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3 Reasons NetEase Is Still a Top Chinese Tech Stock to Own

NetEase's (NASDAQ: NTES) stock popped last week after the Chinese tech company posted its third-quarter earnings. Some investors might be reluctant to chase that rally, especially given that the stock has risen nearly 50% this year, but I think it's still a great buy, for three simple reasons.

1. Accelerating revenue growth

NetEase's revenue rose 27% year-over-year to 18.66 billion yuan ($2.75 billion) during the quarter, which met analysts' expectations and marked an acceleration from its previous quarters:\.

Metric

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Revenue growth (YOY)

11%

9%

18%

26%

27%

YOY = year-over-year. Data source: NetEase.

NetEase generated 74% of its revenue from online games during the third quarter. The unit's revenue rose 20% year-over-year, as Invincible, Onmyoji, and Sky locked in mobile gamers in China and its flagship Fantasy Westward Journey games generated stable revenue from PC gamers.

It also continued to expand its overseas presence with Knives Out, LifeAfter, and Identity V in Japan. Looking ahead, its pipeline of upcoming games includes Harry Potter: Magic Awakened, The Lord of the Rings: Rise to War, Diablo Immortal, and Pokemon Quest -- all of which could further expand its reach beyond China.

Image source: NetEase.

NetEase's second-largest business, its "innovative businesses and others" segment, generated 21% of its revenue. This unit houses its e-commerce marketplace. Yanxuan, its online advertising business, and NetEase Cloud Music, China's second-largest streaming music platform after Tencent Music (NYSE: TME). Its revenue rose 42% year-over-year during the third quarter, led by the growth of NetEase Cloud Music.

The remaining 5% of NetEase's revenue came from Youdao, the online education platform that has flourished throughout the COVID-19 crisis. That momentum continued in the third quarter, as its revenue surged 159% year-over-year on rising K-12 enrollments and robust sales of intelligent learning devices like digital reading pens and translators.

2. A temporary earnings swoon

NetEase's adjusted earnings per American depositary share fell 26% to $0.80 during the quarter. That beat expectations by $0.34, but still marked a sudden deceleration from double-digit growth in previous quarters.

Metric

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Non-GAAP earnings per ADS growth (YOY)

74%

19%

25%

32%

(26%)

YOY = year-over-year. Data source: NetEase.

NetEase faced a difficult comparison to its 74% earnings growth in the prior-year quarter, when it benefited from the sale of its cross-border e-commerce marketplace Kaola to Alibaba (NYSE: BABA) for $2 billion.

Its operating margin also declined year-over-year and sequentially as it ramped up its investments in NetEase Cloud Music and Youdao while testing out lower-margin "casual" games:

Metric

Q3 2019

Q2 2020

Q3 2020

Operating margin

22.8%

22.9%

15.4%

Data source: NetEase.

But during the conference call, NetEase CFO Charles Yang noted that although its operating expenses rose 55% year-over-year in the third quarter, it expects those investments to "gross billions" in future quarters.

If we cut through the near-term noise, NetEase's gross margin dipped only slightly from the previous quarter and prior year, with year-over-year gains in two of its three businesses:

Gross Margin

Q3 2019

Q2 2020

Q3 2020

Online games

63.8%

63.8%

63.6%

Innovative businesses and others

15.2%

18.5%

16.8%

Youdao

25.8%

45.2%

45.9%

Total

53.8%

53.8%

53%

Data source: NetEase.

Those stable gross margins indicate NetEase's earnings should rebound after it cools off its aggressive investments, which will hopefully capitalize on the post-pandemic growth of the online education, gaming, and streaming music sectors, while widening its moat against top rival Tencent (OTC: TCEHY).

NetEase didn't provide any guidance, but analysts expect its revenue to rise 23% this year, and its earnings to dip 4%. But next year they expect its revenue and earnings to rise 17% and 27%, respectively.

3. A low valuation in a pricey market

Investors should always take analysts' expectations with a grain of salt, but NetEase's stock trades at just 20 times next year's earnings estimate. By comparison, Tencent trades at nearly 40 times next year's earnings.

Tencent is generating stronger growth, with analysts expecting its revenue and earnings to grow 36% and 46%, respectively, next year. But its business is also more complex than NetEase's, and it's arguably more exposed to China's newly drafted antitrust rules.

The key takeaways

NetEase might not initially seem as impressive as higher-growth tech companies like Tencent and Alibaba. But its core businesses are still strong, it has plenty of room to expand across the gaming, online education, and streaming music markets, and its stock is cheap relative to its long-term growth potential.

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Leo Sun owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends Alibaba Group Holding Ltd. and Tencent Holdings. The Motley Fool recommends NetEase. The Motley Fool has a disclosure policy.


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