Not long ago, we discussed the merits of Shanda Interactive, a Chinese Internet gaming company which has seen strong growth even during the recessionary environment.  Today we will take a look at another name in the sector which is manufacturing strong profits.

NetEase.com, Inc. (NTES) is actually a bit more diversified than Shanda as the company offers services such as email, instant messaging, personal ads, matchmaking services, alumni clubs, news, personal home pages and community forums.  But despite the many services offered, the majority of profits come from the online game business which pulled in nearly $100 million in revenue just last quarter.

The company offers an assortment of role playing games with Fantasy Westward Journey (FWJ) being the most popular.  The online game portion of the business is extremely profitable with gross margins of roughly 88%.  The company’s advertising business enjoys a 51% gross margin while the wireless services business is yet to post a profit.

Taxation is an important issue that has been hanging over many Chinese companies over the past year.  The government introduced a new tax rate which would be applied to most businesses but also offered provisions for technology companies to be taxed at a preferred rate.  Many companies have applied for this exemption but have not been able to take the lower tax rate until they received approval.  NTES received that approval this past quarter and actually received a refund for taxes paid in excess of what the company owed under the lower rate.  This is not only a nice one time benefit for shareholders, but it also appears the company will enjoy a much lower tax rate for the foreseeable future.

At the end of 2008 the company was sitting on a cash balance of $822.8 million compared to $609.5 million the year before.  Unlike many companies struggling with liquidity in this market, NTES is actually facing the problem of what to do with an excessive cash balance.  The board has approved a share repurchase program, authorizing the company to repurchase up to $100 million of the outstanding shares.  Now authorizations are not necessarily always put into place, but this particular instance appears to have teeth.  The board made the approval on December 12, and by the end of the year, the company had already spent $13.1 million repurchasing shares.

The online game portion of the business should continue to do well in the coming quarters as the pipeline for new releases appears relatively robust.  At the same time, the company is working hard to diversify revenues in order to benefit from its other business lines.  This should allow more stability should one area begin to show weakness.  The diversified approach has the eye of institutional investors and Credit Suisse has named the company as its top pick in the sector.

Analysts expect the company to earn $1.94 in the coming year which could turn out to be conservative if the company continues to purchase shares at a healthy clip.  With the stock trading just below $24, the PE is roughly 12 which appears very attractive for a company with so much growth potential and such a strong balance sheet.  For readers who got involved in Shanda and are now sitting on strong gains, it might make sense to sell a portion of the position and diversify by buying a smaller stake in NetEase.  Both stocks are performing well during challenging times and should only benefit from an economic rebound.

FD: Author does not have a position in NTES
NTES Notes
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