Which Company Will Win This War In China?

by: Amal Singh

The massive Chinese online gaming industry appears to be immune to macroeconomic situations as tepid economic conditions have had little to no effect on this booming industry. Up until now, China had banned foreign video game consoles, which ultimately led to the increased demand for PC games, and because of this, companies like NetEase (NASDAQ:NTES) and Changyou (NASDAQ:CYOU) have experienced massive growth over the past few years.

The quarterly performance of NetEase and Changyou indicates that both these companies have benefited from this trend and lifting the console ban may not matter as consoles are already widespread in China. Hacked versions of foreign consoles are very common, and people will be reluctant to spend money on expensive games.

NetEase's revenue increased 20.5% year-over-year to $392 million in the second quarter while the company also reported a strong gain of 15.4% in its earnings. The sturdy performance of NetEase's online games and advertising services helped it outperform Changyou, which reported 24% increment in revenue and 9% bottom-line growth. Impressive jumps of 33% and 18% in the advertising business and gaming business, respectively, attributed to NetEase's strong bottom-line growth.

Changyou's advertising revenue increased 11% and its online gaming revenue grew 24%. Even though Changyou's gaming revenue fared better than NetEase, the insignificant growth in its advertising revenue allowed NetEase to dominate the PC market.

NetEase's domination of the PC market was enough to persuade Activision Blizzard (NASDAQ:ATVI) to make it its official licensing partner for World of Warcraft in China. However, this collaboration has had a negative impact on the quarterly performances of NetEase of late. The dip in the number of subscribers of World of Warcraft offset some of the gains of NetEase. The impact that it had on Activision's quarterly performance was more severe as the company reported a dip of 42% in its revenue while its EPS plummeted from $0.20 to $0.08.

Despite the decline in the World of Warcraft revenue, NetEase managed to increase its online gaming revenue which was important since this segment accounts for 87% of the company's total revenue.

Prospect analysis

NetEase has boosted its ties with Activision and has won the China rights for Activision's new title called Hearthstone: Heroes of Warcraft. This licensing deal reflects that NetEase is emerging as Activision's primary partner in China and it may gain rights to some of Activision's other franchisees in the future. Both companies are looking to gain traction from the massive Chinese online gaming market and this deal should benefit them over the long term.

NetEase is also aiming to keep gamers interested by introducing expansion packs and upgrades for many of its self-developed games like Fantasy Westward II and Ghost II. NetEase is also looking to diversify its portfolio and to do so it launched a 3D multi-player online role playing game, Dragon Sword, in the previous quarter and has another game called Legend of Tibet in the pipeline.

The Chinese internet market is in a transition phase as many users are shifting from personal computers to mobile devices. NetEase has smartly adapted to this change by launching its popular self-developed titles for mobile devices. To diversify its mobile portfolio, NetEase will launch several more games over the course of next few months.

Given the potential of the mobile gaming market, NetEase is not the only company looking to make the most of the opportunities. NetEase will have to compete against Changyou as it looks to make its presence felt in this segment.

Changyou on the rise

Changyou launched two new mobiles games in China last month and management stated that these games will be used to enhance the company's game marketing and promotion channels. In addition to that, Changyou will also be launching numerous mobile games in the remainder of the year, half of which will be self-developed.

To make its presence more prominent, Changyou is working on developing mobile apps, which will upgrade the existing content and services available to the mobile users. The company launched six such mobile apps in the previous quarter and it looks like it has a stronger pipeline of products than NetEase. Nevertheless, NetEase's superiority in advertising services might enable it to perform better than Changyou in the future.

Sina's threat

In the advertising business, NetEase will have to face stiff competition from Sina (NASDAQ:SINA). Sina witnessed a robust quarterly performance as its revenue jumped 20% and its earnings almost quadrupled to $14 million. Revenues from Weibo, the Chinese version of Twitter, grew 205% while total advertising revenue increased 17% year over year.

With more people shifting to mobile devices, the time spent on the mobile social networking segment, or SNS, has significantly increased this year which ultimately led to a sequential increase of 43% in the company's mobile advertising business. Sina recently released a newer version of Weibo mobile application which provided a superior user interface and added many new features to it. With over 50 million Daily Active users and increased acceptance of advertising, Weibo will help Sina benefit from the mobile advertising segment.

Competition in gaming

NetEase has dominated the PC market, but Giant Interactive (NYSE:GA) may test its tenacity. Giant reported a 20% jump in earnings and an 11% increase in top line in the preceding quarter. However, a mere 5% increment in active paid accounts to 2 million was pale as compared to the industry standards and led to a 9% drop in its share price after it released its quarterly results.

Giant is set to seize the opportunities provided to it by the MMO (Massive Multiplayer Online) gaming market in China. Going forward, Giant will be launching World of Xianxia and the company expects it to be its next hit game. The company also entered into an agreement which will make it the official publisher of Cang Tian 2, a 3D MMO game, in China.

Giant's big move

Also, Giant has joined forces with Qihoo 360 Technology (NYSE:QIHU) to operate online games and this deal will undoubtedly be a plus point for it as it will help Giant expand its presence.

Qihoo witnessed a stunning quarter as the company's revenue surged 106% year over year to $152 million while its net income increased from $7 million to $33 million. According to iResearch, the number of active users of Qihoo's PC-based services increased to 461 million in the previous quarter, covering 96% of China's active PC internet users. In addition to that, the monthly active users of Qihoo's PC browser reached 330 million, covering up approximately 70% of the China's active PC internet users. The company will continue to invest more to expand its coverage, which is good news for Giant as it looks to conquer the MMO gaming market in China.


Company 5-year PEG Trailing P/E Price to Sales (ttm) Debt to Equity Return on Equity Profit Margin
NetEase 0.94 15.27 6.96 5.55 24.07% 45.79%
Changyou 0.62 5.27 2.26 41.36 44.06% 43.03%
Shanda Games 0.54 7.64 1.75 27.78 25.14% 23.34%
Giant Interactive 0.48 11.16 5.25 No debt 37.32% 47.81%
Advantage Giant Changyou Shanda Giant Changyou Giant

So from an investment perspective, NetEase doesn't outperform its peers in any of the metrics above. However, the company is huge and is among the biggest players in the Chinese internet space. It has successfully negotiated the decline of subscribers in World of Warcraft and looks set to get even better. Giant, as evident from the table, looks like the most enticing pick. Given the fact that it has another blockbuster game coming up, investors should take a close look at it.

Disclosure: I 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.