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NetEase Plays Up Its Online Gaming Strength


Image source: Netease.com.

China is a key market for the video-gaming industry, and NetEase (NASDAQ: NTES) has a strong presence in the world's second-largest economy. In addition to developing its own games, key collaborations with Activision Blizzard's (NASDAQ: ATVI) Blizzard Entertainment division regarding World of Warcraft and with other partners has helped produce impressive growth opportunities for the company. Coming into Wednesday's first-quarter financial report, NetEase investors expected the online-gaming company to sustain the pace of increases in sales and profit, and NetEase's results delivered on both fronts. Let's look more closely at what NetEase told investors this quarter and whether it can keep winning in the future.

NetEase stays ahead of the game

NetEase's first-quarter results included the same high growth rates that investors have come to count on from the company. Sales in local-currency terms were up 116%, translating to $1.23 billion and rising at only a slightly slower pace than investors had expected to see. Net income soared 95% when measured in the local currency, which produced dollar-denominated earnings of $381.6 million. Adjusted earnings of $3.12 per depositary share was almost 25% higher than the consensus forecast among investors.

Looking more closely at the game company's results, NetEase had relatively balanced sales performance across the board. Online gaming revenue more than doubled in local currency terms, producing about $933 million in sales. Revenues from email, e-commerce, and the company's category for other revenue more than tripled, although NetEase said that its results were lower than they had been during the fourth quarter of 2015 due to a shift in business strategy for the unit. The traditionally slower-growing advertising services segment posted sales gains of about a third from year-ago levels, but it makes up only about 5% of NetEase's overall revenue.

On the other hand, the negative margin trends we've seen in past quarters continued for NetEase. For the online games unit, six percentage points of declines in gross margin to 67.1% resulted from the increased adoption of mobile games, which aren't as profitable as their online counterparts. Advertising services picked up a small three-point increase, but the email, e-commerce, and others segment saw its gross margin cut nearly in half primarily because relatively higher-margin third-party lottery-related services were suspended.

CEO William Ding continued to express optimism about NetEase's prospects. "Our first quarter performance represents a strong start to 2016," Ding said, "reflecting progress in all areas of our business and continued leadership in China's online games industry." The CEO also pointed to customer satisfaction, saying that "we are very pleased with the reception of our recently introduced games and the ongoing popularity of our classic titles."

Will NetEase level up with more growth?

Looking ahead, NetEase is confident that its game portfolio will remain strong. The company boasts more than 90 mobile games, and new offerings linked to hot movie franchises include Kung Fu Panda 3 and The X-World. The launch of top Korean action role-playing game Raven in April has gone extremely well, and a solid list of new releases for both the mobile and PC-based game segments should produce ongoing excitement about the company. Moreover, the expected release of Blizzard Entertainment's Overwatch on May 24 in China should underscore the importance of NetEase's collaboration with Activision Blizzard.

One area of concern remains the strength of potential advertisers. The sluggish economic environment has put pressure on companies' advertising budgets, but the automotive, Internet services, and telecom sectors remain key sources of ad revenue for NetEase. The Kaola.com e-commerce business has also produced success and has future potential as well.

NetEase also gave investors another dividend boost, kicking up the payout by 14% to $0.73 per depositary share. Because the dividend is tied to a percentage income, investors get a direct reward from NetEase's growth.

NetEase stock spiked higher in after-market trading following the announcement and was up about 2% before the beginning of the trading day Thursday. Longer-term, the key for NetEase will be to stay ahead of trends that could adversely affect its business and to focus on keeping the highest-quality game offerings available to the Chinese market. If it does so, NetEase should have the potential for even better long-term gains.

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