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Chinese gaming company Shanda Games (NASDAQ:GAME), a subsidiary of Shanda Interactive Entertainment (NASDAQ:SNDA), reported solid 4Q09 earnings on February 28, but its stock has plunged to a 52-week low on disappointing 1Q10 guidance. Shanda's Q4 earnings and Q1 usage trends matched my estimates, but the declining revenue of flagship game Mir II in 1Q10 proved that my assumption of stable monetization was wrong. I believe Shanda is likely to recover from current difficulties, as it did in the past.

Positives: Solid Q4 earnings and stable game usage in Q1. As I expected, Shanda Games grew revenue by 5% Q/Q in 4Q09, at the high end of management guidance, and Legend Series games contributed about 75% of total revenues, with Mir II Return (Chuan Qi Gui Lai) becoming a significant growth driver. Despite the surprising revenue decline of flagship game Mir II, management confirmed my view that Mir II and other major games has maintained stable daily usage in 1Q10. Compared with one year ago, I believe the internal distribution of Shanda's user base has become much more reasonable due to the launch of Aion and new Legend Series games including Chuan Qi Wai Zhuan, Chuan Qi Gui Lai and Chuan Shi Qun Ying Zhuan.
Negatives: Surprisingly weak monetization of Mir II in Q1. Due to declining monetization of Mir II, Shanda is guiding 1Q10 revenue to decrease 10%-15% Q/Q. Previously, I assumed Mir II's operation team would sustain its success in stimulating players' spending. The fact proved me wrong: Mir II's expansion pack Jue Dai Shuang Jiao [JDSJ] has failed to increase monetization since its launch in December 2009. JDSJ's major feature is allowing players to carry two Heroes (pets in the form of humans) instead of one Hero in prior versions. Carrying multiple pets is very common in other popular games such as TLBB. However, Mir II's middle-class players strongly opposed this change because raising a Hero (pet) in Mir II was very expensive. They believed the change provided rich players with an extra opportunity to spend their money and gain unfair advantage over ordinary players. These disappointed players decreased their spending, causing a major decline in Mir II's revenue.
Shanda's online gaming business is likely to recover, as it did in the past. The failure of JDSJ has ended the winning streak of Mir II's operation team in the past several years. However, I believe the stable usage of Mir II in Q1 shows the game's core players are still loyal. This means Shanda still has the opportunity to regain Mir II players' confidence and willingness to spend. Looking at Shanda's history, its online gaming business has overcome difficulties during the transition to item-based business model, the Sichuan earthquake, and the global financial crisis. In my view, long-term investors should view the next several quarters as another difficult period for Shanda that will eventually be overcome.

Author's Disclosure: no positions.

Source: Shanda's Online Gaming Business Is Likely to Recover