The Impact of Recent Regulations on Chinese Online Gaming Stocks

In the past three days, U.S.-traded Chinese online gaming stocks have plunged, catching many investors off guard (see table below). The drop was caused by new regulations jointly announced by China's Ministry of Culture and Ministry of Commerce last week. The original document includes 26 items. This article explains several key rules that matter the most to investors, and discusses their impact on Chinese online gaming stocks traded on U.S. exchanges.

Table: Performance of U.S.-Traded Chinese Online Gaming Stocks During June 29-July 1

1. According to Items No.19 and No.20 in the announcement, gambling activities are prohibited in online games. This rule has the broadest and deepest impact. It mainly targets an in-game activity called "Opening the Treasure Box". In this activity, players buy virtual "Keys" (Picture 1) from game companies. Then they use these keys to open "Treasure Boxes" (Picture 2), which can be obtained by killing certain in-game monsters or completing certain quests. The content of these Treasure Boxes is uncertain - sometimes very valuable in-game weapons or armors, sometimes very cheap items. Players can own the virtual items produced in this process. This activity matches the definition of gambling: According to Wikipedia, "Gambling is the wagering of money or something of material value on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods."

Among all the new rules, the prohibition of gambling activities has the broadest impact because such activities are offered by over 90% of the MMORPGs (Massively Multiplayer Online Role-Playing Games) in China, according to a report by Beijing Business Today citing an industry insider. This rule also has the deepest impact: its implementation will cause games containing gambling features to lose 5%-7% of revenues, according to a Beijing Business Today article citing an industry insider. Judging from the percentage drops in stock prices (see table above), this 5%-7% estimate seems to be reasonable. The drops beyond this range can be attributed to other new rules.

Picture 1: Virtual Keys Sold by Chinese Online Gaming Companies to Open Treasure Boxes

Source: Game websites

Picture 2: A Player Is Opening a Treasure Box

Source: 131.com

2. According to Item No.8, online gaming virtual currencies issued by a company cannot be used to buy any other companies' products or services. This rule is most relevant to Shanda (SNDA), which owns two online gaming-related subsidiaries: Shanda Games (SDG), which develops, licenses, and operates online games, and Shanda Online (SDO), which operates billing, payment, and customer support systems. The implementation of this rule will likely create problems for several of SDO's recent contracts: Earlier this year, SDO has entered into agreements with Kingsoft, Shanghai Storm, LineKong, and Goldcool Games to provide billing and payment services to these game companies' certain games, such as Kingsoft's JX Online II and LineKong's The Legend of Kung-Fu. Under the agreements, these games' players can pay using "Shanda Points," the virtual currency issued by SDO. The new rule clearly prohibits such transactions.

Picture 3: A Snapshot of Shanda Online's Services

To understand the next key rule, we must be aware of two facts about Chinese online games:

1. Online games typically have two types of virtual currencies: "game points" that are purchased by players using real money, and "game coins" that are awarded to players after killing certain monsters or completing certain quests.
2. There are two types of online games in China: time-based games and item-based games. Time-based games generate revenue by charging users for the time they play, while item-based games allow free access and make money by selling virtual items. It's easier for item-based games to achieve a large user base because its free-to-play feature appeals to the majority of Chinese players.

3. According to Item No.2, online gaming companies issuing virtual currencies cannot provide the platform for trading of virtual currencies between players. This rule is most relevant to NetEase (NTES). In this rule, the "trading of virtual currencies" has various forms. A major form involves a player exchanging his/her game points for another player's game coins. Many game companies provide virtual currency exchanges to facilitate such trading. NetEase is more relevant to this rule than any of its U.S.-traded competitors because its time-based games, which accounted for over 80% of its online gaming revenues in 1Q09, are more reliant on virtual currency exchanges.

Such reliance results from NetEase's highly successful in-game economic system, which allows low-income users to keep playing while spending little money: these users play hard to earn game coins, and then exchange game coins for game points on NetEase's virtual currency exchanges (Picture 4). They then converted these game points into playing time, and start the process again by playing to earn game coins. This virtuous circle has attracted many players, and help NetEase's flagship game Fantasy Westward Journey achieve a larger user base (1.76 million peak concurrent users in 1Q09) than most item-based games. Although a large portion of this user base contributes little revenue, the game's popularity attracts middle-income and rich users, who contribute most of NetEase's revenues.

The virtual currency exchange is a key part of this virtuous circle. If NetEase is prohibited from providing these exchanges, then this virtuous circle will be broken, and NetEase's in-game economic system and user base will be negatively impacted. In contrast, other U.S.-traded Chinese online gaming companies are much less exposed to time-based games. In addition, most players of these companies' item-based games do not rely on virtual currency exchanges to keep playing because these games are already free to access.

Picture 4: A Snapshot of NetEase's In-Game Virtual Currency Trading Platform

Source: 163.com

Disclosure: No positions.

Comments

[jayminho:]

oh well
we live in a virtual currency world for more than 50 years now..
so.. what difference does it make ?

Jul 02 09:06 AM

[kappa5:]

nice work and information.

Jul 03 05:49 AM

[kagame:]

This helps explain the collapse in NTES stock price Wednesday AM compared to its peers. Although it did also just get upgraded to a $43 price target. Funny how little the analysts actually know.

SNDA dropped further, about $10 total.

I believe these companies will adapt and flourish, despite these regulations. What is more troubling is that the Chinese gov't continues to abuse Western investors with this type of bizarre and oddly timed regulatory action.

Jul 03 10:58 AM

[SFDog:]

Nice article BUT to say as you do that the price drop in the last few days was due to new regulations ignores the overall market sell-off. IMO the price drop in these stocks the last few days corresponds with the drop in the overall market, not from the regulations you mention. SNDA was in the $56 range on Wednesday.

Jul 03 01:00 PM