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On March 26, Bill Simpson wrote an analysis of Changyou (NASDAQ:CYOU). In their market debut Thursday, April 2, shares priced at the top of their estimated price range of $14-$16 a share. With 7.5 million American depositary shares in the IPO, the company raised $120 million.

The text of Mr. Simpson's original writeup follows:

• • •

Changyou.com plans on offering 7.5 million ADS at a range of $14-$16. Note that 1/2 the ADS in this offering will be sold by parent company Sohu.com (NASDAQ:SOHU). Credit Suisse and Merrill Lynch are leading the deal, Citi and Susquehanna Financial are co-managing. Post-ipo CYOU will have 51.25 million ADS equivalent shares outstanding for a market cap of $769 million on a pricing of $15. Ipo proceeds will be utilized for general corporate purposes.

SOHU will own 71% of CYOU post-ipo. CYOU's CEO Tao Wang will own 15% of CYOU post-ipo. Note that post-ipo CYOU will be paying SOHU a one-time dividend of $96 million.

SOHU is a Chinese internet portal operating since 1998. Sohu has a current market cap of $1.56 billion and currently has over 250 million registered accounts.

From the prospectus:

"We are a leading online game developer and operator in China as measured by the popularity of our game Tian Long Ba Bu, or TLBB. TLBB, which was launched in May 2007, was ranked by International Data Corporation, or IDC, for 2007 as the third most popular online game overall in China and the second most popular online game in China among locally-developed online games."

On-line multi-player role playing game company, this CYOU ipo is similar in that fashion to this decade’s ipos of SNDA/NCTY/PWRD/GA. Below we'll do a comparison of those four with CYOU.

Tian Long Ba Bu (TLBB) was developed and launched in-house at CYOU, then a part of SOHU. In addition to TLBB, CYOO also has licensed and operated Blade Online (BO). For the three months ending 12/31/08, TLBB had 1.8 million active paying accounts and BO had 159,000 active paying accounts.

Tian Long Ba Buis a 2.5D martial arts game, launched in May of 2007. Multi-player means literally over a million players/characters can inhabit the game-playing universe at the same time. In 3/09, peak concurrent users exceeded 800,000. CYOU has also licensed this game to third party operators who run the game in Taiwan, Hong Kong, Vietnam, Malaysia and Singapore. Game players may play for free, however they must purchase pre-paid game cards to buy virtual items such as gems, pets, fashion items, magic medicine, riding animals, hierograms, skill books and fireworks. As is customary in China, pre-paid game cards are sold through regional third party distributors who then distribute to Internet cafes and various websites, newsstands, software stores, book stores and retail stores.

Pipeline - CYOU has three games in various stages of development: Duke of Mount Deer, or DMD, Immortal Faith, or IF, and the Legend of the Ancient World, or LAW. Duke of Mount Deer is another martial arts game and is being developed in-house. The other two will be licensed properties. Rollout of DMD will be 4th quarter of 2009 with the other two coming in 2009 and 2010 respectively. It would appear CYOU is banking on Duke of Mount Deer to be their next hit and hoping that this release will pick up the slack from the eventual player slowdown in TLBB.

Market segment - China's online game players numbered an estimated 40 million in 2007 with revenues of $1.4 billion. Online game revenues are expected to continue to grow to $3.4 billion in 2012 at a compound annual growth rate, or CAGR, of 19.9%.

Growth - 94% of CYOU's revenues in 2008 were from the game Tian Long Ba Bu (TLBB). Launched less than two years ago, TLBB has been a huge success, generating over $180 million in revenues in 2008 alone. This ipo is based completely on the success of this one game. While TLBB has generated massive revenues and profitability, online video games tend to have a distinct lifespan and popularity curve. TLBB's popularity seems to have peaked in late 2008, so future growth is going to depend on CYOU's pipeline of coming games. TLBB in the 12/08 quarter had 1,822 paying accounts which was down slightly from the 9/08 quarter. Quarterly revenue growth from TLBB has gone from stratospheric to somewhat flat. Beginning with the 12/07 quarter, following is the quarter to quarter revenue growth of TLBB: 12/07 +102%; 3/08 +76%; 6/08 +13%; 9/08 +11%; 12/08 +6%. Looking at the slowing growth from TLBB, we can clearly see that CYOU will have difficulty growing going forward without their 4th quarter 2009 launch of Duke of Mount Deer becoming a big hit. In fact, I would expect TLBB to book negative revenue growth quarter to quarter by the end of 2009 just as their next in-house game is launched.

Risk - the obvious risk here is a significant market cap on ipo of $769 million (assuming a $15 pricing) based on one on-line game. Looking at the above slowing quarter to quarter growth trends of this one game, the risk here is that unless CYOU's next in-house game (due to hit in late 2009) is a big hit, revenues and earnings power will decline significantly as TLBB sees its popularity wane. This is a significant risk, especially as their new in-house game has yet to have a track record. For me, this large market cap based on one game carries enough risk that I can only be, at best, neutral on this deal in range as the popularity of TLBB is already baked into the market cap in range.

Financials - After paying SOHU a $96 million dividend, CYOU will have slightly under $2 per share in cash post-ipo with no debt.

Revenue growth has been swift since the release of the Tian Long Ba Bu game. Revenues in 2006 were $8.5 million, in 2007 $42 million and in 2008 $201.8 million.

2008 - Revenues were $201.8 million, a massive increase over 2007. Tian Long Ba Bu accounted for 94% of those revenues. Gross margins were an impressive 93%. Operating expense ratio was 36%. Operating profits were 57%. In 2008 Tian Long Ba Bu was a money making machine. Normalizing CYOU's tax rate as it will appear post-ipo, net margins were 50%. Earnings per share were $1.97. On a pricing of $15, CYOU would trade 7-8 X's trailing earnings.

2009 - As noted above, quarter to quarter growth will slow dramatically from 2007 and 2008. CYOU's money making game TLBB appears as if it has peaked in popularity, or at least should see much more constrained revenue growth. As CYOU's next in-house developed game will not hit until late 2009, CYOU's revenues should be rather stagnant on a quarter to quarter basis throughout 2009. Projected revenues for 2009 should be in the $230 million ballpark, an increase of 15% over 2008. Much of this growth will be due to favorable comparables in the 3/09 quarter compared to 3/08 period. Gross margins look to continue to be 90%+. Operating expense ratios should be slightly higher as CYOU ramps up product development and sales/marketing efforts to promote new games. Let's plug in a 37% operating expense ratio. Operating margins should be 55%. It appears that for 2009-2011, CYOU will have an approximate tax rate of 12.5%. Net margins then should be approximately 42.5%. Earnings per share should be approximately $2 per share. On a pricing of $15, CYOU would trade 7 1/2 X's 2009 earnings.

Lets take a glance at CYOU's public competitors.

Shanda Interactive Entertainment (NASDAQ:SNDA) - $2.6 billion market cap. Currently trading 13 X's '09 estimates with an anticipated revenue growth of 25%.

The9 (NASDAQ:NCTY) - $370 million market cap. Currently trading 9 X's '09 estimates with an anticipated revenue growth of 9%.

Perfect World (NASDAQ:PWRD) - $789 million market cap. Currently trading 7 X's '09 estimates with an anticipated revenue growth of 22%.

Giant Interactive (NYSE:GA) - $1.6 billion market cap. Currently trading 12 X's '09 estimates with an anticipated revenue growth of 5%.

Stacking CYOU up with these four, it does appear to be priced within the valuations of the above. A positive for CYOU is that they do have an extremely popular game. The downside is that nearly all revenues are derived from this one game and, at this point, we do not know whether CYOU will be successful in diversifying their game base and revenue stream.

Conclusion - On a trailing basis, the CYOU ipo looks dirt cheap. The problem, however, is the ipo and market cap are based on the huge success of their game TLBB. It appears to me that TLBB has, at the very least, come close to peaking by late 2008. With their next in-house game not launching until late 2009, I would project CYOU to see pretty flat revenues for '09. Looking forward, this is a pretty hefty market cap for reliance on one single game which saw its best year in 2008 and should decline somewhat in popularity going forward. The valuation is not out of line, however, and if CYOU's next in-house game is another big it, there is potential for share price appreciation. The problem, however, is currently we have no idea how CYOU's future games will be received. We do know that the current success of TLBB is most definitely in the market cap on ipo. Neutral here in range. Swift growth in '08 and reasonable PE ratio is appealing, the lack of revenue diversification, however, is a pretty big sticking point for me.

Source: Changyou's IPO Banks Heavily on One Single Game