Investing In China's Online Gaming Sector 9 comments
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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 (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 (DWA) or Fox Studios (NWS) – you are essentially backing one-hit at a time.
Most game companies in China like Shanda, Netease (NTES), or The9 (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
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 (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 (MSFT), Yahoo (YNOO), as well as blogs and BBS on Sina (SINA), Sohu (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 (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.
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This article has 9 comments:
With the rapid rise of China's domestic A-share market in 2006, one can make MUCH better returns on a steady basis, with a lot less risk than the online gaming market.
There are hundreds of million of players in China. The growth was 30% for 2006 & 25% for 2007 in dollar amounts of game industry in China as you mentioned as above. They won't play Shanda games as per your discriminated post.
Do you know that there are 5 GOOD NEW games will be launched in early January?
A lot of Good news will be coming for Shanda. Time will tell.
Disclosure: I am holding SNDA shares. Stephen Ngai
As a matter of fact, I have stopped following the online gaming companies just for this reason.
And for your information, I was in involved in arranging Shanda's seed-round funding.
请你先看清楚再作评论。
Paul Denlinger
I won't touch A-share market for most of shares having bubble prices.
In Nasdaq, most of Chinese Companies are surrounded by those professional hedge funds and short sellers. Like Shanda, it short interest in Dec. 2006 was 4.4 million shares out of the float of around 20 million. My opinion, Shanda is highed undervalued.
With all the new games and turning around of all new business, Shanda will make at least $1.00 EPS in year 2007.
Look at those companies that were bought in the past 2-3 years, what will happen if Shanda Spin them off for IPO?
I won't trust any articles or posts. I only trust on my analysis and digestion of all articles in my research. Stephen Ngai
1) The Netease game you are referring to is called Fantasy Westward Journey. It is around 60% of total revenues and the other game Westward Journey 2 is around 22% of total.
2) The life span of the games are obviously more than 1-2 years as Westward Journey 2 is now well into its fifth year and Fantasy just completed 3 years. As a comparison the Lineage franchise is close to 8 years old and still going strong with the upgrade in 2003. Westward Journey 2 is supposed to have a full upgrade this year.
3) According to the Netease Kingsoft hired 1 senior developer from the company not the whole team.
4) Netease is the #1 email provider in China and has another potential blockbuster game in beta right now called Tian Xia which should go commercial second half of this year.
6) The9 has Guild Wars, Hellgate: London and Granada Espada plus others in the pipeline this year as well as the WoW upgrade, Burning Crusades. The obvious benefit of The9’s business model vs. Netease is though you give up a big chunk of the revenue to the content owner there is significantly less title risk as you just pick and choose the more successful titles and introduce them to Chinese consumers.
Fantasy Westward Journey" and not "Dreaming Westward Journey".
You bring up some good points. Having been actively involved in the Chinese games industry I would like to add some further comments.
1. In addition to the major players you mention other publicly listed companies that deserve a mention are Tencent, the leader in the casual games space with its QQ Game platform, and CDC Games, who have been quite successful operating "Yulgang" through their 17game subsidiary. They also recently announced that they have licensed the MMOG, "Lord of the Rings" (LOTR), which should launch in China later in 2007 or early 2008.
2. One of the reasons why the western publishers such as EA struggle in China is that due to regulatory issues they can't directly publish online games so they need to work with a local partner. Korean companies such as NC Soft who have licensed numerous games to Chinese companies are worth looking at. The game consoles (Xbox, PS3 etc) has too many issues at this point (regulatory, piracy, business model) so the market will continue to be PC-game dominated for the forseeable future.
3. A big issue for the Chinese games industry is the shortage of quality game developers, especially game designers, and low level of game developer education. While Netease has been successful at developing their own 2D/ 2.5D titles no Chinese conmpany has managed to develop a quality 3D title. Imitation still rules over innovation with many copycat games being developed.
4. I would expect all of the Chinese game companies, including Netease, to license foreign titles in the future. This is partly due to the poor state of the local game development industry as mentioned above, and also because WoW has shown that a lot of money can be made from licensing a blockbuster title even if royalties have to be paid out to a foreign party. Due to the risk averse nature of many of these companies they will try to secure western titles that have reached open beta testing or have already launched in the west, or are being developed by famous developers who already have a track record. While this lowers their risk it also means that they will likely have to pay higher licensing and royalties for these titles.
5. Expect to see more games operated on a "play for free, pay for items" model compared to the traditional subscription model. The Korean games industry has already moved in this direction and Shanda and CDC Games/ 17game have shown that it is a viable model in China.
As you mention it is likely that all of these stocks will remain voltile due to the nature of the games business. Netease has some strong positives including their management team and past success at game development, however a big test for them will be whether their upcoming 3D title, Tianxia II, is a commercial success. If not then they don't have much else in the pipeline and licensing will become a priority.
The9 has had a good run with WoW and has licensed numerous upcoming titles but it is not obvious to me how a company that has essentially been operating one game could expect to be successfully operating up to six games within the next 18-24 months. I suspect that their strategy has more to do with "locking up" as many of these titles as possible - Granada Espada was originally meant to launch at the end of 2004 but still hasn't - by paying a small upfront fee and then only paying the bulk of the licensing fees when/ if they actually launch the game. While this may suit The9 it isn't good for their licensing partners and so I don't see them being the "Chinese partner of choice" for foreign companies as some have stated.
Shanda will likely remain very volatile. Their strategy of licensing 2nd tier titles and using their core competencies e.g. card distribution and marketing ability to promote them aggressively, has not been successful recently. Their inhouse game development efforts have been poor and it is doubtful whether Dungeons & Dragons will even launch commercially as initial feedback has not been good and the game, in my opinion, is not well suited for Chinese gamers. However if they license some good titles and abandon their misguided "Shanda box" strategy then they could perform well. BTW, the game you mentioned is called "Archlord", not "Overlord Land".
Disclosure: I don't own any of these stocks but do have business dealings with some of these companies.
the9 has wow (and likely its burning crusades expansion pack, though it has not been announced officially) and otherwise a shaky pipeline. guild wars may do ok, but it was a flop in korea, though a huge success in the us and europe. SUN (wzen is the developer) and granado espada were flops in korea in open beta. i missed the runup in the stock this time, have a few friends who caught it but are looking to sell.
i am convinced ntes' core 2d games are being eroded by zhengtu and other startups. their 2.5 game datang, which they released in q2, has been a total flop. everyone is waiting for tianxia 2, their 3D "masterpiece". it went into limited open beta the last week of december, and i have not yet heard any reports on the game. if it is a hit, the stock will do well. but if it is only marginal or worse, the stock should go to 10. they have nothing else in their pipeline, they are shutting their wvas business, and they can't sell ads even if they were giving them away. ntes should just be looked at as a pureplay game company right now. and if you do it that way, its multiples may be a bit out of whack with its global peers and current growth rates.
tencent has a decent game business, and they need to grow it hard to make their numbers work.
there are at least 5 planned game ipos in china this year.
t2cn, operates freestyle, got a big round from gigamedia in 2006 at about 85m pre. supposedly wr hambrecht got the mandate, which tells you about the quality of the company.
perfect world. beijing developer, two games up, telling analysts and cfo candidates that they will do at least 100m usd in 07 revenue, with 50%+ net margins. softbank put in 6m in 06.
kingsoft, tried last year, will try again, has pipeline issues. raised a big round in 06, but part went to buy out one of their early vcs--legend capital
cdc games. china.com spinout, have one successful game in yulgang, decent looking pipeline, new mangement who gives them a sheen of global credibility
9you. shanghai based, casual games operator, decent business, pipeline issues as far as i can tell, probably will go out in japan
the game business is robust and growing, with a strong and proven revenue model. but gamers are extremely promiscuous and so it is very hard to build a stable long-term business. unless you can build the right mix of licensed and self-developed titles into your portfolio, like EA has. so the good news for independent developers is that the industry is wide open. much more open i think than other internet verticals in china right now. you just have to create a great entertainment experience, and be smart about marketing and distribution. but what shanda and ntes have proven is that you can have great marketing and distribution channels, but if the product is not good the users wont stick around