China’s Online Gaming Market Looks Attractive

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 |  Includes: ATVI, BBBB, CYOU, EA, GA, GAME, HHH, IGM, IGV, IXN, IYW, KNM, MTK, NTES, PWRD, QID, QQQ, ROVI, SKIL, SMH, SNDA, SOHU, TTWO, VGT, XLK
by: Hao Jin, CFA

One of the most important influences on an investment's performance is underlying economic growth. That’s why PIMCO’s Bill Gross suggests investors direct their risk-taking towards fast growing countries that are less levered and less easily prone to bubbling.

The risk of investing in China is that stocks often appear to trade less on rational factors and more on the rumors, gossip and government intervention. Just last month China's government clamped down on bank lending in an attempt to harness China's rapid economic growth, which impacted stocks. Also, the homegrown market is effectively a closed shop which is not open to foreigners. However, there are dozens of Chinese companies traded in the U.S. exchanges.

China's Online Game Market

The China online services are growing at 30% a year. Online gaming represents around 50% of that revenue, according to a HSBC report.

As a recent report released by China's Ministry of Culture shows, China's online game industry reaped 25.8 billion Yuan (or US$3.8 billion) in 2009, up 39.5% over year 2008. There are around 500 online game operation companies in China. The top three are Tencent, Shanda and NetEase. Their total market share is 53%.

Single-Digit P/E Company

Changyou.com Limited develops and operates online games in China. Its massively multi-player online role-playing games (“MMORPG”) business began operations as a business unit within Sohu.com in 2003. The following chart from Google Finance shows its revenue, net income and profit margin for the last 5 quarters.

In 2009 aggregate registered accounts grew 41% year-over-year to 80.9 million. The company said it has several games, including "The Duke of Mount Deer", in its pipeline slated for 2010 release that should attract new users by appealing to a variety of gamers. Its trailing P/E is 6 and forward P/E is 9 with no debt.

14 Multimedia & Graphics Software Companies

Followings are major companies in multimedia & graphics software industry as well as online gaming companies:

Name (Symbol)
Mkt cap
P/E
Forward P/E (1yr)
Activision Blizzard, Inc (NASDAQ:ATVI)
13.69B
54
13
Blackboard Inc. (NASDAQ:BBBB)
1.25B
168
18
Changyou.com Limited (NASDAQ:CYOU)
1.73B
6
9

Electronic Arts Inc. (ERTS)

5.47B
-
27
Giant Interactive Group (NYSE:GA)
1.67B
12
13
Konami Corp (NYSE:KNM)
2.42B
57
16
NetEase.com, Inc. (NASDAQ:NTES)
4.89B
19
14
Perfect World Co., Ltd. (NASDAQ:PWRD)
1.93B
16
11
Rovi Corporation (NASDAQ:ROVI)
3.36B
-
14
Shanda Games Limited (NASDAQ:GAME)
.73B
25
10
Shanda Interactive (NASDAQ:SNDA)
3.30B
15
13
SkillSoft plc (SKIL)
1.09B
15
15
Sohu.com Inc. (NASDAQ:SOHU)
1.94B
14
11
Take-Two Interactive (NASDAQ:TTWO)
.79B
-
7
Click to enlarge

Comparison between CYOU and Major Competitors

Company
Operating Margin
Debt/Cash Flow
Activision Blizzard (ATVI)

10.3%

0%
Electronic Arts (ERTS)
-19.0%
0%
Changyou.com (CYOU)
61.3%
0%
Shanda Interactive (SNDA)
39.9%
23%
Netease.com (NTES)
60.3%
0%
Click to enlarge

The 1st two (ATVI and ERTS) are American companies. The last two (SNDA and NTES) are Chinese players which compete directly against CYOU.

Top 10 Technology ETFs

With repaid changes of technology, it is much safer to use ETFs instead of picking individual stocks. The following are 10 top Tech ETFs (by net assets):

Fund Name (Ticker)

Net Assets
Expense Ratio
PowerShares QQQ (QQQQ)
16.23B
0.20%
Technology Select Sector SPDR (NYSEARCA:XLK)
4.25B
0.22%
iShares Dow Jones US Technology (NYSEARCA:IYW)
1.28B
0.48%
Semiconductor HOLDRs (NYSEARCA:SMH)
991.61M
n/a
Vanguard Information Technology ETF (NYSEARCA:VGT)
978.90M
0.25%
iShares S&P Global Technology (NYSEARCA:IXN)
440.38M
0.48%
iShares S&P North Amer Technology (NYSEARCA:IGM)
402.71M
0.48%
Internet HOLDRs (NYSE:HHH)
358.86M
n/a
iShares S&P North Amer Tech-Software (NYSEARCA:IGV)
307.09M
0.48%
SPDR Morgan Stanley Technology (NYSEARCA:MTK)
241.72M
0.50%
Click to enlarge

On the other hand, if you want to short technology sector, you might use UltraShort QQQ ProShares (NYSEARCA:QID).

Conclusion

People count on the best and brightest arbitrageurs to come into the market for market efficiency. Arbitrageurs exist but they need time to acquire the necessary expertise and to overcome skepticism before they can exploit the apparent opportunities. Also, they usually tend to ignore small caps.

With a single digit P/E and placement in a fast growing market, CYOU is certainly attractive at this price. However, its stock price has already doubled since its IPO last April. Price/Sells ratio of 6.4 suggests CYOU needs to maintain high margin. Other than its most popular game, "TLBB", CYOU doesn't have a catalyst -- there are very few new games. CYOU’s 2009 annual revenue was $268 million, which could make CYOU subject to much greater volatility than big caps. That’s why any single stock should not exceed 5% of your total portfolio.

Disclosure: Long CYOU and QQQQ. Data is from Google and Yahoo Finance as of February 19, 2010.