Ease into this Chinese Internet Play

Despite a high growth this company sports a low valuation. Using this basic option strategy can double your money over the next four months. 

You know a company has reached a certainly level of maturity and permanence when it drops the “dot.com” from its name.   That’s exactly what NetEase (NTES), a China based internet company, did in 2012. Now I’m not suggesting that’s the reason behind the shares 165% since that rather indicative of how it has grown into a $14.1 billion company that offers a full suite of online services and products.

For many in people living in mainland China NetEase is the primary gateway to the internet by providing basic services such as email and instant messaging and photo sharing. When it recently reported Q4 results on February 9th it beat analyst estimates with a 42% increase in revenues to $597 million and a 34% increase in bottom line earnings of $517 million or $9.67 per share.

Somewhat surprisingly the biggest gains came from expanding its email services which was expanded to include the commerce and saw revenues surge 224% to $61 million during the quarter. Ad revenue also saw solid 36% year-over year increase. This type of growth from pretty standard internet services suggests just how fertile the Chinese market is.

Going Mobile

But the real future growth, and profits, comes from its online gaming division which offers multi-player role-playing games including titles such as Fantasy Westward Journey II, Tianxia III, Ghost II, and Heroes of Tang Dynasty.

Gaming revenue grew by 36% to $461 million with a notable shift to mobile platforms. Mobile revenues increased by 50% but still account for just 15% of all gaming revenue suggesting there is still a long runway.

But that future growth comes at current cost as gross margins dipped to 67.5% from 69.9% in the third quarter and below the 71.6% expected as mobile is less profitable. But the shift is inevitable and the company feels the increase in revenues will more than compensate for the reduced, but still fat, margins.

The company raised their full year guidance and will begin paying a dividend effective next quarter. The news was all good enough to cause shares to jump 5% following the report, erasing the 7% decline suffered in the preceding days. Shares have now consolidated back above the 20 dma at $113 offering an attractive entry point or climbing aboard its solid long term trend higher.

NTES 021815

Despite its growth rate the shares, currently at $114.50, trade at a seemingly impossibly low 3x forward p/e multiple. Some this is the discount associated with trading a China based ADR.

The Trade: 

The strategy I’m using to establish bullish position is a basic vertical call spread. Specifically;

For the $20K Portfolio I bought the June $115/125 call spreads for a $3.80 net debit.

-Buy the June $115 calls (NTES150619C0011500)

-Sell the June $125 calls (NTES150619C0012500)

For a $3.80 net debit for the spread. The options expire June 19th. By using a spread with over 120 days until expiration I’m minimizing the cost and negative impact of time decay.

I have an upside target of $125 but would look to take partial profits if the value of the spread doubles to $7.60.

I will further reduce risk by setting a stop loss if the shares close below $109.50 or the value of the spread declines to $1.50. This aligns with my objectives for setting up trades that offer an attractive risk/reward with specific target and stop loss points as discussed in this Profit & Probability piece.

— Steve Smith

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About the Author: Steve Smith