NetEase (NASDAQ: NTES) fundamentals remain stable. With the stock being pulled lower due to political concerns, not due to weak earnings or future prospects, I believe NetEase has value.
NetEase is a Chinese company that provides online services centered on content, communications and commerce. The company is a developer and operator of several online PC and mobile games, email and advertising services. NetEase has licensing deals with major companies including Mojang and Blizzard to bring some of their respective games to the Chinese market.
NetEase’s revenue has grown rapidly, with only a few quarters of decline. Since 2010, the average annual growth rate has been 30%.
As the company got bigger, the growth rate eventually dropped to the low double digits, which is still a solid growth rate considering the size of the company.
The growth was primarily due to the release of new games while existing games continued to grow. Revenue growth is expected to slow as games eventually mature and require more revenue to drive development.
Analysts expect revenue to continue growing next year.
Margins show a good earnings history, with no year of negative returns. However, after a revenue explosion in 2015, profit margins have been falling due to new games and licensing deals.
It has since stabilized at ~17%.
Rapid revenue growth coupled with a declining but profitable net profit margin resulted in years of strong net profit growth.
From 2010 to 2022, the average annual growth rate of net income growth is about 21%. That growth is pretty impressive, especially considering it’s achieved without diluting shareholders. The number of outstanding shares has barely increased, so earnings per share have also increased by about 20% per year.
As shown in the figure below, NetEase achieved approx. From 2010 to 2017, the annual return on equity was about 25%. Considering that nearly all of the earnings are reinvested, the returns are impressive. Starting in 2013, only a small portion of earnings has been paid out in dividends, with occasional small share buybacks to offset dilution.
Return on equity now appears to be stable at around 17%. Given that the company spends about 25% of earnings on dividends, and they manage to continue to reinvest 17% of their earnings in stocks, future stocks and earnings should grow at about 12.75% per year.
The key takeaway is that most of the earnings are reinvested, which I think is prudent given the high double-digit reinvestment rate management has been able to achieve.
I do take comfort in that it seems to have stabilized or even increased in recent months. The high reinvestment capability underlines the strength and moat of the company.
As shown in the chart below, the average annual growth rate from 2010 to 2022 is 19.74%. We can also see that growth has slowed in recent years. This is to be expected given the lower return on equity.
The annual growth rate of EPS from 2010 to 2017 was 25.05%. Meet their ROE during this period. Given an ROE of around 17% from 2017 to 2022, a dividend payout ratio of around 25%, and no meaningful share repurchases, a reasonable estimate of EPS growth for future years is around 12.75%.
The projected growth is in line with analysts’ expectations for the next 2 years, which are also in the low double digits.
The company has grown at an above-average rate over the past decade, and as a result has earned a higher-than-normal earnings multiple. The average annual growth rate is 19.74%, and the average multiple is 18.75. Returning to its average multiple would suggest a return of around 48%. I think the company should trade at a higher P/E than its current 12.9x, but since it looks unlikely to achieve more than 15% annual growth, I think its average P/E no longer provides a margin of safety.
Going back to the standard 15x P/E ratio, which still suggests upside potential of around 20%, seems more plausible.
A quick disclaimer: Technical analysis alone is not a sufficient reason to buy a stock, but combined with a company’s fundamentals, it can significantly narrow your target price range when you buy.
Shares of NetEase are currently trading below its 50 moving average, which has acted as a strong support area several times in the past. This is common among continuously growing companies, which NetEase classifies as . A return to its 50 moving average would indicate a 40% return. That would also bring the stock closer to its average multiple and just above the standard multiple of 15.
However, if the stock continues to fall (current market weakness and political developments in China could be catalysts), then I expect strong support from its 200 moving average. I don’t think this low valuation is likely to happen, but in this market, I think anything is possible.
There is no doubt that NetEase is a powerful company. The company has shown strong fundamental growth for years in a row and isn’t expected to stop anytime soon. Although the reinvestment rate has declined in recent years, it still shows good prospects for future growth. With a return on equity of 17% and a dividend payout ratio of about 25%, the estimate of annual growth of about 12.7% is very reasonable.
The current valuation seems attractive considering the 12.7% annual growth rate. The company trades well below its average price-to-earnings ratio. While I think the slowdown in earnings growth is somewhat justified, at least a standard multiple of 15 should be given going forward.
Clearly, it is no accident that NetEase is far less volatile than other Chinese stocks, although its undervalued valuation is partly due to political concerns surrounding the Chinese stock market. The company’s earnings per share are expected to decline only marginally this year, after growing at +30% in the prior year.
Barring political turmoil, the company is expected to grow at double-digit rates with a below-average valuation. The stock chart is in line with earnings hints, and it might make sense to consider NetEase.
Therefore, I give the company a “buy” rating.