December 19, 2011
Written By Paul Goodwin
“If you’ve been reading Cabot China & Emerging Markets Report for a while, you know that our stock- selection discipline uses the acronym SNaC, which stands for story, numbers and chart. The idea is that our ideal stock presents an attractive combination of 1) a great story (business proposition, including uniqueness and appeal of products, size of potential consumer pool, barriers to entry, intellectual property, brand strength, etc.) 2) strong numbers (revenue and earnings growth, profit margins, trading volume, growing institutional support, positive earnings estimates, etc.) and 3) a chart that shows increasing investor appetite for the stock or a positive technical base.
“Our stock pick in this issue is NetEase.com, Inc. (NTES), and we have to say that this is one instance when our investment case involves an excellent story and strong numbers, but that the chart isn’t the kind of blast off that we usually like to see in our selections. Here’s the lowdown. NetEase.com is one of the Big Three of Chinese Web portals (along with Sohu.com and Sina.com). Each of these portals offers a pretty standard mix of news, weather, sports, email, messaging, social groups, search, mobile services and games. Each portal also offers a different emphasis, with Sohu putting more energy into online communities and Sina making waves with its Sina Weibo microblog service. NetEase is putting its money on online gaming, especially the massively multiplayer online role-playing group games like World of Warcraft and StarCraft II, which it licenses from Blizzard Entertainment. The company also develops its own games that center on themes from Chinese history and legend, including Fantasy Western Journey, Westward Journey Online II and III, Tianxia II, Heroes of Tang Dynasty, Datang and Ghost. The company’s partnership with Activision Blizzard (ATVI) is a huge positive, as it raises the likelihood that new titles from that firm will also release in China via NetEase. The company gets 85% of its revenue from online games, and the growth in revenues has been outstanding, with the enormous size of the Chinese population and the continuing buildout of Internet access providing new potential subscribers.
“Revenue growth was just 8% in 2007, but hit 53% in 2008, 23% in 2009 and 49% in 2010. Earnings per share have grown every year since 2002 ($0.05/ share) to $2.55 per share in 2010. This year should bring a 49% increase to $3.79 per share. NetEase’s ancillary numbers are also excellent, with five straight quarters of after-tax profit margins above 40%. The company has no debt (and hasn’t had any since 2008) and generated a cash flow margin of nearly 52% in 2010. And finally, NetEase’s cash reserves were reported at $1.7 billion (with a ‘B’) in the company’s Q2 report. What is NetEase doing with all that cash in the bank? The board of directors recently announced a share repurchase plan of $50 million, which can’t hurt. There’s also the possibility that NetEase might cough up a special dividend. But mostly the cash gives the company plenty of breathing room for in- house development of new games, which will likely be the most reliable source of revenue increases in the future.
“The story and numbers on NetEase.com look good, much better than good, in fact. How’s the chart? Well, NTES had eight good months in 2009, soaring from 15 to 49. And the stock also popped from 26 to 55 into March 2011. But right now, NTES is trading at about 46, which puts it below its 2009 high. And the stock has been trading between 40 and 50 since late January, with only one significant breakout above that range (in March) and one below (in late September). In short, this doesn’t look like the stock chart of a cash-rich, debt- free, high-quality company that grew revenue at 49% last year and with a stock that’s trading at a very reasonable P/E of 13. We’re not value investors, but with markets in a uproar, we know a good conservative play with high potential when we see it. We think you can buy a little NTES right here, with the intention of waiting it out as it gathers strength for a sustained advance. BUY.”
Paul Goodwin, Cabot China & Emerging Markets Report, 12/8/11