Selling NetEase (NTES)

Every time I sell a stock, it feels like a little bit of a failure. Today is no different, as I've offloaded my shares of Chinese gaming company NetEase (NTES) following their weak earnings outlook.

The catalyst for this sale was certainly the much-worse-than-expected outlook given by the company in their conference call last night (regrettably, I didn't see that coming or I would have sold in the pre-call 10% runup following the solid earnings report). From a broader perspective, however, I've come to the realization that it is simply time for me to give up trying to predict the volatile gaming market cycle in China, which is essentially what those who are investing in NTES and its competitors must do.

The market is certainly still a great one -- onling gaming remains very robust in China, but it is so extraordinarily competitive that the fall from hitmaker to has-been can be frighteningly rapid. I witnessed the decline of Shanda following the quick fall from grace of their most popular games, and after losing money on that company I've decided to take my gains in NetEase and move on.

I still think NTES is a better company than Shanda, certainly, and they do have the powerful Fantasy Westward Journey game franchise that remains very popular, even as it has clearly plateaued in user growth ... but I have absolutely no confidence that I'll be able to tell whether or not NetEase's game pipeline is any good before it's too late.

NTES was downgraded by Lehman and Citigroup today, with the Citi analyst essentially saying that NTES is no longer a growth company -- the business is too competitive, with lots of home-grown companies already actively pushing new games and a world of game developers trying to break into the marketplace. That could be overstating it -- and there may be plenty of money still to be made in Chinese online gaming, but I'm unlikely to be the person who can figure out how to make it.

It's quite possible that I'll put this money to work in Baidu (BIDU), which I wrote about recently as I was tempted to buy shares before the earnings release (I didn't, though the price is just about the same today). Though still very risky and highly valued compared with NetEase, I have a much better understanding of Baidu's industry and much more faith in the growth prospects of their business -- especially given the much less competitive and hit-driven environment they work in, and their ability to thrive against that competition (as evidenced by their continuing market share gains versus both Yahoo and Google).

NetEase may remain a good investment for some people, particularly those with their fingers on the pulse of the Chinese gaming market, but I'm taking my profits and admitting my inability to read these tea leaves.

I purchased NTES shares last year for $12.61 (split adjusted), and have now sold my full position at $15.55.

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Beating Estimates with Netease (NTES)

I hope you understand how difficult it is to avoid resorting to pun-throwing when talking about NTES ...

Back on Netease-y street.

It's Netease-y being a Chinese gaming company.

Netease-y does it.

OK, got that out of my system.

Netease (NTES -- click to register for free RT streaming quote) is one of the titans of Chinese internet gaming, and a top tier web portal and wireless services firm (that wireless stuff is what pummeled the stock more than a year ago if I remember correctly, as the wireless fortune telling business got the ol' tsk-tsk from the People's Government). While they're still the largest free email provider in China, lately their earnings reports tell us that they're really just an online MMPORPG company -- most easily comparable to The9 or Shanda, though they seem to me to be both more diversified than The9 and much more stable than Shanda.

But the news is, they released their fourth quarter this week (transcript of the call is on the China Stock Blog), and all is once again well for NTES. They had a little hiccup in the third quarter, but they had a remarkably busy Q4 that included significant increases in the number of game players of their two core titles -- a nice recovery that made a mockery of my prior guess that Fantasy Westward Journey (the most popular game in China right now, according to them) and Westward Journey Online 2 had plateaued. It's nice to be wrong in this case.

So we're back on the climb with NTES ... the chart is pretty odd looking for this one -- tremendous moves on earnings the last three quarters, a huge move up that shocked everyone when their earnings blew expectations away in August, then the dramatic fall when that growth rate stalled a bit last quarter, and now another huge climb back to where we were six months ago now that we are again allowed to believe that NTES is growing.

This is exhausting. But I think if we can ignore the short term blips caused, in large part, by how difficult it is for analysts to guess what's happening in the Chinese internet space these days, NTES looks to me to be very well positioned for the continuing overall growth of gaming and internet use in the middle kingdom.

While Shanda (SNDA) has moved to a free-play model (trying to sell avatar accessories, etc., instead of charge for game play), NTES seems to be doing quite well with continuing to charge for games. That means they're handling the development cycle significantly better than SNDA, since their current hit games are continuing to grow in popularity and they're now just a few months out from release of their next generation 2.5D and 3D games while Shanda's next generation games seem to be continually delayed and they gamble their future on hardware.

(And no, I have no idea what 2.5D means. How can you have half a dimension?)

So my opinion of NTES hasn't changed in the last month, though I'm happy to see that this latest swing was to the upside. I'm holding my shares, but with this and my Shanda position already giving me plenty of exposure to MMPORPG's in China I'm not interested in adding any more -- I think I've got enough, especially for someone who thinks this particular kind of entertainment is totally unappealing.

It's certainly worth checking out the transcript of the call and the recent Piper analyst notes over at the China Stock Blog -- with the lack of between-quarters information that we get out of China, it's that much more important to really pay attention to the filings and, as far as it's possible to understand what they mean, to the conference calls.

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Annual Checkup -- NTES

There won't be a lot new to say about Netease (NTES -- click to register for free RT streaming quote) until they release earnings, which I expect will be sometime in the second or third week of February (that's just a guess, I haven't seen an announcement yet). NTES has been the more stable of my Chinese internet gaming investments, and the stock has performed much better this year than has Shanda. I wrote a bit about both companies back in November when they were on the ropes -- NTES because they didn't keep up the growth rate of the previous quarter, and SNDA because of their new "free games" revenue model and continuing poor results at the bottom of their game development cycle. I bought in to NTES right around $50 a share, so it has done fine for me to date (though it's much lower than during it's spectacular run earlier this year), and I'm still confident in the company's long term prospects -- not because I have great insight into the company, but because their market is potentially so massive that all of the companies should do well and they are very inexpensive relative to that growth potential right now. I find the China Stock Blog to be a great way to keep up on these "hard to follow" companies, especially analyst notes and conference call transcripts. With full positions in both NTES and SNDA I think I am probably already overexposed to this very volatile Chinese internet gaming sector, especially given all the political and regulatory risk on top of the strong competitive environment and execution risk, so I have no intention of adding to this one in the near future -- but I also see great potential for gains with these long-term speculative investments and do not plan to sell.

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Netease-y Street (NTES)

Netease (NTES)


Bought May 6, 2005 at $50.45

I've got to be honest with you -- I thought this was the safer, less volatile long term growth play on Chinese internet use and gaming, and Shanda, which I have a larger position in, was the one that might rocket to the sky without warning.

Nice to be wrong, sometimes ... and you never know what will happen when SNDA reports earnings next week.

So in one sentence, what do I like about Netease?

Netease is reaching a new audience for online gaming in China, and even after it's recent run up it trades at a tremendous discount to its meteoric growth rate.

Warning: three paragraph rant coming: Larry Kudlow was on the XM CNBC channel as I drove home last night, and when he mentioned Chinese internet stocks (in regard particularly to Netease, which obviously got everyone's attention with it's 25% jump up after earnings), he sounded as if he'd rather invest in rat feces than chinese internet stocks. This is not the first time I've thought he was wrong, but I can't seem to stop listening to him lecture to his sychophantic guests (does he ever even ask questions without answering them first?)

How can you avoid a whole class of companies that is undervalued relative to their growth, feeds the second largest and fastest growing marketplace in the world, and has developed a leadership structure with a few strong brands and companies at the top -- not only Shanda and Netease, but Sina, which is having its troubles lately thanks to mobile services, and Baidu and Sohu and maybe a few others?

His complaints were the lack of transparency in Chinese stocks, and the fact that they are subject to the whims of the Chinese government's regulations. On the first, sure, they are less transparent than US companies -- but there are a lot of US companies whose structures and filings I don't understand, too. The Chinese companies that trade as ADRs report to the SEC, and I don't see why they have much more reason to be fraudulent than US companies. I'm not going to buy a Chinese penny stock, I've seen to many of those that are clearly just shell companies with too many layers of confusing ownership, and I'm not crazy about some Chinese companies -- I owned China Yuchai until I realized that I couldn't figure out who really owned and controlled it, and that there was much more competition in their space (diesel engines) than I originally thought. And I'm a little nervous about owning government-controlled entities because I'm not sure their priorities will be in line with mine, but that's not a hard and fast rule -- I did own PetroChina for a while (after all, so does Warren Buffett), and in other countries I have much less compunction about that. I have profitably owned both PetroBras and Statoil (Brazilian and Norwegian, respectively), and probably sold both too soon.

But enough about that -- why did I buy Netease, and why do I like it? I am still holding, even after our ridiculous leap up the leaderboard this week.

Some of the argument in favor of investing in Chinese gaming stocks in general I already made in my writeup on Shanda -- no need to repeat it here, read it if you want to.

But Netease at first seemed to me to be a bit more stable a creature, at least in design, than Shanda. They've actually had a rockier past than Shanda, but have a broader portal business already, whereas Shanda is just trying to build one. In Wall Street Speak, Shanda has been a "pure play" on Chinese online gaming, whereas Netease's foray into gaming began as only one of the parts of their online businesses. That's changing with this earnings report, as wireless services now make up just a small and shrinking part of their business and advertising, which is also growing very fast, is not keeping up with the explosive growth of gaming revenue for Netease.

So now that we should really think of Netease as "just" a gaming company, why hold?

A big part of why I'm still holding and not taking profits is that their new game, Fantasy Westward Journey, is already a huge hit. We already know that it has been very successful particularly among women, who are not targeted by many of the popular games. I'm just guessing, along with everyone else, that Shanda's next generations of games will find an eager audience as their existing ones have, but I could be wrong. And both SNDA and NTES have several 3d or 2.5D games in development or early beta -- this is a big deal, as World of Warcraft's worldwide success should show us.

China Stock Blog has some good stuff on Netease, as usual -- notes from conference call and from bullish and bearish few analyst reports. Netease's interpretation of regulatory change seems to be a bit different than that of the news agency Interfax, which is reporting that significant adjustments are already underway to gaming rules. No one else is really sure what the Chinese will do -- on one hand they're investing huge amounts of money into building the gaming industry and building something akin to business incubators for gaming companies in several cities, and on the other hand they talk about the need to regulate video game "addiction" and antisocial behavior.

So will China kill the goose that lays the golden egg? Will, frankly, the Chinese government do something that kicks their young men out of internet cafes and tries to get them working more hours, when the Chinese economy cannot create enough employment for it's people as it is? I don't think so. Like the long debate over the tiny blip in currency revaluation, this is a lot of sound and fury, signifying, I hope, not much. I don't have any contacts in the Chinese ruling committee, however, so take my conjecture with a big, kosher-size grain of salt.

Why or when might I sell Netease?

I try to avoid selling stocks just because I think they've gone up "too fast" or "too far" -- is there really such a thing? It can be very tempting to conver the paper profits scrolling across your ticker into cold, hard cash -- but I don't think it makes much sense to look backward like that and think only about your purchase price and the price you could now get. Look at the company -- is it still growing? Are prospects better or worse? Is the news that pushed it up so high really news that makes you understand the company differently and place a different value on them?

In the case of Netease, yes, now that I've seen the numbers they got for Fantasy Westward Journey and the growth they're capable of in their gaming business, I see no reason to sell. I might get clobbered if the chinese decide to destroy their most successful technology industry, or if competitors just beat early movers SNDA and NTES, but I have no reason to think either of those outcomes is probable. I'm trying to invest in companies that have the opportunity for dramatic long term growth -- why would I sell just because some of my hopes have come through?

This is not a part of my portfolio that I'm relying on to supply me with cat food in my old age -- I'm going to let it ride.

If Netease appears to development management "trouble", that might be a reason for me to sell (their management seems to have been pretty conservative thus far, from what I can tell, but I don't have as much confidence in them as I do in the leadership at Shanda). Other than that, as long as the Chinese economy continues to build a middle class, the government continues to support private enterprise, and the Chinese people continue to have an interest in low-cost entertainment, I see no reason to sell Netease.

There's a good Fool article here by the guy who recommended this in the Rule Breakers newsletter, if you want to read more.

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