Changyou 3Q11 Earnings Preview: Conviction Buy Or Cautious Buy?

Oct.24.11 | About: Limited (CYOU)

Changyou (NASDAQ:CYOU) announces its earnings with parent company Sohu (NASDAQ:SOHU) on October 31, before the market opens. The Street expects the company to earn $0.99 per share on $117.5 million in revenue. EPS estimates range from $0.85 to $1.06 per share among the 11 analysts covering the company.

In 2Q11, Changyou reported $105 million in revenue (+35% year/year) and earned $1.02 per share, exceeding the average estimate of $0.93 per share. The new MMORPG game, Duke of Mount Deer (DMD), had a strong debut, with 72% increase in server volume to 110 and a 20% growth in user base since late July. However, Changyou also experienced a drop in peak concurrent users (PCU) by 15% to 970K and a decrease in margin due to heavier R&D and marketing expenses. Nonetheless, the management guided revenue increase of 34 – 38% for 3Q11.

Heading into the earnings, investors need to look for results from the current hit title Tian Long Ba Bu (TLBB) and DMD. Changyou’s stock is down ~40% since 2Q11 due to diminishing popularity toward DMD in the weeks following its launch as its game play is not different from that of TLBB. Server count growth has slowed dramatically and has plateaued at 128 since the beginning of October. While Changyou has a rich portfolio of 2D and 2.5D games (currently 9 total) to offset a potential weakness in DMD, my concern is that majority of the revenue (~91%) comes from its aging franchise TLBB. To win investors’ confidence, Changyou needs to generate increasing acceptance of the other titles, but we have not seen Changyou take such initiative and it is uncertain whether it can leverage the other titles.

DMD could potentially become a bigger revenue component for Changyou, but I would like investors to note the worldwide systematic decline in gamer interest toward new and legacy games. Specifically, we have not seen a blockbuster game in China other than Shanda’s (NASDAQ:SNDA) AION, which generated over 1 million PCU several weeks after launch. Meanwhile, DMD is facing headwinds to achieving half of that number 2 months after its launch. Similar decline can also be seen in World of Warcraft, which experienced a 25% decline in PCU despite introducing new expansion packs. World of Warcraft currently has ~1 million PCUs compared with 1.5 million PCUs three years ago. Korea, almost synonymous with MMPORG, the gaming center of the world, also experienced decline in gamer interest toward the top titles in which PCUs are estimated to be 250K compared with 350K a couple years ago. The systematic decline could partially explain why Sohu is focusing on strengthening network externalities to develop Sougou Search as it becomes greater component of Sohu’s total revenue and the company can be less dependent on its potentially declining online gaming unit.

As I noted in my previous articles on Sohu, Changyou operates in a highly competitive online gaming industry in which gamer preference can be highly capricious and unpredictable. Changyou’s MMORPG game offers similar value proposition compared with those from Shanda Interactive, Giant Interactive (NYSE:GA), and NetEase (NASDAQ:NTES). However, products including Sougou Search, Sogou Browser, Chinese character input, and Sohu TV’s in-house dramas differentiates Sohu’s value proposition from that of Sina (NASDAQ:SINA), Baidu (NASDAQ:BIDU), or Tencent. Even though Changyou trades at 7x 2011E earnings, the company could be a value trap unless it has the ability to differentiate its titles from those of its competitors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.