Playing Chinese Internet Gaming Companies

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Seemingly every Chinese internet company wants a piece of the lucrative online gaming market, which is characterized by the popularity of massively multiplayer online role-playing games (MMORPG) and adventure classic gaming (ACG) games. Tencent (HKG: 0700) occupies the top five positions in the Credit Suisse Game League Table with Cross Fire at the top, but given that it trades on the Hong Kong exchange, we elect to analyze four online game ADR competitors that are more accessible to US investors.

Sohu.com (NASDAQ: SOHU) is a top gaming brand in China that runs several MMORPGs like Duke of Mount Deer and Chinese Hero. The company grew Q1 revenue 30% y-o-y, beating its earlier guidance and consensus estimates. Non-GAAP EPS of $0.61/share also beat guidance of $0.50 to $0.55 per share due to lower marketing expenses. However, Q2 guidance came in below consensus with brand advertising revenues projected to increase 12% to 16% q-o-q and game revenues projected to increase 2% to 4% q-o-q. Non-GAAP income was considerably lower than consensus due to SOHU’s significant investment in online video, which has been a drag on earnings. Due to the heavy investment in its sales force and content, we are prepared for margin compression. Going forward for the year, we expect lower brand ad revenue, higher taxes, and higher costs from sales and marketing. As SOHU chooses to invest heavily in video and search ads, cash flow will be negatively impacted, so we believe interested parties will want to wait until the strategies prove accretive before investing.

Changyou (NASDAQ: CYOU) was spun off by SOHU in December 2007 and IPO-ed as its own entity in April 2009. CYOU is best known for developing Tian Long Ba Bu (TLBB), an extremely popular MMORPG, and currently has a platform of 2.5D and 3D game engines. Q1 revenue fell 30% y-o-y, which was better than expected with TLBB and Shen Qu growing the company’s online game revenue by 3% q-o-q. Q2 guidance of strong revenue will come from TLBB’s fifth anniversary but at the expense of significant promotional expense outlays that will reflect in weaker margins. Active paying accounts for web games were down 6% q-o-q but ARPU grew 32% q-o-q, reflecting a relatively stable customer base that is paying more and revenue from the new Shen Qu, which we view positively. The company has four new massively multiplayer online (MMO) games coming out this year and four web games are being developed. In light of a decent pipeline, we remain cautiously optimistic on CYOU.

Shanda Games (NASDAQ: GAME) is an online gaming company that we are increasingly bullish on given pipeline visibility. The launch of key new games will be a major driver of revenue growth, as will mobile games. Big upcoming launches this year are Final Fantasy XIV, World Zero, and Dragonball. Age of Wushu from Snail Games and RIFT have also been added to the pipeline. Some analysts estimate that combined, they could drive revenue growth of ~10% in 2012 alone, which we think is attainable. Both are highly anticipated 3D martial arts MMORPGs. Q4 results were flat. Revenues were on par with expectation but net income was slightly lower due to the one-time dividend. GAME’s two largest products by revenue, Mir 2 and Woool, posted revenue declines. These declines were balanced out by Dragon Nest and Mir 3 sales. We expect Woool II’s launch (expansion pack) this year to buoy sales for that franchise. Q1 guidance beat consensus, but total users (active and paying) were down 3% q-o-q. Average revenue per user was up just 1% q-o-q to RMB 92.8 million. However, with a slew of new product launches and upgrades, we believe user trends will reverse and revenues will get a nice boost in the next couple quarters. We are positive on GAME.

Renren Inc (NYSE: RENN) is the “Facebook of China.” RENN reported 4Q results in line with preannouncement figures—revenue of $32.8 million close to preannounced $31 million to $33 million. However, Q1 guidance of $28 million to $30 million was rather weak compared to latest consensus of $31 million and $36 million before the preannouncement. RENN’s core advertising business continues to suffer; management projects a ~30% q-o-q decline in Q1 on top of the 24% q-o-q decline in Q4. The lackluster user activity growth will negatively affect new advertiser acquisition. We turn toward mobile gaming as a bright spot for growth. Over 50% of daily unique users access RENN through mobile devices, and the company has plans to launch two new mobile games next quarter. Management expects a 45% y-o-y jump in online gaming growth, which should provide a monetization channel for current mobile traffic. Note though, that the increased investments ($60 million to $70 million) in Nuomi and 56.com will compress margins. The $80 million, all-cash 56.com acquisition closed last quarter; we felt RENN paid an excessive premium. Ultimately, we are concerned about RENN’s lack of user activity growth momentum and believe it will underperform competitors in the space. 


Fool blogger Meena Krishnamsetty does not own shares in any of the stocks mentioned in this article.

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