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A Messy Story Creates an Opportunity in NetEase Stock

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Even with Chinese stocks struggling across the board, NetEase (NASDAQ: NTES ) has had a particularly tough run lately. NTES stock has dropped by nearly half from late 2017 highs. NetEase stock, in fact, hit a two-year low earlier this month before a modest rebound.

From a near-term standpoint, the decline makes some sense. Chinese stocks remain in a bear market . Many of the country's best-known and most widely held issues have tumbled. Alibaba (NYSE: BABA ) shares are down 25%. JD.com (NASDAQ: JD ) has dropped 49%. Macro concerns, perhaps catalyzed by trade war fears, have been a key driver of the sell-off.

NetEase itself is undergoing some changes as well. It's trying to pivot away from its reliance on video games and move more aggressively into e-commerce, as Dana Blankenhorn detailed earlier this year . So far, that strategy has had mixed results - and uncertainty surrounding the success of those efforts likely has added to the pressure on NTES stock.

But that short-term bad news makes NTES an intriguing play from a long-term standpoint. If an investor believes - as Blankenhorn argued last month - that the sell-off in China stocks has gone too far , the entire group looks potentially attractive. And with NTES dealing with its own issues and being one of the hardest-hit Chinese stocks so far in 2018, it could be one of the best-performing if and when sentiment turns.

The Short-Term Pressure on NetEase Stock

Save for a brief rally this summer, it's been pretty much straight down for NetEase stock. Fundamentally, the numbers look reasonably strong. Revenue rose 15% year over year in the first quarter and 25% in Q2. But the growth simply hasn't been enough to satisfy the market: NTES stock actually sold off after both reports.

And there are some concerns here. Online gaming revenue growth has slowed markedly, with sales rising just 7% YOY in Q2. As Bloomberg pointed out last month, Chinese regulators appear to be delaying game approvals , which also has impacted larger rival Tencent Holdings (OTCMKTS: TCEHY ). Those delays appear part of a larger trend to limit video game playing among children and other customers.

Regulators also have taken aim at NetEase's finance website, part of a crackdown on an online media sector that includes the company's well-known 138.com site. Add to that the pressure on Chinese stocks and fears about the country's economy, and it's not terribly surprising that NTES has struggled.

Is NTES Stock Now the Best China Play?

That said, ten months ago, few investors likely would have seen a 50% decline coming. And there is now a case that NTES stock is the best play for investors who believe the sell-off in Chinese stocks will eventually end.

After all, there's good news here as well. E-commerce growth has been impressive, with revenue rising 100%+ YOY in Q1, and 75% in Q2. Game revenue is being restricted at the moment, but it's still growing. Mobile adoption in the country will only rise going forward, and even a more limited pipeline should allow sales and profits to rise for many years to come.

The company's media and e-mail offerings may face their own regulatory pressure - but neither business is going anywhere. Margins have been pressured this year by investments in operating expenses - but the pace of increases in SG&A and marketing should slow going forward.

At the end of the day, even in a tougher environment, this still is a business growing revenue in the range of 20% this year. It remains impressively profitable. NetEase stock even pays a dividend , albeit a small one, and continues to repurchase stock as well. That emphasis on shareholder returns is unusual for such a fast-growing stock. And so is the earnings multiple applied to NTES.

High-Risk and High-Reward for NTES Stock

That business is available for just 20x forward earnings - one of the cheaper multiples in the space. It's a valuation that incorporates little growth going forward - and one that also has room for expansion if and when sentiment toward Chinese stocks returns. It's not that difficult to imagine NTES stock once again being priced at 25x+ earnings, particularly if growth resumes, and that suggests easily 30% upside from current levels.

The question is whether there's any need to rush into NetEase stock at the moment. As I wrote about Baidu (NASDAQ: BIDU ) earlier this month, there's a real "falling knife" problem with Chinese stocks on the whole. With the dollar strengthening and emerging markets looking shaky, there's no guarantee the sell-off in NTES and its peers is at an end.

But for investors willing to take on that risk, NTES stock looks like one of the more intriguing plays. Its pivot to e-commerce should help revenue growth. Regulators likely will back off at some point. Margins can expand. So can the multiple applied to NetEase stock. There's still a lot of potential upside here - it just may take some time for the market to focus on that upside and not just the risks.

As of this writing, Vince Martin has no positions in any securities mentioned.

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The post A Messy Story Creates an Opportunity in NetEase Stock appeared first on InvestorPlace .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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