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NTES ADGO NRG - ERTS ELY

08/8/2004

Netease.com earning

NTES-  higher revenue higher expense

NTES reported 2004 Q2 earning earlier last week. Under revenue basis, NTES topline revenue is in line with expectation.  The next Q revenue growth estimate is also very impressive with 10% to 20% sequential rate.   However, NTES next Q will incur very large one-time marketing charge of  0.11 per share so that earning next Q will be much lower than expected: 0.34 - 0.36 per share. 

From investor point of view, the one-time marketing expense should not be excluded in valuation in my opinion. According to NTES management, the large marketing expenses are not likely to happen frequently.  However, I myself suspect that they will be likely to happen once every year.  Without detailed information from NTES, I would amortize this one time charge of marketing expense into 4 quarters.  If I normalize this way, the next quarter adjusted earning estimate will be  0.42 - 0.44, which is about 10%  lower than expectation but not as bad as the reported estimate number appears .

NTES outlook-  low valuation high growth potential

NTES earning per share currently still is growing  at 40% - 50% under  GAAP earning basis including all the one-time charges. 
NTES stock price is trading at PE = 23. Adjusting for its cash position,  NTES is trading at 20x forward PE of 2004 earnings or 13x forward PE of 2005 earning.  The current PE is only half of current yearly growth rate.

Current Q revenue breakdown:
      Wireless business:   18% of revenue
       Internet Ads:            18% of revenue
       Online Game:           64% of revenue.

Wireless is minority of business so that we can pretty much forget about SMS risk. Internet ads and online game are majority of NTES business which has been growing very fast recently. At beginning of 2004 NTES had only one online game XY2 with about 220k peak game users.  In June there was 250k XY2 peak game users and  111k XYQ game users.  The growth of  online game business was mainly due to newly introduced game XYQ growing from 0 to 111,000 peak users in half year.

Before year end of 2004 NTES will launch a new Korea game.  Early next year NTES will launch 2 internal games. With 3 more games coming NTES will very likely meet or beat 2005 earning of $2.13 per share earnings. The Wall Street analyst estimate  of 35% earning growth is very conservative in my opinion based on 3 new game launch next year and fast growing economy of China.

NTES vs ERTS

In the long run given a reasonable low valuation, the  stock price will follow earning per share.  As comparison, Electronic Arts ( ERTS ) is largest game stock in US. Its earning has grown 10 times over past 5 years while its stock  price zoomed 3 times.   ERTS currently trades at PE = 25 and its PE 5 years ago was  75.  The long  term performance of growth stock investment not only depends on the future earning growth rate but also on the current valuation of  the stock.  If  ERTS traded at PE of 25  five years ago, 5 years of long term investment would have yielded 10 times of stock price appreciation. 

Compared to US game industry,  China game industry is still in early stages. Further more, from my contacts of friends and relatives from China, There is no sign of recession of Chinese economy although the inflation kicked up recently.   I continue to believe that China economy growth will surpass that of US.  Although there is no guarantee that NTES will grow next 5 years as fast as ERTS past 5 years,  I continue to be optimistic on NTES long term growth prospect.

ADGO - Adams Golf earning

ADGO vs ELY

ADGO reported another great earning last week.  Its Q2 revenue growth was 12% year over year.  Its Q2 earning growth was 37.8% year over year.  The growth was mainly from Fair Ways and Irons products.  At current price of  $1.19,  ADGO is trading at its liquidation value with PE of 10. Price to sales is 0.49.

In comparison, golf industry leader Callaway golf (ELY) earning dropped 60% due to poor acquisition and poor products. ELY CEO resigned recently due to poor performance.  ELY PE is 33 and price to sales is 0.84.  ELY is trading at 2 to 3 times more expensive than ADGO.

According to Adams Golf management, New product Redline2 fair way and driver are expected to be released in Fall of 2004. New upgrade of popular IDEA IRON product is expected to be released in early 2005. With 3 new products coming in the near future, I look forward to better earning ahead for ADGO next year. 

NRG Energy  - my new target $40

NRG - why free cashflow instead of  Net Income

I was asked why I used Free Cashflow instead of Net Income earning to assess NRG stock. Due to distortion of accounting such as bankruptcy fresh-start accounting and amortization of goodwill or contract,  free cashflow of NRG reflect better economics of NRG rather than Net Income.

Many times, a company can report large Net Income earning while it still lose money in true economics sense. Another time, a company can report small or negative Net Income earning but it still enjoy huge profit with booming business. The disconnect between reported Net Income earning and true business economics is mainly due to artifact of account rule.  My fundamental  analysis is always concerned with true earning power or true profit under true economics of a company rather than a reported net income number.  It is true earning power that determines how much a stock price is worth rather than a reported number.

NRG Q2 earning

NRG reported excellent Q2 earning. Its business is seasonal so that comparison between Q2 to Q1 is not meaningful.

NRG also issued yearly estimate for 2004 for the first time.  Overall NRG 2004 estimated EBITDA is in line with my original estimate in my first NRG trade alert report. 

NRG worth $53 under NRG estimated 2004 EBITDA

EBITDA based valuation is fairly common investment method for valuation of a company.  NRG this earning release put out $750 2004 EBITDA excluding unsupported subsidy or project.  Yahoo finance shows NRG has about 4 billion debt. However, in reality, 1 billion debt is from unsupported project or subsidy.  "Unsupported" means that NRG will not pay back the debt or interest. NRG will let its unsupported subsidy go bankrupt. Due to limited liability nature of its subsidy company, NRG will not be responsible for those debt.  So the real true debt of NRG is only around 3 billion. NRG has 1 billion cash currently.   Utitlity power industry trade at 10x to 14x of  Enterprise value(EV) to EBITDA. Assuming 10x mutiple of EV to EBITDA ratio, NRG stock price is worth $53 per share.

NRG worth $37-$40  under 2004 estimated adjusted free cashflow

NRG expects $304 million of 2004 free cashflow.  NRG expected 2004 adjusted free cashflow excluding working capital change is about $371 million. By applying 10x to 11x multiple to its adjusted free cashflow, NRG is worth $37 - $40 a share.

NRG 2005 outlook - uncertainty of  California, Connecticut

I am cautiously optimistic on NRG 2005 prospect. The main uncertainty is California subsidy and Connecticut business. California contract will run out at year end of 2004.  California subsidy 2004 contribution of cashflow currently is expected to be $130 million.  California subsidy cashflow is expected to be significantly lower in 2005.  Recent California Energy Committee  report seems to be positive to NRG recognizing the value of aging power plants due to the power transmission shortage of Southern California.  Quite many aging NRG California power plants sit on the beach so that there is potential of real estate gains too.

Connecticut 2005 outlook is expected to be improving.   How much of  NRG Connecticut operation cashflow improvement in 2005 is still unknown.

Conclusion for NRG

NRG is worth between $37 to $50 based on either on free cashflow or  EBITDA basis. The NRG 2004 free cashflow estimate is lower than my original estimate. There is also uncertainty of California business downside and Connecticut business upside near term. Therefore, To be conservative, I lowered my NRG 1 - 2 years target to $40 per share instead.  I continue to like NRG stock at current price.

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