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NetEase Still Can't Win the Earnings Game

Dan Caplinger, The Motley Fool

Even the best growth stocks have slumps from time to time, and Chinese video game giant NetEase (NASDAQ: NTES) has gone through a particularly tough environment lately. Since last December, the company's shares have lost more than a third of their value, and macroeconomic concerns about the trade relationship between China and the U.S. have weighed on investor sentiment about Chinese stocks more generally.

Coming into Wednesday's second-quarter financial report, NetEase investors hoped that the company would be able to get its key metrics moving back in the right direction. NetEase did find ways to produce some improvement from last quarter's tough conditions, but even though the Chinese video game giant appears to be fully back on track, not everyone was satisfied.

Large animated creature fighting smaller animated characters.

Image source: NetEase.

The latest from NetEase

NetEase's second-quarter results at least showed a bit of sequential improvement compared to a terrible first quarter to begin 2018. Revenue rose 22% in local-currency terms during the period, translating to $2.46 billion. However, adjusted net income fell about 22% to $411.8 million, which resulted in adjusted earnings of $3.15 per share.

On the positive side, NetEase was at least able to get top-line gains from all of its key segments. Online game revenue saw sales climb 7%, leading to a 9% rise in gross profit for the segment. E-commerce performed much more strongly, posting top-line gains of 75%, and email and other revenue managed a better-than-40% climb. Advertising services was relatively weak, though, with sales rising just 6% and gross profit picking up 5% from year-ago levels.

Fundamentally, NetEase saw a number of recent trends continue. Mobile games continued to account for a greater portion of overall online game revenue, approaching the 75% mark for the quarter. Self-developed mobile games like Chu Liu Xiang, Knives Out, and Identity V helped to support the game unit as well. Meanwhile, on the e-commerce side, the rapid development of marketplaces Yanxuan and Kaola.com helped to produce rising gross profit figures. Seasonality also gave a boost to advertising revenue. However, NetEase said that the email and other businesses suffered segment losses due to higher music licensing costs and reduced performance from key online platform businesses.

Costs also weighed on NetEase, with operating expenses climbing by just less than half from figures from 12 months ago. Of particular concern were rising marketing expenditures, research and development, and staff-related costs. Shipping costs also weighed on the bottom line. Reduced income taxes helped to cushion the blow to some extent, but they still didn't provide a perfect solution for NetEase.

CEO William Ding celebrated the news. "We are pleased with the solid growth we achieved across all of our business segments," Ding said, "including online games, e-commerce and advertising services, and the strong improvement to our bottom line." The CEO also noted that both PCs and mobile devices have combined to give NetEase considerable engines for growth in the future.

What's next for NetEase?

NetEase wants to keep expanding in key ways. Initially, the company did best with its massively multiplayer online role-playing games (MMORPGs), but NetEase has been able to reach the top of the gaming charts with new releases outside the MMORPG space. Moreover, the company is paying more attention to ensuring that its games are accessible and suitable not just to Chinese players but to a worldwide audience, and that could open up the possibility of much wider distribution of its games in the near future.

Dividend investors got some good news from NetEase. Under its variable dividend policy, the company will make a distribution of $0.61 per share to its shareholders later this month. That's more than double what investors got last quarter, reflecting at least a sequential boost to the company's income.

Yet most NetEase shareholders didn't choose to see it that way, and the stock fell 10% at midday Thursday following Wednesday night's announcement. Without a clearer path back to accelerating growth, NetEase could struggle to keep up with the rapid pace of progress among both traditional and new players in the video game industry.

More From The Motley Fool

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends NetEase. The Motley Fool has a disclosure policy.

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