Changyou (NASDAQ:CYOU) reported mixed 2Q14 results on July 28: Total revenues of $177.8 million were below Wall Street consensus of $186.7 million, my estimate of $189 million, and management's guidance of $182-188 million.
Changyou attributed the revenue miss mainly to gamers cutting spending in its flagship game TLBB. During the quarter, TLBB received an expansion pack named Kuang Zhan Tian Xia (KZTX), which lowered the game's difficulty to expand its user base. Easier gameplay reduced gamers' reliance on virtual items, causing paying player base to shrink more than expected. In my view, Changyou was trying to bring down TLBB's average revenue per user (ARPU), which is a common practice for mature games.
The revenue miss was the first time Changyou failed to meet its revenue guidance since going public in April 2009. I believe this rare revenue miss and the attempt to bring down ARPU confirmed that TLBB, which accounted for 63% of Changyou's total revenues in 2013, is no longer a growth driver for the company. Despite the revenue miss, Changyou surprisingly reported positive net income of $2.4 million, handily beating Wall Street consensus of -$7.45 million, my estimate of -$23.6 million, and management's guided net loss of $14-20 million. Management attributed the earnings beat primarily to lower-than-expected operating expenses as Changyou scaled back its major marketing campaign aimed at promoting its emerging game platform business.
Looking ahead at 3Q14, Changyou guided $186-192 million total revenues and a non-GAAP net loss between $0 million and $6 million, which translates to a non-GAAP EPS between $0 and -$0.11 per share. The revenue guidance represents a 4.6%-8.0% quarter-over-quarter growth. I attribute this guided growth to the typical industry-wide seasonality during school summer breaks, as students spend more time and money on playing games. To explain the forecasted net loss in Q3, Changyou reiterated its plan to use the cash flow generated by the online game and advertising businesses to promote its emerging game platform business and invest in other opportunities.
Management also mentioned in the earnings call that the major marketing campaign for Changyou's game platform will remain at least until the end of 2015. At first glance, this guidance is in stark contrast to the company's scaling back of operating expenses in Q2. However, investors should note that on July 16, Changyou announced its $91 million acquisition of a 51% stake in mobile browser developer MoboTap. This deal used 23% of the company's total reported cash and cash equivalents at the end of 2Q14. In my view, this move confirms that Changyou is still in a spending mode in search of future growth.
I believe investors should wait on the sidelines for Changyou's stock. Q2's rare revenue miss shows the company's online game and advertising businesses have entered a mature stage where not much can be done to move the needle in terms of financial growth. Changyou has identified its game platform as its next major growth driver. This platform includes game information website 17173.com and several mobile and PC applications that provide services to video gamers. During the Q2 earnings call, Changyou management did mention that they will try to commercialize the platform by providing Internet value-added services, without further explaining what these services will be.
In my opinion, Changyou is in a transition period where its old growth drivers have become too mature but its new growth drivers are still in their infant stage in terms of revenue generation. I believe investors should wait on the sidelines until we see data points that indicate this transition period is coming to an end.
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