For the past couple years Wall Street has avoided most US listed Chinese stocks like the plague. While negative sentiment has not been completely without merit given a number of Chinese frauds mostly among smaller cap companies, a number of quality names have also been thrown out with the bath water.
More specifically, the Chinese online gaming sector has continued to be viewed skeptically despite a consistent earnings track record. Changyou.com (CYOU) once again proved the skeptics wrong with a solid second quarter 2012 earnings report announced just days after its share price hit an all time low of $17.00 per share.
Despite being heavily dependent on its mega-hit game Tian Long Ba Bu ("TLBB"), Changyou has shown what its Chinese online gaming peers have already shown over the past decade - hit titles can generate and even grow revenues over a very long period. CYOU's Q2 2012 online gaming revenue grew 8% sequentially and 35% annually to $137.2m on the foundation of TLBB as well as growth in newer titles such as Wartune. Consolidated revenue also increased to $147.3m with the addition of advertising revenue which grew to $9.1m, up 10% from the previous year.
What Changyou has done extremely well in contrast to a number of peers such as Perfect World (PWRD) has been controlling its expenses. Gross margin for self developed online games is extremely high, often ranging from 80-90%. CYOU reported 84% Q2 gross margin which was flat relative to the same level a year ago. While Perfect World also enjoys high gross margin, its operating expenses have grown disproportionately vs. revenue growth. As a result, PWRD saw its net margin shrink from around 50% to the 30-40% range over the past few years.
In contrast to Perfect World, Changyou has generally kept its operating expenses inline with revenue growth. In the second quarter, the company's ongoing operating expenses grew 31% year over year which tracked below its 35% online gaming revenue growth. Corporate net margin remained high at 49.6% excluding goodwill impairments. PWRD in comparison reported just 31.6% net margin in its Q1 2012 earnings report.
While CYOU's revenue growth on a percentage basis has not been as high as some peers, strict management of expenses has allowed the company to post consistent earnings growth. Net income at Changyou grew 14% year over year to $69.1m in the second quarter, or $1.29 in earnings per share ("EPS"). On a trailing four quarter basis, the company's annual EPS grew to $4.80 per share. At its recent record low share price of $17.00, Changyou traded at just 3.5x trailing earnings.
Amazing as it may appear, Changyou's earnings profile is only half the story. From a balance sheet standpoint, the company is even more discounted. At the end of the second quarter, CYOU had over $460m in cash and cash equivalents with no bank debt. Subtracting its net cash balance from its market capitalization, Changyou recently traded at a mind-boggling 1.8x enterprise earnings.
Investors may wonder how Changyou has accumulated so much cash. The answer is quite simple as explained in my previous Perfect World summary. Once a self developed game becomes a commercial success by generating sufficient revenues, it literally becomes a cash cow for the company due to its high gross margin nature. As Perfect World explained in its Q4 2011 earnings conference call, corporate cash flow is often similar to net profits. For cost conscience Changyou, cash flow was even better at $82.5m in the second quarter vs. its quarterly net profit of $69.1m.
Like Perfect World, Changyou's management does not like to comment on its share price too often. Similar to Perfect World which announced a special $2.00 cash dividend last quarter, Changyou also announced a massive $3.80 per share dividend for its shareholders, representing $201m in total payouts. While future dividends may not be as large, continued dividends even at this scale could be sustainable. This dividend of $201m compares to CYOU's 2011 annual positive cash flow of $276.6m.
US listed Chinese stock investors have taken large hits in the past couple of years and Changyou has not been an exception, with its shares down 16% year to date and 42% since the start of 2010. At least until sentiment shifts, investors can enjoy dividends more consistent with the company's profitability than reflected by its discounted share price. A trailing earnings multiple in the low single digits with dividend yields in the high teens percentage should make most value investors salivate.