NetEase Might Be Slightly Undervalued – DCF

This analysis was first published on ChineseAlpha, an equity research platform that demystifies listed Chinese companies by providing in-depth, quality research. Read the whole article.

The online entertainment industry is experiencing steep growth, powered by a vast demand inside China's mainland and globally. NetEase is a company that has been able to grow progressively in its early years, but it underwent a rise in its valuation from 2014 onwards.

Today, the company is able to face the competition of giants of the industry and maintain its market share over the years. In particular, the gaming sector sees NetEase in second place, behind Tencent games.

Background

NetEase was founded in June 1997 and the company (from a legal standpoint) was incorporated on July 6, 1999, in the Cayman Islands. However, the principal offices are located at NetEase Building, in Guangzhou, People's Republic of China.

The structure of NetEase is the same that is typical of almost all the Chinese companies: a holding company in a tax haven, to access American stock exchanges, and sub-holdings through which organizations inside China are controlled.

Business highlights

The online gaming sector is having a truly solid expansion, with Tencent and NetEase being the giants that control the largest shares of the market. Just like the best globally known Tencent, also NetEase can count on several businesses apart from the gaming one.

The management of the company divides the company into three main parts:

• Online Games through which the firm acts as:

A developer and operator of self-developed games for Internet users inside mainland China and internationally;

An operator of licensed games from Blizzard Entertainment, Mojang AB (Microsoft company) and other international developers.

• Online Education

NetEase offers educational services for people of all ages via its subsidiary Youdao, listed on the New York Stock Exchange (DAO:NYSE).

• Innovative Businesses and Others

In this part, the management puts NetEase's music streaming services as well as news. Another business in which the company is invested is a private-label e-commerce,  Yanxuan, which targets the Chinese middle class, with a strong emphasis on quality of living.

DCF analysis

Our DCF model indicates NetEase's intrinsic value of USD 124.15 per share.

Assumptions to the DCF are a 12% CAGR to revenue, 35% effective tax rate, an internal WACC of 5.56%, and an average terminal value based on EV/EBITDA of 15x and a perpetual growth rate of 2%.

The choice of the multiple to be used is not always easy with a business like the one of NetEase. However, in our experience evaluating tech platforms, the revenue multiples, which usually is inaccurate at best, give the best explanation of the results of the price that can be seen in the market. This is because the growth and success of a certain company are strictly tied to those metrics, as the bigger a platform is, the better the number of users and reach.

This analysis gives us a rather scattered output, but the current price seems to be in a middle area between the more rigorous EV/EBIT and EV/EBITDA and the more permissive EV/revenues and P/sales.

Risks and competition

Youdao is currently operating with negative operating margins of -50% for the past three years operating at a net loss, reporting minus USD 268 million in 2020. The segment has been experiencing significant growth since its IPO with revenue YoY revenue growths of 61%, 78% and 143% for the years 2018, 2019, and 2020 respectively, 

Despite Youdao's spectacular growth, the company is still too small to contribute any significant improvement on its parent company's financials if they ever manage to turn around their operating margins and begin to generate profits. Youdao will continue to be cash outflow to NetEase and hurt the valuation of its parent company in the foreseeable future.

Youdao's growth may see a plateau from weak demand for their educational services and devices, primarily from K-12 customer base, as China is witnessing the slowest population growth in decades.

Meanwhile, there is mounting pressure to compete for market share from major competitor Tencent and new tech company entrants implementing aggressive growth strategies to expand their gaming divisions. For example, ByteDance outbid Tencent to acquire Moonton Technology in March 2020. 

Despite growth in revenues for gaming giants NetEase and Tencent, Alibaba Group's Linxi Games has stolen a slice of the total iOS game revenues pie as they grew from 0.38% market share to 6.64% from 2019 to 2020.

This analysis was first published on ChineseAlpha, an equity research platform that demystifies listed Chinese companies by providing in-depth, quality research. Read the whole article.

Disclaimer: This article's content is intended to be used solely for informational and educational purposes, and not as investment advice. Always do your research and consider your personal circumstances before making investment decisions. EqualOcean and ChineseAlpha are not liable for any losses that may arise from relying on the information provided.