Goldman on the New Online Gaming Model (SNDA, NTES, NCTY)

As the trend toward free massively multiplayer online games (MMOs) in China takes hold (think: Shanda Interactive's Maple Story and CDC Corporation's Yulgang) Goldman Sachs believes that the decision to convert Mir 2 from pay to free-to-play could have a dramatic effect on the gaming industry. Key extracts from a Goldman note to clients released earlier today:

Shanda's experiment in switching ~16 of its Mir 2 servers from pay-to-play to free-to-play threatens to capture users of other 2D pay-to-play games, pressuring smaller rivals to become free too. The experiment comes at a time when industry-wide growth is slowing (Netease, Shanda, and The9 reported disappointing 3Q revenue growth last week) due to maturing online game penetration levels (China at 7% of urban population, versus Korea / Taiwan saturation at 10%) and powerful new entrants accustomed to lower operating margins (e.g. Tencent's 30% versus Netease's 58%). We have IL ratings on Netease/Shanda with 12 month target prices of $59/$24 based on 20X 2006 EPS; risks include industry margins declining.

On Valuation

Stock prices for Netease, Shanda, and The9 dropped by 5%-25% last week, prompting much commentary to the effect that Netease and The9 are 'cheap' relative to 'other' Chinese internet stocks. However we view these as game companies first rather than internet companies: Sina's and Sohu's portals are still likely to be widely popular and heavily revenue generative in 2009, whereas Netease's Westward Journey 2 (due to age) and The9's World of Warcraft (due to license expiry) are not; the game companies need to refill their pipelines every year to avoid the product gaps they may now experience. Comparing the Chinese game companies with game companies elsewhere, we believe enterprise value to revenues is the most relevant metric, to avoid paying peak-of-product-cycle earnings multiples on peak-of-product-cycle margins. Chinese leader Netease is at ~10X 2005 revenues, whereas global online leader NCsoft is at ~6X, global offline leader Electronic Arts is at ~4X, and most other game developers and publishers are at 1X-3X; investors are paying up for China's faster industry revenue growth prospects.