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Morningstar | Reducing FVE of NetEase to USD 283 per Share; Shares Undervalued. See Updated Analyst Note from 10 Feb 2019

We have reduced the fair value estimate of narrow-moat NetEase to USD 283 per share from USD 344 per share, reflecting the delayed monetization of its new games and weaker economy. Ten-year revenue CAGR is now 13% versus 15% previously, while operating income CAGR has been reduced to 9% from 12%.  NetEase is still undervalued in our view, as the international expansion of the gaming business and the turnaround of its e-commerce business are not yet reflected in the share price. The resumption of gaming license approval has led to a rally in the share price, and more approvals of NetEase games will be the near-term catalyst for the shares.

We have reduced the 10-year gaming segment revenue CAGR to 10% from 11%, as the pause of gaming license approval in 2018, which has now been resumed, delayed monetization of its new games. Our long-term growth projections for the segment are largely intact, we expect growth to slowdown to 7% by 2027. We continue to be confident in NetEase’s international expansion and strong research and development capabilities in developing popular games. The contribution of overseas gaming revenue to total gaming revenue has climbed to 10% in the third quarter, thanks to Knives Out’s strong performance in Japan. The codevelopment of massively multiplayer action RPG mobile game Diablo Immortal in the well-known Diablo franchise and the decade-long partnership between Blizzard Entertainment and NetEase is a vote of confidence in the company’s strong execution in the gaming segment. The game is expected to launch globally this year, and is expected to further increase its growth in the international business.

Advertising revenue was weak in 2018, and we expect to see slow growth of only 3% per year from 2018 to 2020 as a result of the weak macroeconomics, Sino-U.S. trade spat and challenges in different industries in China. Internet services, automobile, and real estate sectors are NetEase’s top performing verticals. Auto sales were down 13% in December and 3% in 2018 year over year according to CAAM. The market appears to expect auto sales to decline without major policy support while CAAM expects a flattish performance in 2019. The Internet sector is facing more challenges now as the mobile market is close to saturation. Some Internet companies have announced plans to reduce headcount. They also face new regulations or more scrutiny by the regulators. We expect revenue growth to recover to 7% in 2021 and 5% in 2022 as the economy recovers and taper to 3% in the long run.

The e-commerce segment will see a slower revenue growth of 70% and 57% in 2018 and 2019 due to high base effect and weaker consumer sentiment, it is expected to slowdown to 7% by 2027. Kaola, the cross border e-commerce platform and Yanxuan, the private label e-commerce platform, will continue to see growth potential as a result of expanding middle class in China. Kaola will benefit from the government’s promise to increase imports and favorable policies such a higher tax-free limit on cross border e-commerce single transactions. According to iMedia, in the first half of 2018, Kaola had the highest market share of cross border e-commerce in China with 26.2% share, followed by Tmall and JD.

We expect non-GAAP operating margin to decline to 13% by 2021 as the lower-margin businesses are growing faster, and management continues to invest in research and development and sales and marketing (for instance, for new game launches). In the long term, we think the company will see margin expansion to 19.2% by 2027 as the new businesses such as e-commerce, broadcasting and cloud music gain scale.