NetEase is the second largest video game company in China. Over the past 10 years, NetEase has grown revenues by an average of 29% per year without a single down year. Over the past 5 years, revenues have grown 15% per year despite an unfavorable regulatory and economic environment in China. Earnings per share grew 25% per year over the past 10 years and 30% per year over the past 5 years. The company is very capital efficient and has averaged a long-term return on equity in excess of 23% over the past decade. NetEase also has a shareholder-friendly founder, William Ding, who owns 45% of the shares outstanding and is focused on returning excess cash to shareholders. Over the past 5 years, the company has on average returned 63% of its free cash flow to shareholders via a mix of dividends and stock repurchases.
Surely a company with such a phenomenal track record would demand a premium multiple in the market. No so. We recently acquired shares in this excellent business for a trailing PE multiple of just 12.5x. To give you some frame of reference, over the past 20 years, NetEase has traded for between 10x and 40x PE with an average PE of about 21x. Using declared dividends over the past year, NetEase has a 3% dividend yield (and nearly 9% free cash flow yield) at our purchase price. This is a Chinese company so yes there is geopolitical risk and yes there is a weak macro environment in China. However, rarely does one get the chance to buy such a high-quality company at such a low multiple so I believe we are well compensated to bear these risks.
The Video Game Business
The video game segment makes up 80% of revenues and nearly 90% of the company’s gross profit. NetEase’s gaming revenues are further split 75% mobile and 25% PC games. Currently, most of NetEase’s revenues come from China. However, even with a gradually declining Chinese population, the video game market is a secularly growing industry. This is because the addressable market for the gaming industry is not the total population, but the population that has grown up with video games and adopted games as a key part of their life and entertainment. Today, that is mostly people who are 40 and under. There are comparably few 60- and 70-year-olds playing video games in China (or anywhere else). However, I also believe the 30- and 40-year-olds who are gamers today will remain gamers throughout their life as they age. Another mitigating factor is NetEase’s ability to tap into the Western markets and diversify their revenues.
Contrary to some outdated beliefs, the gaming business is no longer a boom-and-bust business where you have fat and lean years driven by hit games. Rather, the development of live services within games has led revenues to be much more stable and recurring. The most successful games are often evergreen with continuously updated content, vibrant in-game communities and social features, and recurring monetization via the sale of in-game virtual items and cosmetics (character skins/outfits). Many of NetEase’s most popular games are a decade old and still doing well. As an extreme example, the origins of NetEase’s Fantasy Westward Journey games can be traced back 20 years!
Although periodically there will be new entrants, the top grossing charts are remarkably stable. The Chinese gaming market is dominated by Tencent and NetEase. The rest of the market consists of a long tail of smaller developers. Ten years ago, Tencent was the #1 gaming company in China and NetEase was the #2. Ten years later, Tencent is still the #1 and NetEase still the #2.
Although being #2 at something may not sound that exciting, in many ways NetEase is the better and more creative game developer. At Tencent, gaming is just one division alongside messaging, cloud, and payments. At NetEase, gaming is the lifeblood of the business. Tencent has long adopted a strategy of investing in and acquiring studios and nearly all of Tencent’s successful games in the west have come from acquisitions (Riot Games, SuperCell, etc.). NetEase tends to develop games from the ground up and the culture is much more creative. This is driven by the passion of its founder William Ding who remains involved in the development process. As an example, NetEase developed Eggy Party in 2023, a silly, fun party game involving characters who are eggs which became an unexpected smash hit in China.
Importantly, I believe NetEase’s creative game development expertise positions it well to succeed and diversify into the Western markets. NetEase already has some early success with Naraka: Bladepoint routinely placing in the top 10 most played games on Steam (PC game platform). Impressively, Naraka is a three-year-old game that has continued to grow its active player base. More recently, NetEase also found some success with open-world survivor game Once Human. I believe these are early indicators that NetEase can figure out the western game markets. A number of games in the pipeline look promising. Marvel Rivals is what Overwatch 2 should have been before Blizzard completely fumbled the sequel to their popular hero shooter. NetEase appears to have improved on the most successful game play mechanics of Overwatch while overlaying it with the unmatched IP of Marvel superheroes. Based on player excitement and feedback from beta testing, this will be a game to watch when it launches in December of 2024. Where the Winds Meet and Fragpunk are also upcoming games that hold promise.
While NetEase has the potential to crack the Western gaming markets, Western gaming companies are required to have a Chinese partner to distribute games in China. NetEase recently re-signed an exclusive distribution agreement with Blizzard Entertainment to be the operator of Blizzard games such as World of Warcraft, Hearthstone, Diablo, etc. in China. (NetEase used to operate Blizzard games in China until Blizzard pulled out of the China market for a year due to the inability to agree on sharing economics, but that’s a story for another day). The reintroduction of Blizzard games in China over the coming quarters will be a nice boost to revenues and a bit of help on profits as well.
The headlines of China cracking down on the video game industry is an outdated headline from 2021-2022 period. Over the past year, the Chinese government has been much more supportive of the gaming industry. Gaming licenses (which are required to launch new games in China) have been issued in increased numbers this year. More recently, the success of Black Myth Wukong, the first AAA video game produced by a Chinese studio was praised both in the West and in China. The Chinese media widely reported on the success of the game, which is based on classical Chinese mythology. The game even led to a significant boost in tourism to the heritage cultural sites featured in the game. The success of Black Myth Wukong has helped China look at video games in a new light as an artform and a way to express cultural soft power.
Other Businesses
The roughly 20% of non-gaming revenues comes mainly from Cloud Music (#2 music streaming platform in China), YouDao (educational learning company), and Yanxuan (consumer lifestyle brand in China). The common theme among these companies is a significant improvement in profitability over the past few years.
Cloud Music is undergoing a profitable transition away from live streaming tipping revenues towards recurring music subscription revenues more akin to Spotify. Importantly, subscription revenues are also higher margin allowing Cloud Music to improve from reporting an operating loss of 1.6 billion RMB in 2020 to an operating profit that will likely exceed 1 billion RMB in 2024. Further improvements are likely as the mix shift towards subscription revenues is ongoing. With just 20% of users paying for a subscription, there is still opportunity to continue to grow paying subscribers.
YouDao reported an operating loss of 900 million RMB in 2021, but has steadily narrowed its losses and is nearing breakeven in 2024. Yanxuan and other businesses have been able to improve gross margins from 24% in the first half of 2022 to about 34% in the first half of 2024.
Valuation
The valuation is attractive. Even if NetEase never manages to grow again (which seems unrealistic as this is a company that has averaged 25% earnings growth per year over the past decade), you can earn a high single digit return from just the free cash flow yield. NetEase has been prudent with their capital allocation and has a track record of returning most of their excess cash back to shareholders in the form of dividends and share repurchases.
If we are willing to assume some return to historical valuations, the opportunity becomes even more attractive. Let’s assume NetEase manages grow to earnings per share 10% per year. Let’s further assume that the trailing PE multiple expands from 12.5x currently to 20x over the next 7 years (this would still be a bit below NetEase’s long-term average of 21x). The multiple expansion would add another 7% per year to the stock’s return. Let’s assume another 2-3% return from the dividend yield. Adding the earnings growth, multiple expansion, and dividend yield together yields an annual return of nearly 20% per year. Keep in mind that these are not particularly heroic assumptions as it assumes below average earnings growth and below average multiples.
In summary, NetEase is a great business with an excellent track record that is trading for historically low multiples. Time will tell, but I think the odds are in our favor that this could end up being a lucrative investment.
Disclosure
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I hold an investment in NTES shares.
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