NetEase (NASDAQ: NTES) was founded in 1997, predating Tencent (OTC: TCEHY) by a year, but it's often overshadowed by its larger rival. Its core video game business, which generated 79% of its revenue last quarter, is smaller than Tencent's, and its top mobile games still can't top Tencent's flagship title Honor of Kings in China.
Despite those challenges, NetEase's stock rallied nearly 40% this year as Tencent's stock rose less than 10%. Let's examine four key reasons the underdog outperformed the market leader, and why that trend could continue in 2020.
Image source: Getty Images.
1. Lower exposure to online ads
The Chinese economy is growing at its slowest rate in about three decades, and the U.S.-China trade war and tariffs are exacerbating the pain. That slowdown is causing many companies to cut their advertising budgets. The government's tighter oversight of gaming, fintech, and healthcare companies is also throttling ad sales to those markets.
As a result, many top advertising platforms -- including Baidu (NASDAQ: BIDU), Weibo (NASDAQ: WB), and Tencent -- struggled with slow ad growth in recent quarters. Baidu's ad revenue, which accounted for 73% of its sales, dropped 9% annually last quarter. Weibo's ad revenue, which accounted for 88% of its top line, grew just 1% last quarter.
Tencent's ad revenue, which accounted for 19% of its sales, rose 13% annually last quarter but marked a significant slowdown from its previous quarters. Tencent attributed that slowdown to sluggish ad sales on Tencent Video, but it's also likely struggling with competition from Gen Z-oriented rivals like ByteDance.
NetEase doesn't generate significant revenue from online ads. The unit generated just 3% of its revenue in the second quarter, and it stopped disclosing its ad sales separately in the third quarter. That low exposure to the fickle ad market likely makes it a more appealing investment than Tencent.
2. A more focused play on gaming
NetEase remains the second-largest game publisher in China after Tencent, and video games generally hold up better than digital ads during economic downturns.
Tencent publishes three of the top 10 highest-grossing iOS games in China, according to App Annie, but NetEase publishes four: Onmyoji, Immortal Conquest, and two titles from its Fantasy Westward Journey franchise. Its battle royale game Knives Out is also one of the highest-grossing iOS games in Japan. The strength of these games indicates that NetEase isn't losing the gaming market to Tencent.
Image source: NetEase.
NetEase's gaming revenue rose 11% annually last quarter. That marked the unit's slowest growth in five quarters, but still matched Tencent's 11% growth in gaming revenue in the third quarter. NetEase still has a long pipeline of games to boost its growth, including Cyber Hunter, Xuan Yuan Sword: Dragon Upon the Cloud, Bloom & Blade, and Activision Blizzard's World of Warcraft Classic and Diablo Immortal.
NetEase generates most of its revenue from video games, but Tencent's gaming unit only generated 29% of its revenue last quarter. Therefore, investors who preferred a more direct investment in China's gaming market -- which finally passed some major regulatory challenges last year -- likely preferred NetEase to Tencent.
3. A more streamlined business
A common criticism of Tencent is that the company's diversification dilutes its focus. Tencent generates most of its revenue from video games and online ads, but it's also growing its cloud and fintech businesses, expanding into virtual assistants and connected devices, and investing in a growing list of domestic and overseas companies.
NetEase, however, streamlined its business over the past year. It sold its online comics unit to Bilibili, sold its Kaola e-commerce platform and a stake in its streaming music platform to Alibaba, and spun off its education unit Youdao in an IPO. It also restructured its business from four segments to three: gaming, Youdao, and innovative businesses and others.
Those moves all make it easier for investors to understand NetEase's business than Tencent's. Streamlining its business, cutting costs, and dumping weaker units also boosted NetEase's operating margin 350 basis points annually to 22.8% last quarter.
By comparison, Tencent's operating margin plunged 800 basis points annually to 26.6% last quarter as it ramped up its investments. Therefore, investors who were burned by Tencent's ongoing ecosystem war against Baidu and Alibaba likely gravitated toward NetEase as a safer Chinese tech play.
4. A lower valuation and a higher dividend
Analysts expect Tencent's earnings to rise 15% this year and 22% next year, which are reasonable growth rates for a stock that trades at 26 times forward earnings. Tencent also pays a tiny forward dividend yield of 0.6%.
NetEase is expected to post 130% earnings growth this year (thanks to its spin-offs and divestments), followed by 7% growth next year. It also trades at a reasonable 19 times forward earnings, but it pays a higher forward yield of 1.3%. NetEase also recently approved a special dividend, which temporarily boosts that yield to 2.4%.
Both Tencent and NetEase are still solid long-term plays on China. However, NetEase's lower valuation and higher yield -- which complement its aforementioned strengths -- suggest that it could continue to outperform Tencent next year.
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Leo Sun owns shares of Baidu and Tencent Holdings. The Motley Fool owns shares of and recommends Activision Blizzard, Baidu, Bilibili, NetEase, and Tencent Holdings. The Motley Fool recommends Weibo. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.