When are video games more than games? When they’re investment opportunities with big growth potential in an emerging market — in this case, the online video game industry in China.
In 2009, The Wall Street Journal wrote about the explosive growth rate in online gaming in China, where revenue — led by massively multiplayer role-playing games (MMORPGs) — increased more than 50% over the previous year. Projections call for an average 20% annual growth rate, surpassing the U.S. share globally and accounting for nearly half of the world’s online gaming market.
This happens as U.S. video game companies are facing serious challenges. Game sales are a cyclical mess tied to console sales and the Christmas season, packaged game titles are expensive to produce and the market is mature.
Big Western game studios like Electronic Arts (NASDAQ:EA) and THQ (NASDAQ:THQI) have been hit hard in recent years by casual gaming on Apple’s (NASDAQ:AAPL) iOS and Google (NASDAQ:GOOG) Android devices, while companies pursuing the “freemium” mobile app market, like Zynga (NASDAQ:ZNGA), are attracting investor attention, even as they combat high customer acquisition costs.
In China, piracy of packaged software also is problematic for Western publishers looking for PC and console game sales — but limited availability of powerful gaming PCs and current consoles means that market remains small anyway.
However, online gaming has fewer privacy problems, and a much bigger audience. As of the end of 2011, more than half a billion Chinese citizens had Internet access. While the percentage of homes with broadband access and the specs of computer hardware may be significantly lower than in the U.S., sheer population, low system requirements of online games and ubiquitous Internet cafes make up for it.
ZDNet Asia says China’s online gaming market, which was worth $6.6 billion in 2011, could exceed $9.2 billion by 2014. Five Chinese video game companies combined last year for an impressive $7.5 billion in revenues, and present compelling plays for a potential online gaming surge:
NetEase (NASDAQ:NTES) operates China’s second-largest online games website and provides its own online MMORPGs, as well as licensing popular Western titles such as World of Warcraft and Starcraft II for the Chinese market. In March, NetEase announced a three-year extension to its licensing partnership with Activision that will include the latest World of Warcraft expansion, Mists of Pandaria (designed with the Chinese market in mind).
NTES shares currently trade near all-time highs around $60. NetEase consistently has grown earnings for the past two years, and profits are expected to continue increasing by about 13% annually for the next two years. NTES is decently valued, trading at less than 12 times forward earnings of $5.02 per share. The company is debt free and has about $2 billion in cash.
Shanda Games’ (NASDAQ:GAME) portfolio includes 36 titles in release, among them its top three franchises: the Mir 2 series, Wool series and Dragon Nest. Its strategy for 2012 includes expansion of its online games into Europe and other regions and developing Facebook titles.
GAME shares, which currently trade around $5, have gained about 30% since the start of the year but still remain about half their value after the company’s 2009 IPO. Profits grew by about 25% in 2011, and analysts expect 10% annual growth through 2013. At just more than 5 times forward earnings of 93 cents per share, GAME looks like a potential bargain.
ChangYou (NASDAQ:CYOU) offers popular online games including DDTank and Tian Long Ba Bu, which Forbes ranked as one of the world’s most profitable game franchises. The company plans to introduce five key online titles this year, including MMORPG Shen Qu and first-person shooter Battlefield Online. ChangYou also outlined plans to expand its presence in mobile games, social games and overseas markets. It acquired game developer 7Road in December 2011, adding 300 Web-based engineers to its team.
At $25, CYOU shares are down about 50% from their peak around $50 last summer, though the company still is trading well above its IPO opening. Despite earnings beats in the past seven quarters, CYOU has been punished in some part thanks to the financial performance of parent company Sohu (NASDAQ:SOHU) and concern that diversification and acquisitions might cut profit margins.
In 2011, ChangYou grew earnings by 26% to $245 million, or $4.61 per share, and revenues by almost 40% to $484.6 million. This year’s earnings are expected to remain flat, though they’re forecast to grow by double digits in fiscal 2013. CYOU currently trades for less than 5 times expected fiscal 2013 earnings of $5.16.
Perfect World (NASDAQ:PWRD) is behind hit online games like Battle of the Immortals. The company has actively pursued a more diverse market, with CFO Kelvin Lau telling Gamasutra: “We generate over one-fourth of our total revenues from operating and licensing our games abroad and maintain a geographical coverage of over 100 countries and regions worldwide.”
PWRD shares currently trade near $13 — up 25% year-to-date but still well off their 2009 peak around $46. Profits have steadily increased since 2007, including a 19% jump in 2011. The earnings outlook for the next two years is rocky, with analysts expecting 50% growth to $4.65 for the current fiscal year, but a 20% drop to $3.71 in fiscal 2013. Still, Perfect World’s P/E of 3.5 is attractive even compared to its bargain-basement brethren.
Tencent (PINK:TCEHY) is the market leader, holding 31% of the Chinese market in 2011. Its online games due for release in 2012 include Train Tycoon — a Grand Theft Auto variation — and Kritika. The company also is courting iOS developers, aiming to take advantage of the growing mobile games market and the popularity of Apple’s iPhone in China.
However, Tencent doesn’t trade on any major U.S. indices and is the most thinly traded of the five at about 100,000 shares per day. Still, after a rocky 2011, shares have recovered by almost 50% this year to all-time highs around $30. Full-year earnings in 2011 grew 27% — overshadowed only by the previous year’s 56% growth. Still, TCEHY is expected to continue 20%-plus earnings growth in 2012 and 2013, too — but it’s the priciest of the bunch, with a forward P/E of about 22.
As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.