Morningstar likes this 'very undervalued' Chinese gaming stock

Published Fri, Sep 3 20211:29 AM EDT

Regulatory fears may have left Chinese tech stocks battered for much of 2021— but Morningstar says one stock is "very undervalued." Chinese video gaming giant NetEase has seen a lot of volatility in recent months, after several regulatory blows including new rules curbing the number of hours children can spend playing online games to just three hours a week. As of Wednesday's close, the company's Hong Kong-listed stock was up 2.17% for the year, but still more than 25% lower than its February high. "Times have been rough for narrow-moat NetEase, but it's not likely to get much worse," Ivan Su, a senior equity analyst at Morningstar, wrote in a Aug. 31 note. Morningstar raised its price target for NetEase's Hong Kong-listed stock to 217 Hong Kong dollars (about $27.90) — an upgrade from the previous 142 Hong Kong dollars ($18.26). The stock last closed at 148.90 Hong Kong dollars, representing an upside of about 45%. We believe the market has overreacted to recent regulatory risks and overlooked the firm's long-term opportunities overseas. We now consider NetEase very undervalued. senior equity analyst, Morningstar Ivan Su The increased price target came largely due to expectations of higher long-term growth and profitability in the gaming segment for NetEase, Su said. "We believe the market has overreacted to recent regulatory risks and overlooked the firm's long-term opportunities overseas," the analyst said. "We now consider NetEase very undervalued." The recent regulatory changes in China limiting online gaming time for those under 18 are expected to have "negligible impact" on NetEase's long-term earnings, the analyst said, as NetEase disclosed that this age group "contributed to less than 1% of its overall grosses." Opportunities outside China NetEase's operating margin is expected to increase as its core gaming business expands into more profitable overseas markets, Su said, adding that the company currently has less than 1% market share in the gaming market outside of China. Having proved its ability to make high-quality and longstanding mobile games for the Japanese market, NetEase is "well positioned to capitalize on this massive opportunity outside its home," and is expected to achieve moderate success expanding to the U.S. and Europe. "We forecast overseas operations will contribute 30% of game revenue in 2024, a significant increase from the 12% posted in 2020," Su said. He said the current game pipeline for NetEase is "perhaps the strongest it's been for the last few years," citing the recent launch of battle royale PC game Naraka Bladepoint as one that has "quite a bit of upside potential." Regulatory concerns loom Still, regulatory concerns will likely continue weighing on the video game sector in the short term. Last month, Chinese video game stocks tanked after a Chinese state-run publication affiliated to the official Xinhua newspaper published an article calling gaming a type of "opium." That story was later taken down and republished, with references to the drug removed. The People's Daily, another state media publication, also published an article arguing that gaming firms should not have preferential tax measures. A decision by Beijing to end preferential tax rates could result in NetEase seeing an equivalent of an 11.8% drop in long-term earnings, Su warned, though he added that Morningstar sees "a less than 25% chance" of this happening. "Video games are, perhaps, China's best cultural exports," the analyst said. "This is evidenced by the Ministry of Commerce's recent inclusion of NetEase and other gaming companies into the list of National Cultural Export Key Enterprises — an indication that the government has vested interests in the long-term success of gaming companies." — CNBC's Arjun Kharpal contributed to this report.

Visitors play 'Anki Go' offline interactive battle game at China Telecom booth during 2021 World 5G Convention at Beijing Etrong International Exhibition & Convention Center on September 1, 2021 in Beijing, China.

Yi Haifei | China News Service via Getty Images

Regulatory fears may have left Chinese tech stocks battered for much of 2021— but Morningstar says one stock is "very undervalued."