Investing in Chinese Game Operators

Includes: NTES, PWRD, SNDA
by: The Wall Street Transcript

On July 28, The Wall Street Transcript interviewed Tian X. Hou, Managing Director at Pali Capital, Inc. providing coverage of Chinese gaming, internet and media equities. Key excerpts follow:

TWST: As we look at this business, what are the growth expectations?

Ms. Hou: If we talk about the years from 2007 to 2010, what we are looking at is 30% CAGR, at least based on our model. And to some people, my projection is conservative. And the reason I may be conservative is because I have not fully modeled the upside from Chinese game exports.

If we look at the landscape in the China market, more and more we see domestically developed games take the leadership. Imported games have now given way to domestic games and we see more and more domestic games being exported to other countries. Going forward, if exporting can start to take off, certainly the online game revenue will not only include current revenue generated in the China market but will also include the licensing revenue, which would be huge. So 30% CAGR may be conservative.

TWST: Within that high growth industry, how do investors play it? What should they take a look at?

Ms. Hou: There are several things that they should look at. First, is the management committed to developing good games? That is very important. You don't want to have a management team that is indecisive about what they want to do. If they are indecisive, then they either hate a game or they don't like the game. If they don't have a full commitment, then they cannot understand when the game fails. The game's success or failure is 50-50. If you're not fully committed, you may not be able to handle the pressure on the stock market because if you have a game that fails, your stock will suffer.

Second concerns the R&D capability. Are they strong in terms of developing their own games? Do they have a good track record? How fast can they develop a good game and how much will they spend to develop a good game? The third important thing is marketing. Do they know how to market their games? And do they know how to differentiate their games from others and to market to different gamers?

Those are three factors that you need to pay attention to — they are business fundamentals. In terms of stock price, the China game companies have traded at a deep, deep discount to the international game companies. And something may eventually be changed. The reason that the discounts happen are because a game played in China is much different from a game played in the US. There is a lack of understanding about their business models among US investors.

We are seeing companies continuing to grow and I am sure investors will eventually realize the potential and the underlying value of these companies. Those companies are trading at 14 times p/e this year, and 10 times next year's earnings. These companies enjoy more than 50% growth year on year and have a rich cash position, a high margin and huge margin leverage. If I were an investor, I would want to play this sector not only because of the high growth but also because they are undervalued.

TWST: What names should investors look at?

Ms. Hou: The name I like the most is Perfect World (NASDAQ:PWRD) because this company has become the biggest game exporter of all the Chinese game developers. They develop what we call 3D games, and normally they can come out with a game in six months with a $0.5 million R&D cost. It is the best R&D team in the world. 3D games take other game developers two or three years and $3 million to $5 million to develop worldwide, so you can see how fast this company is and how good they are. They have been exporting games to many countries. One game they export to 14 countries, another game they export to seven countries — you add them all together, it's 37 countries. Nineteen of them have already had a commercial launch. There are 18 more to come, and next year if all those games can be fully operational, we're looking at a huge licensing revenue for this company that has been underestimated by the Street.

And the other company I like is NetEase (NASDAQ:NTES). They run games with the time-based model and they have figured out how to grow a time-based model game recently. It grew rapidly in 1Q08. In addition, they also have some smaller games added to the portfolio, so we expect the existing games along with the newer games to make contributions to growth going forward.

The other company we like is Shanda (NASDAQ:SNDA). It is not strong in in-house R&D, but it is very strong in operating a game. We do think that eventually this company may become an operator rather than a game developer, as the China game market becomes more segmented or specialized.