While Economics can be a very complex discipline, the fundamentals often boil down to one very basic truth: “Price is the natural equilibrium between supply and demand.” Price is usually denominated in a particular currency - such as the US Dollar, Japanese Yen, or even precious metals such as gold. But what happens when the currency is virtual, such as in a role playing game with “virtual” goods and services and no physical “real world” transactions taking place. Do the laws of supply and demand still apply?
Giant Interactive (GA) would argue that they do. In fact, the company has been dealing with a rise in inflation in its most popular online game ZT Online. In the real world, inflation is often caused by an increase in the money supply which dampens the purchasing power of each “dollar” or other currency being studied. Many analysts (including myself) are concerned with the fact that the US Fed is pumping liquidity into our system which equates to more dollars in circulation which has resulted in a lower value for each dollar. The same phenomenon has been happening within the virtual world of ZT Online.
The issue with ZT Online occurs when players are created for the express purpose of “gold farming.” It appears that thousands of new players have been created and used to acquire gold either through an initial allocation given by the game, or by finding gold in different places in the game. (I am not an active participant so I do not have first-hand knowledge of the actual process.) These user accounts who are not active participants within the game are then taken and sold in the real world for actual Chinese currency to actual gamers who will use the gold in the game. So what ends up happening is that more gold is created within the game for the additional users that are created, but many of these new users are not active participants leaving the game with a glut of virtual gold currency. This decreases the spending power of the virtual gold and is a detriment to the true users of the game.
In their most recent quarterly announcement, Giant Interactive stated that they made a change to the rules to discourage the practice of gold farming which should be a benefit to the game long-term. However there was concern within the investment community that previous statistics such as Average Concurrent Users [ACU] were actually inflated due to the presence of these gold farmers. In fact, there has been a class action suit filed on behalf of those who participated in the IPO as there was little disclosure of this gold farming practice and it has cause some of the statistics in the offering prospectus to be called into question.
To be fair to management, despite the confusion revenues have been steadily increasing and the launch of the next game Giant Online along with expansion packs for ZT Online appear to be successful. It will take a few quarters to see just how quickly the number of users ramps with Giant, but the initial statistics are favorable. Margins have contracted a bit due to spending on technology to support the new game, but they are still impressive and likely to improve as the revenue base catches up to the investment spend of the last 2 quarters. The revenue base should be very stable as the company cannot recognize all revenue immediately but must amortize it over the course of the useful life of each purchase.
On Christmas Eve, management issued a press release stating that it had instituted a share repurchase program of up to $200m to purchase outstanding ADRs. This came as a direct result of the stock weakness following the quarterly report. Management stated that the purchase plan “reflects commitment to increase shareholder value and confidence that the current ADR price does not reflect the current potential value of the company.” The announcement touched off a rally in the stock which is still trading well below its IPO price.
With current consensus numbers expecting nearly $0.80 per ADR in 2008, the stock appears to be trading at a very attractive value. There is difficulty, however, in working with consensus numbers because of the small number of analysts actually covering the company and the lack of current information available. While a small base of analyst coverage certainly opens opportunity for a wise investor, it also increases the risk as there could be other issues in addition to gold farming that have not yet been uncovered. I am currently waiting to see more information on how the market reacts to the share repurchase plan before committing capital to the name. But I am certainly keeping my eye on GA as a potential investment as the “virtual inflation” phenomenon appears to now be under control.
Disclosure: Author does not have a position in GA