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A few years ago I sat on a panel about venture capital in China at a conference hosted by the business school CEIBS (China-Europe International Business School) when I was still Chief of Research for VC firm Inter-Asia Venture Management.

Joining me on the panel was Huang Jing. At the time, he ran Softbank’s Asia Infrastructure Fund in China (he now heads Bain Capital China). He had led Softbank’s investment into Shanda (NASDAQ:SNDA) and has a fabulous investing track record.

We discussed his $40 million USD investment in Shanda as I just could not figure out the justification for its market valuation. At the time I recommended that people short the stock. I subsequently looked silly as the stock soared higher and higher to become the Nasdaq’s best performing stock in 2004. Then it crashed in 2005, and I looked more like Warren Buffet than Henry Blodgett.

To me, investing in Chinese game companies is similar to backing movie studios like Dreamworks (NASDAQ:DWA) or Fox Studios (NASDAQ:NWS) – you are essentially backing one-hit at a time.

Most game companies in China like Shanda, Netease (NASDAQ:NTES), or The9 (NASDAQ:NCTY) bank much of their revenue from just one or two games that have limited life spans of one or two years. Investors hope that the company they back can develop or license the next big hit before old hits go stale. Or the hope to exit at the right time and make a ton of money as most of Shanda’s venture capital investors did.

The overall numbers of the online game sector in China are so compelling that it might make sense for people who like a little risk to look at the sector. My firm estimates that growth in China’s online game sector will slow to 25% in 2007 from 54% in 2005 to about $750 mil. USD a year but will still grow at a healthy clip as more Chinese gain access to the internet. CNNIC estimates that 31.8% of China’s 125 million netizens played online games in 2006.

Online games are a place for China’s gamers to make friends and escape from reality. Utilizing BBS and blog research techniques, we found that that players play to “provide a space to achieve a lot of dreams” as they help “heal my wounded mind in the real world” and to “find friendship and love.”

click to enlarge
China\'s Online Game Market Size

If investors want to buy a stake in the future of online gaming in China, there are 3 main players that they should be looking at: Netease, Shanda, and The9. They can also get some exposure by looking at Electronic Arts (ERTS), Activision (NASDAQ:ATVI), or Ubisoft, as all have made some inroads into China, but the Chinese firms are where the major money will be made – or lost.

Netease

My firm recently interviewed executives and programmers in the game industry to find out what they thought about the industry as a whole. The majority overwhelmingly felt Netease was the “#1 competitor/ player” because they had “the best management team” and “developed their own games” for the China market.

Because of its strong management team, Netease is the best company for investors to put their money if they want to get a piece of the online sector in China long-term. Holding 26% of the market, Netease generates 81.8% of its revenue from online games. Nearly 50% of this revenue came from one major title, Fantasy Westward Journey. Basing so much revenue on one title is risky for investors, but much less than what The9 and Shanda have done as we will see later.

Netease has also built its user base by offering other services including blog hosting, BBS, email, and chat programs. Gamers who already use instant messaging services from MSN (NASDAQ:MSFT), Yahoo (YNOO), as well as blogs and BBS on Sina (NASDAQ:SINA), Sohu (NASDAQ:SOHU), and Tencent’s QQ appreciate the convenience of the combined services that Netease provides. Offering services beyond games also lessens the political risk of being company basing 100% of revenue on games if the Government continues to try to stop game addiction for Chinese children and damages the sector much as it has done to mobile value added services.

Netease also develops their games in-house helping to make the games appeal to Chinese specifically. Gamers love their Dreaming Westward Journey series of games. One BBS poster wrote:

“In one month I reached level 40! It is so interesting and I would like to make more friends in the game.”

Another player blogged:

“My whole school is crazy about Dreaming Westward Journey, wherever they are the only topic is the game.”

But Chinese youth are fickle and many did not like Netease’s game Da Tang. As one BBS forum poster posted, Da Tang “is not good enough, if they charge to play they will lose gamers.” Another potential weakness is that the team responsible for Dreaming Westward Journey left Netease for another online game provider called Kingsoft, that Intel (NASDAQ:INTC) just invested in.

This exodus of talent has scared investors and Netease’s stock price has suffered as a result. The stock’s 52 week high was $25.49 while the low was $13.99. At present, the stock sits at $17.82 USD. However, Netease has maintained solid growth and Q3 2006 revenues reached $68.6 million USD, up 23.7% over Q3 2005.

Although there is risk involved in backing Netease, its strong executive team, various revenue streams, and local know-how lead me to believe that is it a better place to invest money long-term than Shanda or The9. I think that is going to be a good performer in 2007.

The9

A full 98% of The9’s revenue comes from Blizzard’s hit MMRPG World of Warcraft. Gamers love the game. Comments on BBS and blogs range from “It is the first online game that I can get 100% involved in,” to “To be honest, I feel that WoW is the world’s best online game.” Another gamer posted “Tomorrow is Saturday, I will use every minute to increase my game level.”

This excitement has led the stock to trade near its 52-week high at about $32 USD at the end of 2006. Although gamers love WOW, at some point the game will lose favor with gamers. It might happen in 2006 or it might happen in 2007, but it certainly will happen.

Without anything serious in the pipeline, The9 might be a good short for investors once gamers start to tire of the game. Keep your eyes open for changes in attitude towards the game by gamers.

Shanda

Now we get to the incredibly volatile Shanda whose stock yo-yos up and down based on rumor and hype and on the mechanizations of those with short/ long positions. It is not a stock for retail investors to put money into unless they can stomach the rises and falls.

Shanda has built much of its business on games like Hot-blooded Legend and Legend of Mir, games that have lost their luster and are now playable for free. Gamers recently said on BBS forums, “Hot-blooded Legend was so popular in the past, but now we don’t like it. Look at how poorly Shanda runs it,” and “The game is too old, it is hard for a newcomer to play since there are too many high level players, that’s not fair.”

Investors have made the shares run up by banking on replacement titles “Dungeons and Dragons” and “Overlord Land” and rumors of takeovers.

But at the end of the day, these new titles have failed to wow gamers as Legend of Mir originally did. One gamer posted on a BBS:

“Dungeons & Dragons is so boring, the fighting is not exciting and the images are dark. I fell asleep after five minutes.”

Another wrote:

“I suggest playing World of Warcraft (The9) instead of Overlord Land which is plain stupid.”

Unless Shanda develops something quick, be wary of its stock price. It can and probably will bounce up and down. But this is a stock for day traders rather than people who buy and hold.

The online game sector in China is hot and will continue to be in 2007. For investors with an appetite for risk, there are a lot of opportunities in the sector. Long-term, Netease is the place to be and has the opportunity to grow significantly in the next year.

Note: CMR analysts Allen Lee and Ben Cavender contributed to this article.

Source: Investing In China's Online Gaming Sector