision’s World of Warcraft. NetEase is focused on making its self-developed games stronger and as such, it has been putting its marketing machinery behind them.

Playing it nice and easy

Moreover, the company’s strategy of extending the life cycle of its games through expansion packs, along with new games, should lend further momentum to its top line going forward. Apart from releasing a number of expansion packs, NetEase’s pipeline includes games such as Dragon Sword, a 3D MMORPG, Legend of Tibet, a 2.5D MMORPG, and a first person shooter game.

NetEase’s game development, coupled with the booming online gaming market in China, is certainly a positive and should lead to better top-line performance going forward. Its new games and expansion packs would bring fresh content to the players in the country and help mitigate the falling popularity of an eight-year-old franchise such as WoW.

Activision Blizzard expects further declines in the subscriber count of World of Warcraft in the future due to stiff competition from free-to-play games and saturation levels of gamers being attained. Even though the publisher has decided to make substantial investments in order to arrest the decline in subscriber count, I doubt if it would be very successful for reasons I’d pointed out earlier. Keeping this in mind, NetEase has been doing the right thing by promoting its own games and focusing on their development.

NetEase’s diversification doesn’t stop here. The company’s advertising services revenue grew 15% in the previous quarter while email services revenue jumped a whopping 65%. Although these businesses contribute a small portion to NetEase’s overall revenue, the company expects that the rapid growth of internet in China could lead these services to perform even better going forward.

Throw in NetEase’s mobile gaming initiatives and it becomes clear that the company is leaving no stone unturned in making the most out of the Chinese internet and gaming industry. The company has so far witnessed 75 million installations of it mobile games by the end of the previous quarter with 29 million daily active users. To keep this momentum intact, NetEase would be launching a number of new mobile games this year.

A compelling buy

If the above mentioned reasons didn’t sound compelling as to why the stock should be bought, its valuation would certainly convince you. NetEase trades at 13.68 times trailing earnings, and this multiple comes down to 11 times on a forward P/E basis. The company doesn’t have any debt on its balance sheet, but it does have $2.6 billion in cash. NetEase is looking to use that cash to good effect and will now be paying an annual dividend from this fiscal year.

Management plans to “make annual cash dividend distributions commencing in 2013 in an amount between 20% and 25% of its anticipated annual net income after tax in the current fiscal year.” Now, analysts expect the company to earn $4.99 a share this year, and if NetEase decides to pay out at least 20% of its net income after tax, it would result in a dividend yield of around 1.7% at current prices (based on net income forecasted by analysts).

After a solid performance so far this year, NetEase still has the potential to move higher. Its cheap valuation, shareholder friendly moves, smart business strategy, and a booming internet and gaming industry in China are reasons that make this stock a must buy. 

Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and NetEase.com. The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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