Morningstar | NetEase Sees Accelerated Growth in 3Q; Shares Undervalued
We maintain our fair value estimate for narrow-moat NetEase at $344 per share and continue to think the shares are undervalued. The recovery of online gaming and deferred revenue growth once again testifies to the company's strong research and development capability. That said, near-term operating expense increased, especially for research and development, and the ongoing shift to lower-margin e-commerce business will put pressure on margins, in our view.Net revenue growth in the third quarter accelerated to 35% year over year (up 4% sequentially) from 22% in the second quarter, helped by a lower base and a pickup in online gaming sales to 28% growth from a 7% increase. Meanwhile, deferred revenue was up 16% sequentially, an improvement compared with a 10% decline in the second quarter, helped by new PC and mobile game launches (PC and mobile game sales rose 29% and 27% year over year, respectively), indicating better online game revenue growth in the fourth quarter. We think the launch of role-playing game Ancient Nocturne in September and cooperative survival RPG Night Falls: Survival in November will lead to a sequential increase in mobile game revenue in the fourth quarter.
Year-over-year operating expense growth accelerated to 60% in the third quarter versus 47% in the second quarter and 37% in the year-ago quarter, mainly led by research and development (96% year over year) and sales and marketing expenses (43% year over year). Lower-margin e-commerce segment revenue grew at 67% year over year, only a slight slowdown from 75% in the second quarter. The e-commerce segment registered a gross margin of 10% versus 65% for the games business in the quarter. As a result, non-GAAP operating margin was lower at 12.5% versus 14.3% in the second quarter and 20.4% in the year-ago period.
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