NetEase operates a consumer web portal that not only generates advertisement revenue (12-13% of total revenue) of its own but also serves as gateway to numerous MMORPG offered by the company. The company is planning to diversify into e-commerce and e-payment platform as well. However success seems far-fetched on that front, as the company did not succeed much in growing its portal fast and vast enough. The company earns 88% of revenue from its online games and that has a higher gross margin (75%) compared to 54% gross margin in advertisement business. Its most popular game World of Warcraft is licensed to it by Blizzard Entertainment. NTES recently licensed the popular strategy game i.e. Starcraft II from Blizzard as well.
NTES had a tremendous 47% growth in Online Games revenue in 2010. It was mainly attributable to the combinations of the first full year of operations of World of Warcraft and the impact of large scale promotions for company-owned games Fantasy Westward Journey, Tianxia II and Westward Journey Online II, as well as the launch of Heroes of Tang Dynasty in April 2010.
The company commercially launched Starcraft II in April and intends to use it as a platform for developing new game types or new features to play. The pipeline for 2011 has major expansion packs i.e. newer versions of the above games. Notable launch is Cataclysm System expansion pack of World of Warcraft. However it should be in the latter part of the year. Excluding extraordinary marginal revenue from Cataclysm System or Starcraft II, Netease revenue growth in 2011 will face head-winds due to higher base effect.
Catalyst: Newsflow on success of Cataclysm System and Starcraft II.
NTES has NTM PE of 13.6x and a Cash-adjusted EV/EPS of 10.3x. This highest relative valuation among Chinese Online gaming companies is mainly due to the World of Warcraft franchise. Since 2010 was the first full year of operation for the game, 2011 would suffer from the higher base effect and thus difficult comps. The important differentiators to counter slowing revenue growth could be success of Cataclysm System and Starcraft II.
Target Buy / Sell range would be $40-44 - $55-60
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