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NetEase Posts Another Quarter of Accelerating Sales Growth

NetEase (NASDAQ: NTES) reported its fourth-quarter earnings on Feb. 20. Its revenue rose 36% annually to RMB 19.84 billion ($2.89 billion), which missed the USD guidance by $20 million but marked its third straight quarter of accelerating sales growth.

NetEase's non-GAAP (generally accepted accounting principles) net income rose 26% annually to RMB 2.36 billion ($343 million), $2.66 per American depositary receipt (ADR), which topped estimates by $0.22. On a GAAP basis, its net income rose 32% to RMB 1.7 billion ($247 million), or $1.92 per share.

Should investors consider investing in NetEase, which shed a quarter of its value over the past 12 months, after that report? Let's dig deeper to find out.

Image source: Getty Images.

How fast is NetEase growing?

NetEase generated over 55% of its revenues from online games last quarter. Thirty-four percent came from its e-commerce platforms, 7% came from its "innovative businesses and others" (formerly known as its "email and others") unit, and the remaining 4% came from its advertising business. Here's how those four core businesses fared over the past year.

Segment

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Online games

(11%)

(18%)

7%

28%

38%

E-commerce

175%

101%

75%

67%

44%

Innovative businesses and others

55%

102%

43%

32%

14%

Advertising

11%

4%

7%

2%

3%

Total

21%

4%

22%

35%

36%

Source: NetEase quarterly reports. Year-over-year revenue growth, on an RMB basis.

NetEase's gaming business, which was crippled by a nine-month freeze on new approvals in China, roared back to life during the fourth quarter as the company's main growth engine. NetEase attributed that growth to the strength of mobile titles like Fantasy Westward Journey, New Westward Journey Online, and Knives Out. NetEase's new Night Falls: Survival also topped China's iOS download chart in November.

The growth of NetEase's Kaola and Yanxuan e-commerce platforms decelerated, but Amazon (NASDAQ: AMZN) could give it a shot in the arm soon by merging its Chinese import unit with Kaola via share-swap deal.

Meanwhile, the slowdown in its "innovative businesses and others" segment, which generates most of its revenue from its streaming music platform NetEase Cloud Music, indicates that the unit could be struggling to keep pace with its biggest rival, Tencent Music (NYSE: TME). The sale of its comic book assets to Bilibili (NASDAQ: BILI) also possibly exacerbated that slowdown.

Image source: Getty Images.

The growth of NetEase's advertising business, which hasn't been a top priority in recent quarters, also remains weak as investors stick with 800-pound gorillas like Baidu and Tencent instead.

But mind the margins

NetEase's revenue growth looks solid, but its gross margins were a mixed bag.

Segment

Q4 2017

Q3 2018

Q4 2018

Online games

61.4%

65.1%

62.8%

E-commerce

7.4%

10%

4.5%

Innovative businesses and others

(3.3%)

(3.3%)

(5.2%)

Advertising

71.2%

63.6%

66.3%

Source: NetEase quarterly reports. Gross profit margins, on an RMB basis.

NetEase's gaming gross margin expanded annually, buoyed by higher total revenues and certain fixed costs in online games, but declined sequentially due to its higher dependence on lower-margin mobile games and licensed titles.

Its e-commerce margins fell both annually and sequentially on higher promotions and discounts, which indicates that its e-commerce business is struggling to stay relevant in the shadow of Alibaba (NYSE: BABA) and JD.com.

Yanxuan's controversial business model of selling "unbranded" products also leaves it vulnerable to government crackdowns on counterfeit goods. Kaola, which focuses on imports, could fare better (especially with Amazon's support), but it still trails behind Alibaba's Tmall Global in that smaller market.

As for the innovative businesses unit, NetEase noted that a "decreased revenue contribution from certain online platform businesses which have relatively higher gross profit margins" caused the segment to stay unprofitable. In other words, NetEase probably secured fewer paid subscribers for NetEase Cloud Music as Tencent Music aggressively expanded after its IPO last December.

Lastly, the gross margin of its advertising business improved sequentially on seasonally higher demand for ads. However, higher staff-related expenses and content acquisition costs caused the year-over-year decline.

Is it time to buy NetEase?

Analysts expect NetEase's revenue and earnings to rise 24% and 21% annually, respectively, this year. Those are solid growth rates for a stock which trades at 29 times this year's earnings. It also pays a forward dividend yield of 0.7%.

NetEase remains a solid investment on the Chinese tech industry, and it could rebound on any progress in the trade talks between the U.S. and China. But it also remains an underdog in its core gaming, e-commerce, music, and advertising markets. I'm also not a fan of the way NetEase sells unbranded goods or clones hit games. Therefore, I'd personally stick with "best in breed" plays like Tencent, Baidu, and Alibaba before buying second-tier players like NetEase.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon, Baidu, JD.com, and Tencent Holdings. The Motley Fool owns shares of and recommends Amazon, Baidu, JD.com, NetEase, and Tencent Holdings. The Motley Fool has a disclosure policy.

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