NetEase.com (NTES)

[eastunder]

Buy at a High?

http://www.forbes.com/sites/taesikyoon/2012/06/08/buy-at-a-high/?partner=yahootix


Believe it or not, even during sharp market sell-offs such as the one we’re witnessing now, there are a few stocks not only bucking the trend, but actually hitting new highs. And not of the 52-week variety either. I’m talking all-time highs.

Obviously, these are few and far between. Within the portfolio of 45 stocks currently being recommended by the Forbes Investor, the investment newsletter I edit, there’s just one, NetEase, Inc. (NTES).

NTES is a provider of online communities and personalized premium Internet services in China. It focuses on the online gaming market – specifically, massively multiplayer online role-playing games (MMORPGs). Current game offerings include company-developed titles such as Fantasy Westward Journey, Westward Journey Online 2 & 3, Tianxia 3, Heros of the Tang Dynasty, Datang and Ghost. It also includes the incredibly popular World of Warcraft (WoW) and Starcraft 2 MMORPGs licensed from Blizzard Entertainment. The company’s Netease.com web site also offers a number of other services such as aggregated news content across multiple categories, instant messaging, online personal advertisements, matchmaking, alumni clubs and community forums.

Thanks to the increased penetration of Internet access and rising income levels in China stemming from the nation’s high economic growth, the popularity of online gaming has grown significantly over the past several years. NTES has been among the biggest beneficiaries of this boon. Even as its competitors and other China-based Internet services providers have seen their stocks struggle to hold gains in 2012, NTES has continued to surge, hitting a new all-time high of $65.53 per share yesterday. At the close, the stock was up 42% so far this year.

Given the stock’s gains, is NTES still worthy of consideration? I think so. One thing I like about NTES’s outperformance is the fact that it was achieved the old fashion way. Unlike many other stocks setting new highs, its gains were not helped by or the result of favorable external events, such as a change in government policy or speculation of a possible acquisition. Rather, it was the direct result of increased investor interest stemming from an exceptionally consistent track record of operational outperformance.

This track record has resulted in positive momentum in the stock. One thing I’ve learned is to not underestimate the power of positive market momentum. Stocks that have it can continue to rise irrespective of value. Just look at Amazon (AMZN). It’s up around 25% so far in 2012 despite trading at more than 170 times expected current year earnings.

Much of NTES’s recent outperformance was sparked by the renewal of the company’s license with Blizzard Entertainment in March, allowing it to remain the exclusive provider of the popular WoW online game franchise in China for another three years. This put to rest any concerns investors may have had regarding the possible loss of this lucrative business. Shares then extended their gains after NTES reported stronger-than-expected Q1 results last month. Revenue climbed 30.3% year-over-year to $318.2 million. This was primarily the result of a 31.4% surge in online game services revenue on steady growth in legacy online games and growing popularity of newer company-developed titles. Net income rose 27.7% to $149.5 million or $1.14 per share – 9 cents ahead of the consensus estimate.

Despite the stock’s gains, shares still remain reasonably valued, trading at 14 times their expected 2012 earnings. This is well below online search, content and community providers Bidu.com (BIDU) and Sohu.com (SOHU), which trade at 27 and 18 times their respective forward earnings estimates. However, it’s higher than fellow Chinese online gaming providers, Changyou.com (CYOU) and Shanda (GAME). In fact, based strictly on valuation, one could easily argue that these stocks offer better value propositions.

Over the long-run, this may prove true. But as we have seen time and time again, valuations can, and often do go ignored. Additionally, there’s a good reason why those stocks sell at such lower price multiples – greater uncertainty surrounding future growth. Existing game titles at Changyou continue to do well, but investors remain skeptical on the prospects of new games being developed that the company will likely rely on to fuel future growth. While I think Shanda’s developmental pipeline and new game launches hold more promise, the company actually saw a sequential drop in the number of users in Q4 2011 and stated that the popularity of one of its largest titles may have peaked.

NTES’s premium suggests investors are far more confident in the company’s ability to continue delivering strong and consistent profit growth. Armed with the WoW license renewal, the continual popularity of company-owned online gaming franchises and strong launches of new titles to help drive growth over the next several years, I share in this confidence. That’s why I expect NTES’s history of exceeding expectations to continue. This should keep current investor interest high and help maintain the stock’s momentum.