Hong Kong-listed game developer NetDragon Websoft Holdings (OTC:NDWTY) [777:HK] is a leading game developer which delivered a strong +51.6% and +85.4% YoY growth in revenue and profit, respectively, for its gaming business in 1H2019. Notwithstanding the excellent performance of its gaming business, my sum-of-the-parts valuation of HK$25.10 for NetDragon suggests the stock is undervalued, and there is a 38% upside to its share price of HK$18.16 as of October 10, 2019.
A robust new games pipeline, including the hugely anticipated Eudemons II, the mobile version of the company's flagship PC game Eudemons Online, and the potential narrowing of losses for its education business with the launch of its high-margin online tutoring services going forward are key re-rating catalysts for the stock.
Started in 1999 and listed on the Hong Kong Stock Exchange in 2009, NetDragon is a leading online game developer in China with a history of successful self-developed games such as Eudemons Online, Conquer Online, Heroes Evolved, and Vows of Heroes. It was also the first Chinese game developer to venture overseas, with its games localized in more than 10 different languages and accessible to millions of users in more than a hundred countries.
NetDragon entered the online education industry with the establishment of its subsidiary Elernity in 2010, and it expanded its online education business beyond its home market China in 2015 with the acquisition of UK-based education system provider, Promethean. Following further acquisitions (such as education products provider JumpStart in 2017 and global learning community Edmodo in 2018) and strategic investments, NetDragon's online education business has created a global K-12 educational community network and ecosystem which provides education services to over 1.3 million classrooms, 12 million teachers, and close to 100 million users in 192 countries globally.
NetDragon derived approximately 59.0% and 39.2% of its 1H2019 revenue from its gaming (both online and mobile games) and education businesses, respectively. Its mobile solution, products, and marketing business contributed the remaining 1.8% of the company's top line in 1H2019, and generated a segment loss of RMB10.5 million in the same period. For its two core businesses, the gaming business contributed a segment profit of RMB1,065.9 million in 1H2019, but this was partially offset by a segment loss of RMB385.7 million for the education business. NetDragon as a company was loss-making in the FY2015-FY2017 period, before profits from its gaming business grew to exceed losses from the education business starting FY2018.
Gaming Business Firing On All Cylinders
NetDragon's gaming business segment revenue and net profit grew by +51.6% YoY and +85.4% YoY to RMB1,575.8 million and RMB972.1 million, respectively, for 1H2019. Notably, this strong growth was driven by a broad-based increase in revenue from its three major gaming intellectual properties or IPs, and there was an improvement in all of the key operating metrics.
NetDragon's three key gaming IPs are Eudemons Online, Heroes Evolved, and Conquer Online.
Eudemons Online delivered a +56.5% YoY increase in revenue of both the PC and mobile versions of the game for 1H2019, on the back of record high gross billings. Apart from the addition of new expansion packs and new playing features to increase user playing time, cross-industry collaboration with well-known celebrities and brands was key in creating new gaming content and driving brand awareness for Eudemons Online.
Cross-industry Collaborations With Eudemons Online
Source: NetDragon's 1H2019 Results Presentation
Heroes Evolved, China's second largest multi-player online battle arena or MOBA game with 300 million registered users and 2 million daily active users globally, saw a significant increase in gross billings and a +27.0% YoY increase in revenue in 1H2019, driven by the staging of global contests to increase user engagement. NetDragon staged multiple global contests for Heroes Evolved targeted at non-professional gamers such as Heroes Evolved National League and Heroes Evolved World Championship which were broadcasted live. Conquer Online achieved a +43.0% increase in 1H2019 revenue, as NetDragon launched four expansion packs for the game during the same period.
In terms of operating metrics, NetDragon disclosed that there was an increase in monthly active users, daily active users and paying accounts. New playing features and content enhancement via the launch of multiple expansion packs led to an increase in the number of both new players and return players. Also, a key critical success factor for NetDragon's gaming business is game testing. NetDragon engages in long game testing cycles prior to the launch of new games. It places a strong emphasis on testing new games in great detail, and optimizing the features and design of its games based on the results of its testing.
With NetDragon's gaming business posting such strong growth in 1H2019, the key question is whether the growth is sustainable, especially since the PC gaming market has been shrinking as more people switch to playing mobile games and also other alternative leisure options.
There are several misguided perceptions about the state of the gaming industry, which needs to be addressed for investors to have confidence in the future growth prospects of NetDragon's gaming business.
Firstly, PC games revenue is still growing. Although mobile games revenue was up +76.2% YoY for NetDragon in 1H2019, PC games revenue growth was also a respectable +47.5% YoY. Existing PC gamers, mostly aged above 30, are stickier than expected, and the majority of them have not switched to mobile leisure games, according to NetDragon's analysis of its own gaming data and statistics.
At the company's 1H2019 earnings call on August 30, 2019, NetDragon provided more details of the characteristics of its core PC gamers:
I believe that in the next 2 to 3 years, we will still have great growth for the PC game users. So the market, actually, the market size for PC games is indeed shrinking. But then it will not affect us a lot as some users are still -- they still like to play games on their PCs. So many of them are above 30. And we also have a lot of interaction with users. And we encourage them to learn new ways of playing. But then for those people over 30, perhaps they will stick on to playing the games on their PC. This is their habit, and we do not intend to change them drastically. So these are our core users, they will continue to play our games on their PCs and it is anticipated that they will continue to do so in the coming years. So they're a very stable user base for us... And for the PC users, as I mentioned, they are very stable. And we find that they are very loyal, in fact. And about 5% of them will try on different leisure games, but then only a small number of them. Basically, they will continue with their old habit of just playing the games on their PC.
Secondly, PC games and mobile games are not mutually exclusive. With a portfolio of gaming IPs, NetDragon is allowing users to play its games in different modes, by launching its games on multiple platforms, including PC, online, and mobile. NetDragon has noticed an increase in the number of return users and also new users who might have played their first PC game after getting hooked on the mobile version of NetDragon's game. This means NetDragon is not constrained by the shift in games from one platform to another. It aims to continue grabbing a share of the gaming market as long as people are still playing games.
Thirdly, the demographic profile of gamers has changed over the years. While gamers used to be aged between 15 and 30 years old in the past, NetDragon notes that it currently has a broad base of users with its gamers aged between 15 and 50 years old. In other words, the new generation continues to play games despite an increasing variety of leisure options, while the old generation of gamers haven't given up on gaming yet. NetDragon understands this new dynamics very well, and it is working hard to meet the needs of both young and old gamers alike.
Robust New Games Pipeline With High Expectations For Eudemons II Mobile Game
NetDragon's new games pipeline includes more than 10 new games under development or in testing stage, which includes Eudemons II, Heroes Evolved "Thrones", Battle of Giants, Cyber Legends and Vow of Heroes among others.
NetDragon's New Games Pipeline
Source: NetDragon's 1H2019 Results Presentation
Among the new games, there are high expectations for the Eudemons II mobile game planned for launch in 1H2020, as Eudemons Online is NetDragon's flagship PC game and gaming IP. Similar to movie sequels and franchises, mobile versions of popular PC games tend to perform at least as well as their PC counterparts.
The key concern is regarding a potential delay in game licensing approvals by regulatory authorities, which could lead to the timeline for the launch of Eudemons II and other games to be pushed backwards.
All new games to be launched in China have to go through the same process, where the games are submitted to the authorities which will review the games one by one and assess if the content is appropriate. NetDragon, like any other game developer, has to wait in line, and there is nothing that the company can do to speed up the game licensing approval process. NetDragon does receive feedback and questions from the regulators on a quarterly basis, so its years of experience in this field allows it to address issues and concerns quickly, and this helps to make the company's game application and approval process smoother.
NetDragon's strategy to counter regulatory uncertainties in its home market China is to localize and launch new games in overseas markets such as the Middle East and North America first. This strategy has borne fruit, with the company's overseas games revenue up +52.1% YoY in 1H2019.
Improving The Profitability Of The Education Business
The education business's segment loss widened from -RMB158.7 million in 1H2018 to RMB308.9 million in 1H2019, while headline revenue was down -24.2% to RMB1,048.5 million in the same period. Adjusting for revenue relating to tenders which are usually regular in timing, the education business's adjusted revenue would have been up +4.7% YoY.
NetDragon's education business also generated segment losses of -RMB423.3 million in FY2017 and -RMB420.7 million for FY2018. As the education business currently generates the majority of its revenue from sales of low-margin hardware products like Promethean-branded interactive whiteboard products, it has been difficult for the company to improve the profitability of its education business.
Promethean Interactive Whiteboard Products Such As ActivPanel
Source: NetDragon's 1H2019 Results Presentation
But things are about to change with the launch of its online homework help service called AskMo within its newly-acquired global learning community Edmodo in September 2019, the beginning of the school year. AskMo is a mobile app-based service which combines a live tutor with artificial intelligence-assisted self-studying covering English, science, technology, engineering, and mathematics topics. A live tutor walks the student step-by-step in solving problems and understanding specific topics in 10 to 15 minute sessions. AskMo operates on a freemium model, with a price range from free to $50 per month.
By the end of the year, NetDragon targets to expand its portfolio tutoring products to include online one-to-one and one-to-many video tutoring services. These will be mid-premium and premium products priced above $50 and $150 per month, respectively. The operating profit margin of the online tutoring business is expected to be in the high double-digits, versus a negative operating profit margin of -16.3% for the gaming business as a whole in FY2018.
On-demand Homework Help Service AskMo And Tutoring Product Development Roadmap
Source: NetDragon's 1H2019 Results Presentation
NetDragon's tutoring and online homework help services have a few key competitive advantages versus competing services. Firstly, AskMo utilizes unique artificial intelligence technologies such a photo bot that can recognize handwritten questions and convert them into a format that tutors can process and help to answer. Secondly, NetDragon plans to incorporate its other education products and technologies into its online tutoring service such as its existing white-boarding capabilities to allow for a better and more interactive learning experience where students and tutors can "work together" on shared interactive digital whiteboards. Thirdly, Edmodo has more than 100 million registered users, so NetDragon has a significant potential customer base to tap on. The Edmodo platform itself already has a significant number of highly qualified teachers who have specific subject expertise and are now acting as live tutors for AskMo.
Also, NetDragon has shown a willingness to monetize the value of its non-gaming businesses in the past. It sold app store platform, 91 Wireless to Baidu (NASDAQ:BIDU) in 2013, while it divested the country's first online game portal 17173.com to Sohu (NASDAQ:SOHU) in 2003. There is a high likelihood of NetDragon selling its education business in part or whole to realize value for shareholders in the future.
I arrive at a target price of HK$25.10 for NetDragon based on a sum-of-the-parts valuation, which offers a 38% upside to its share price of HK$18.16 as of October 10, 2019. My sum-of-the-parts valuation assumes an 8 times P/E (based on the average P/E multiple of Hong Kong-listed pure-play gaming companies) applied to my forecasted FY2019 net profit of its gaming business, and a $477.5 million valuation for its 73% equity interest in the education business pegged to the valuation of its Series A equity funding round in January 2015.
The key risk factors for NetDragon include unfavorable government policies negatively impacting its gaming and education businesses, a longer-than-expected time taken for the launch of its Eudemons II mobile game, a widening of losses for its education business, a failure to integrate its acquired companies successfully, and overpaying for new acquisition targets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.