Questioning Giant Interactive's Latest Strategic Move

| About: Giant Interactive (GA)

This week Giant Interactive (NYSE:GA) reorganized its five development teams into five daughter companies, with Giant holding 51% of equity and the teams 49%. The event was reported by the Chinese media, but not by the English media yet.

For background knowledge, here is a short description from Yahoo Finance about Giant.

Giant Interactive Group, Inc. develops and operates online games in the People’s Republic of China. The company focuses on massively multiplayer online (MMO) games that are played through networked game servers in which thousands of players are able to simultaneously connect and interact. Its online games include ZT Online, a two-dimensional online role-playing game; ZT Online PTP, a pay-to-play game based on the ZT Online free-to-play game; Giant Online, a military-themed MMO game; and ZT Online Classic Edition, a version of ZT Online for players who prefer the original monetization features of ZT Online. The company markets and sells its prepaid game cards and game points through distributors and retail outlets, including Internet cafes, software stores, supermarkets, bookstores, newspaper stands, and convenience stores, as well as through official game Website. As of March 31, 2009, its distribution network consisted of approximately 280 distributors, and reached 116,500 retail outlets. Giant Interactive Group was founded in 2004 and is based in Shanghai, the People’s Republic of China.

I cannot help analyzing this unusual event. Accountingwise, there is no effect as of now, since the revenue contribution from the those projects are immaterial. Giant may show better GAAP net income because half of the loss from those companies at this early stage will be burdened by the new equity owners, the teams. Capital market is unlikely to count in that effect, though, and will actually price Giant pro forma, so that it is not going to affect Giant's stock price in the near term.

In the future, if any one of the daughter companies has a hit game, Giant will get 51% of the net income, which is a smaller percent than if it does not spin off the daughter companies. Apparently Giant is betting on having a smaller cut on a much bigger pie. By having those companies stand alone, Giant hopes that one of them will turn into another giant, a typical venture capitalist thinking mode.

Somehow I do not have a good feeling about this move, which seems a bit unusual and extreme. Yuzhu Shi, the CEO of Giant, had a problem in managing the firm after he successfully brought the firm to the Nasdaq market. He commented a few times about how the employees became much better off and lost interest in working hard. Shi launched a new game, Giant Online, named after the company, but it failed to become a hit, much due to the lack of devotion and imagination of his team. Shi figured that he should have the teams back into the entrepreneurial mode, and hence he moved to an extreme: having the teams bear as much risk as they possibly can.

One question that naturally came up is why hadn't all other companies done this if this were such a good way to align interests. Certain attrition is removed, but at the same time certain synergy is removed as well. The best form of company is to have as many hardworking employees as possible working for the same goal, and it is questionable if a project team possesses the necessary elements of a successful company. The way Giant Online reorganized its company structure could be premature.

The president of Giant commented that "if the daughter companies perform well and reach the standard to go public, we will support spinoffs". It is another dangerous thought in my view, and I hope that it was expressed just for encouraging the daughter company leaders. The capital market does not welcome one-trick ponies; the best way for both Giant and a daughter company to benefit is for Giant to swap stocks with the daughter company if the daughter company ever becomes successful.

In my previous article about Giant, I suggested shorting Giant based on its accelerated revenue decline. My theory is still intact. Giant has been so far running inside a downward channel. It looks like that the downward pressure is not going to be lifted any time soon. I expect further price drop from here, but I am going to close my minor short position with the next dip, giving Giant the benefit of the doubt.

Giant is on a risky move. If it succeeds, Giant's fate may be changed. If it fails, Giant will become a dwarf. I am not optimistic for Giant, but I do wish it success in its endeavor.

Disclosure: Short GA.