NetEase Plays For Keeps By Diversifying Around Games

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I t's no surprise that NetEase plays for keeps.When your primary market is China -- a competitive, evolving and maturing region for online games -- you have to stay on your toes. So the Beijing-based gaming and Internet company, best known for its desktop PC games, is investing heavily to diversify around its pipeline of mobile, action role-playing challenges that appeal to a broad and growing audience.

In October,NetEase ( NTES ) put up $2.5 million to partner with Finnish game developer Reforged Studios. NetEase also has invested in new Silicon Valley offices where a research team is creating mobile games for Western markets. And this summer, NetEase launched a funding initiative of up to $500,000 each for independent mobile game developers.

Although there's no shortage of mobile game companies in China, few have had the lasting success of NetEase, says T.H. Capital analyst Tian Hou.

"We believe that NetEase is on a trajectory of sustainable long-term growth fueled by its marketing expertise and game R&D know-how," Hou said in an emailed response to queries.

The cumulative number of downloads of NetEase's major mobile games was 173.2 million in the second quarter ended June 30, up 78% from the quarter before, Hou says. Mobile games will be a key growth driver for NetEase in the second half of 2015, as the monetizing of its mobile games is just beginning, he adds.

Larger Rivals

Rivals among Chinese game developers includeTencent Holdings ( TCTZF ),Shanda ( GAME ) ( CYOU ), among others. But NetEase's online gaming revenue shot up 65% in the second quarter while Tencent, a larger rival, saw a 17% increase in online gaming revenue.

There are headwinds for NetEase, however. While revenue climbed, its research costs also jumped, rising 148% in the second quarter to $7.9 million on higher costs related to mobile games. Its gross profit margin for the online game business was 69.3%, down from 77.6% in the year-earlier quarter, the company said.

Still, NetEase currently has the highest-possible Investor's Business Daily Composite Rating of 99. NetEase is more than just a gamer as it has expanded to build on China's thriving mobile and e-commerce markets. It also happens to be China's largest email provider, with more than 790 million registered email users as of June 30. In addition, it has launched an online payment platform and a cross-border e-commerce initiative called, focused on selling goods from overseas merchants.

The initiative is still in its early stages, but it continues to broaden its e-commerce capabilities by adding high-quality suppliers and increasing warehouse efficiencies. T.H. Capital's Hou said's scale remains small and shouldn't affect the valuation of NetEase's core business. It will, though, require capital investment that will pressure margins.

"While we believe e-commerce has significant growth potential in China, there is a significant amount of uncertainty regarding NetEase's new venture, which mainly resides in the fact that NetEase lacks e-commerce experience," Hou said.

Accelerating Sales

When NetEase reports third-quarter earnings on Wednesday, analysts expect the 18-year-old company to continue to report accelerating sales and profit. NetEase has posted revenue growth for five straight quarters, including a 65% increase in the second quarter to $736.6 million, topping analyst expectations. NetEase also recorded strong growth in its gaming, advertising-services and e-commerce divisions during the second quarter.

Analysts polled by Thomson Reuters are calling for a 61% jump in third-quarter revenue to $780 million. Profit is seen rising 24% to $1.78 a share, matching the prior quarter's gain.

During the second-quarter conference call with analysts in August, NetEase founder and Chief Executive William Ding said each of its three business segments showed healthy revenue gains. Online game revenue climbed 64.8% compared with the year-earlier quarter, advertising services revenue increased 22.8%, and email, e-commerce and other revenue jumped 123.3%.

Online Sell-Off

This summer, there was a broad sell-off in Nasdaq-listed Chinese Internet stocks on concerns about China's slowing economy and devaluation of the country's currency, the yuan. But on the services side of the economy where NetEase operates, gross domestic product grew at a strong 8.4% in the third quarter.

NetEase stock has climbed 55.2% over the past 12 months, closing Nov. 5 at 144.87.

More than three-fourths of NetEase's revenue comes from multiplayer games such as its popular "Fantasy Westward Journey" franchise. The mobile version was launched in March onApple 's ( AAPL ) iOS as well as Android, the mobile operating system developed byAlphabet's (GOOGL) Google unit. Within three days, it hit No. 1 on research firm App Annie's list of top apps.

"The game stayed at the top spot for the entire second quarter of 2015," BNP Paribas analyst Vey-Sern Ling said.

NetEase operatesActivision Blizzard's (ATVI) gaming platform, as well as its "World of Warcraft" and other franchises in China. It distributes popular games such as "Diablo III" and "Overwatch."

Last year, NetEase's online gaming accounted for 78% of total revenue. Advertising services were 12%, and email and e-commerce accounted for 9.2%.

Top Verticals

NetEase Chief Financial Officer Onward Choi said on the conference call that top-performing advertising verticals included automobile, Internet services and the food-and-beverage sectors. Ling adds that online advertising could become a more lucrative source of income.

"We see upside potential for NetEase's online advertising business as it increasingly focuses on extracting value from its multiple undermonetized Web properties," he said.

In China, where the population is expected to reach 1.39 billion this year, smartphone and tablet games are forecast to generate more than $5.5 billion in 2015 revenue, up 66% from the previous year, Asia market-intelligence firm Niko Partners reported. UBS analysts said in a September research report that they expect revenue from China's mobile games market to grow at a 27.7% compound annual growth rate from 2015 through 2018.

NetEase also sees opportunity in the West. Inside its North America headquarters, research teams are creating and testing a lineup of mobile games targeted to Western markets, says David Ting, general manager of NetEase North America. The next crop of mobile games will enable players to train and equip heroes, battle armies of monsters, or become childlike wizards tasked with restoring harmony in the world.

One new game called "The Beautiful Dream" is based on a classic Chinese love story. It calls for players to cross the bounds of life and death to reunite a hero with his lost love. It's NetEase's third mobile game released in the West, following "Lunar Flowers" and "Speedy Ninja."

"While these next games might lean more mid- to hard-core, it'll allow us to round out our knowledge and expertise in publishing westward, which will further define how we build out our business in the next several years," Ting said.

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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