China ADR stock research

(Sept. 18, 2009 - Junqiang Zhang)  Investors have to pay attention to online game developers and operators when it comes to NASDAQ listed Chinese stocks. Combined revenues of the sector surpass that of any other internet segment, including online search. NetEase Inc. (NASDSQ:NTES) is the most profitable within the industry, a must-get-it-right company when it comes to the whole sector. This article will provide insight not only into the operations of NetEase Inc. (NTES) but to the rest of the sector.

Revenue/EPS

NetEase.com Inc. (NASDAQ: NTES) has released its second quarter performance result on 13 August 2009. It revealed a growing revenue and EPS, with US$127.7 million and US$0.02 respectively.

Figure 1. NetEase’s total revenue

The 11.6% growth of total revenue is attributed to the increase of online game services by US$8.4 million, as well as advertising services by US$4.7 million. Particularly, the improvement of online game services is mainly due to revenue recognized from removing game points from dormant accounts.

Figure 2. Net Profit and Total Revenue

With the economy recovery in China, the revenue of advertising services experienced a sharp increase by 77.5%, from US$6 million to US$10.7 million. At the same time, gross profit margin of advertising services jumped up from -13.1% to 16.6%. However, compared with US$15.2 million in the second quarter of 2008, this revenue is still relatively low.

Although NetEase.com has increased its net profit since the first quarter of 2009, its net profit margin stayed still. It was even worse quarter over quarter. However, EPS has recovered back to the level of second quarter of 2008 at US$0.02.

Competitors

SINA and SOHU compete with NetEase (NASDAQ:NTES)  directly in terms of internet portal. SINA (NASDAQ:SINA), as an online media company and information services provider, underwent a downturn in the second quarter of 2009. Its total revenue decrease by 1.1% quarter-over-quarter, and the net income even shrank by 40.9% to US$13.3 million, compared to US$22.5 million in 2008Q2. SOHU (NASDAQ:SOHU), however increased 24.6% in total revenue and 21.6% in operating income. But its net income has a negative growth due to the large proportion of provision for income taxes.

Since online game services contribute 89.6% revenue, obtaining a good position in this competition are more crucial for NetEase to survive. The main rivals include Shanda Interactive (NASDAQ:SNDA), Changyou.com, Giant Interactive (NYSE:GA)  and The9 Ltd. Figure 3 and 4 are comparisons of NetEase and its rivals in terms of total revenue and net profit margin.

Figure 3. Total revenue in 2009Q2

As shown in the sector graph above, NetEase (NASDAQ:NTES) has taken the second large market share in online game industry. Although Shanda Interactive (NASDAQ:SNDA) enjoys the largest part of the market, its net profit margin is relative lower than NetEase (Fig.4). Giant Interactive (NYSE:GA)has the highest net margin, but its market share is smaller than NetEase. Thus, it is believed that NetEase is the most profitable online game services provider with relatively large market share and high net profit margin.

Figure 4. Net Profit Margin, 2009Q2

SWOT analysis

Strengths

NetEase is one of online game providers with capability to develop games, which are profitable and add a large part of its revenue. Fantasy Westward Journey, for example, had 617,293 average concurrent users for the month ended December, 31, 2008. Together with another in-house developed game Westward Journey Online II, it has contributed 73.5% of total net revenue in 2008.

Besides in-house developed online games, a well-known MMORPG called World of Warcraft has been licensed to NetEase by Blizzard Entertainment. This game has ever contributed 90% of total revenue, which is US$59 million, to previous operator (The9 Ltd.) in the first quarter of 2009. Possessing license of WoW therefore is considered to be potential profitability for NetEase as long as the commercial operation is conducted successfully.

Weakness

The total revenue of NetEase relies heavily on two in-house developed online games, namely Fantasy Westward Journey and Westward journey Online II, which accounted for 73.5% of total net revenues in 2008. This undiversified revenue can bring NetEase high risks, which may have great impacts on its Income Statement. One of the risks, for example, can be that NetEase fails to develop new versions of these two games to attract climates.

Opportunities

The economy of China began to be recovered since January 2009. The expenditure of industries in advertising is increasing at the same time. Thus for NetEase, current period is a good opportunity to improve its market share in website advertising services. In addition, the market of online game grows as citizens’ income level increases. Whether NetEase can grab more market share depends on its ability to introduce new attractive online games to the market.

Threats

Before operating WoW commercially, NetEase needs to receive necessary governmental approvals including approval and a publication number from the PRC General Administration of Press and Publications. At the moment, WoW still endure beta test even it was ever operated by The9 Ltd in China. Although the probability of disapproval from GAPP is fairly small now, the delay of launch of WoW’s new version, Wrath of the Lich King, can affect its popularity and profitability adversely as well. In fact, currently there is no information to reveal the schedule when NetEase can receive approval of Wrath of the Lich King version from the government.

---

If you like us, spread the word to the fellow investors on your favorite Social Bookmarking websites