NetEase Earnings: Decline in Share Price Unjustified Despite Near-Term Gross Margin Concerns

Narrow-moat NetEase’s 09999 ADRs fell about 6% despite in-line second-quarter results, reflecting concerns about second-half gross margins, but we believe this reaction is shortsighted, leaving investors an opportunity to buy at a 35% discount to our fair value estimate. Gaming revenue growth decelerated to 2% year on year during the quarter, but a favorable mix shift drove an almost 400-basis-point expansion in gross margin. Nonetheless, management’s expectation for a less favorable mix shift toward lower-margin mobile game revenue for the second half raised concerns about near-term profitability. We differ from the market as we expect higher revenue and better selling, general, and administrative leverage to translate to higher profits, given the continued success of the newly launched titles. We fine-tune our near-term forecast but maintain our fair value estimate at $146 per ADR (HKD 226 per H-share). With NetEase’s shares trading at just 15 times 2023 core earnings, we think the market is undervaluing the strength of its growing game portfolio, and we continue to view the current risk/reward profile as highly attractive.

Despite the market’s concerns, we think operating profit growth will accelerate. This is primarily due to the rapid success of Justice Mobile, a blockbuster title launched on June 30. Two months after its release, the game remains number two on the iOS top-grossing chart, second to Tencent’s Honor of Kings. Therefore, we expect revenue growth to more than compensate for gross margin pressure, translating into accelerated operating profit growth over the next two quarters.