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Get Ready for Round 2

In June we highlighted NetEase (Nasdaq: NTES), a Chinese online gaming stock that not many may have heard of. We noted that a future price pullback, perhaps caused by a disappointing quarter, should grab the attention of investors. Flash forward to August, and the opportunity has occurred. Since reporting quarterly results on August 8, shares have declined roughly 14 percent to $270.58 as of Thursday’s close.

The results really weren’t bad, but the previous quarter was so fantastic that expectations had risen so high that even a decent quarter wasn’t good enough. Revenues increased by 49.4 percent on a year-on-year basis, but net income rose just 2.5 percent and the profit margin fell to 22.2 percent. Sequentially, compared to the tremendous first quarter, NetEase failed to increase revenues (minus 2 percent) or net income (minus 24.6 percent). The previous quarter raised the bar too high.

The lower margin is largely attributable to revenue mix, including the shift toward lower margin mobile gaming and ecommerce, and higher marketing spending. Mobile game revenues weakened compared to the first quarter (which ended March 31), as the online gaming segment revenue declined 12 percent quarter to quarter, but it was still up 46 percent compared to a year ago.

One of the company’s mainstay games, Onmyoji, appears to have missed expectations in Mainland China. But the game achieved record-high downloads in Japan and Southeast Asia while it ranked first in South Korea by downloads and top ten by revenue. On Mainland, the mobile-game performance wasn’t uniformly bad, either; its Invincible game achieved record sales.

Overall, mobile-game revenues grew 73 percent, while PC-game revenue increased 4 percent. Since mobile game revenue accounts for roughly 72 percent of overall online-gaming revenues, compared to 61 percent a year ago, which reduced margins. Meanwhile, NetEase has an extensive portfolio of existing games and a pipeline of launches to come, including the expected new version of the hugely popular Minecraft, which has been well received so far in beta testing.

In NetEase’s non-gaming businesses, ecommerce had a surprisingly strong quarter, with revenues growing 69 percent year over year and now contributes 25 percent of overall revenue. The business is expanding domestically and internationally, and NetEase plans to use its platforms as gateways for cross-border ecommerce and for lesser-known, but high-quality global brands to engage Chinese consumers. The minor downside is that the segment only has a gross margin of 11 percent (compared to 63 percent for online gaming), so the higher revenue contribution pulled down the company overall profit margin.

Although the second quarter looks disappointing compared to the fantastic moment the company had enjoyed in recent quarters, and the third (current) quarter looks like the results could be somewhat soft too since contributions from new games probably won’t be significant until the fourth quarter, the pullback looks more like a buying opportunity than anything to us. There is no doubt the Chinese and global gaming markets will continue to grow. NetEase has a proven history of developing popular games and its gaming pipeline remains one of the best in China, rivaled only by Tencent (OTCMKTS: TCEHY). Meanwhile, it’s gaining traction in other businesses that may reduce margins but nevertheless will increase overall earnings. Over the next twelve months, look for the share price to at least re-approach its previous peak.

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