June 15th, 2013 by hackel Leave a reply »

Netease

Last  month we purchased our first company based in China, coming after greater than normal research and investigation, lasting several years.

Netease (NTES), one of the leading providers of internet services within China, derives 87% of its revenues from online gaming, 10% from online advertising and 3% from email services, the country’s largest with 550 million, and growing, users. Their success with email and gaming is now allowing them to branch out to other services. Total firm revenues are US $1.3 billion with $685MM in adjusted free cash flow against a $7.5 billion market value of equity (36% in cash).  Compared to the US, internet penetration in China is low, estimated at just 42% of the populace.  The firm’s various websites are, according to independent firms, among the most visited in China, if not the world.

The lengthy review time was needed as the company is not audited by a US firm nor is any inspection of its books evaluated by a US firm, although two Board members are CPA’s. Cost of equity capital was raised by 1% due to lack of well-known oversight, reducing fair value by 16%. While the SEC has brought action against five accounting firms in China, NTES is not involved in such proceedings, but may be ultimately impacted if the case against the auditors is lost. It is conceivable, though quite doubtful, they could lose NASDAQ listing, although its shares would continue to trade and be active. I am hopeful an agreement signed last week allowing the US Accounting Oversight Board permission to review Chinese audit records will develop into full scale cooperation, quell the regulatory riff, lift any conceivable financial veil, and bring down the firm’s cost of capital. It appears this is what the Chinese desire given various scam companies and resulting publicity that have taken place. Also, slower growth in China alongside strong need for credit on local levels will require such action.

China has seen its sovereign risk rise over the recent month according to our models, reflecting its economic slowdown. Its  5 year CDS spread over similarly dated US Treasury bonds also rose this month, going from 29 to 58 basis points, and equity cost of capital is raised by this latter  amount over the US risk free rate, still at an historically low 2.15% When all risks are considered, the cost of equity capital hurdle (7.7%)for NTES  is high for a firm with its credit, however has been overcome as a result of products, time in business, independent proofs, lack of significant litigation, stock ownership, joint ventures, as well as the financial metrics.

Their auditor is registered in China. Chinese company law is modeled after that of the UK, yet the firm follows international accounting standards. While foreign exchange rules in China are controlled, the Renminbi is freely convertible for current account items including dividend payments, interest and trade transactions.

On the metrics side, NTES sells at a 9.1% free cash flow yield, a 24.5% return on invested capital, economic profit/sales[1] of 27.2% (GOOG is 18.5%, and AAPL is 21.3%) and has zero bank debt or bonds. Operating leases are for rent, server custody and office machines which are modest in relation to cash, operating cash flows and equity. Their share repurchase program is minor.

Over the past 7 years, free cash flow has grown by 356% and revenues by 475%. The stock is volatile and subject to those risks inherent in any technology firm.  Given its valuation, however, like portfolio holding Google, which I was forced to write on last fall when its shares fell by $100, only to recently rise to all-time highs, NTES appears to offer strong risk-adjusted long-term prospects, taking into account its cost of capital.



[1] Economic profit removes the distortion of firms which by their nature operate with a low capital base. The CT Capital definition is far superior to the general concept employed by the industry as we use adjusted free cash flow, not EBITDA, which is an analytical trap. For a full explanation, please write.

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