Editor's Choice

Is Changyou Right for You?

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

Over the past decade, many analysts have touted the strength of Chinese Internet stocks, one of the fastest growing sectors in the world’s second largest economy. However, I think a lot of investors are overlooking an important market in China - online gaming. This market is a young one with plenty of growth potential, growing 35.1% year-on-year in 2012.

Thus I present my undervalued growth stock of the day - Changyou.com (NASDAQ: CYOU), a rapidly growing online game developer in the People’s Republic of China.

Fundamentals First

I first stumbled upon Changyou in a stock screener search for undervalued growth stocks. These were the criteria I originally set.

  • Market Cap: Over $1 Billion
  • P/E Ratio: Under 25
  • Gross Margin: Over 15%
  • 5-Year Revenue Growth: Over 25%
  • 5-Year EPS Growth: Over 25%
  • 5-Year ROI: Over 25%
  • 5-Year ROE: Over 25%

In the entire U.S. market, only four stocks fit all seven criteria - Apple, Baidu, Deckers and Changyou.com. However, Changyou’s fundamentals caught my attention above all else - it was the best value in all seven categories.

Changyou’s Fundamentals (as of 1/25/2012): (Source: Google Finance)

<table> <tbody> <tr> <td> <p><span><span><span><strong>Market Cap</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>P/E Ratio</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Gross Margin</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>5-year Revenue </strong></span></span></span></p> </td> <td> <p><span><span><span><strong>5-year EPS </strong></span></span></span></p> </td> <td> <p><span><span><span><strong>5-year ROI</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>5-year ROE</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span>$1.67 Billion</span></span></span></p> </td> <td> <p><span><span><span>6.24</span></span></span></p> </td> <td> <p><span><span><span>83.33</span></span></span></p> </td> <td> <p><span><span><span>124.35</span></span></span></p> </td> <td> <p><span><span><span>661.37</span></span></span></p> </td> <td> <p><span><span><span>75.03</span></span></span></p> </td> <td> <p><span><span><span>75.74</span></span></span></p> </td> </tr> </tbody> </table>

What is Changyou?

Changyou was originally the game-producing business segment of online search portal Sohu, but was spun off in 2007. The company went public in 2009 as a U.S.-listed ADR. Its flagship properties include Tian Long Ba Bu, Duke of Mountain DeerBlade Hero, DDTank and other popular titles. The company has a workforce of approximately 3,300 based in Beijing.

The company has also started licensing Western games, such as Electronic Arts’ Battlefield Online, which began beta tests last November.

Macro Factors

According to Chinese site Techweb, the Chinese gaming industry grew 35.1% to $9.1 billion last year. Niko Partners, which specializes in researching the Asian video game market, originally forecast the market to hit $9.2 billion by 2014. They missed the mark by a year and $100 million. Revised estimates from various firms forecast the Chinese video game market to grow annually at 12.4%, potentially reaching $21.7 billion by 2017.

To put this into perspective, the market was only worth $200 million a decade ago.

The entire Chinese video game market is PC-based, since video consoles - such as the XBOX 360, Playstation 3 and Wii - have been banned in the mainland since 2000. "The government thought that was the best way to protect Chinese youth from wasting their minds on video games, after a parental outcry," explained Niko Partners researcher Lisa Hanson.

But since it would be impossible to completely ban personal computers, PC-based games have taken off. Online PC games in China have been gaining momentum ever since 2001, when the market first reached $100 million.

Micro Factors

In 2005, several of China’s government agencies addressed the perceived threat of Internet game addiction. It introduced a “Fatigue System”, which limited the experience points gamers could earn in a single day in certain games. While game companies were required to abide by these rules, they easily bypassed these restrictions, offering “1.5x Experience Cards” which allowed users to continue gaining experience points after their daily limits were reached.

Although the "Fatigue System" is still active today, the rules are loosely enforced and easily circumvented, and have yet to adversely impact online game sales.

Changyou’s online games also cost far less to produce than Western “Triple A” games, which cost up to $30 million to produce. Changyou's profit margin is currently 47%, compared to Western video game giant Activision Blizzard's 20%. 

The Chinese online video game market offers a mix of free-to-play, subscription-based and micro-transaction business models, catering to a wide spectrum of casual to hardcore gamers.

Looking Back

Last quarter, Changyou posted earnings of $1.41 per share, a $0.23 improvement over the prior year quarter which topped the Zacks Consensus Estimate by $0.09. Revenue grew 29%, while online game revenues and online advertising revenues rose 30% and 32%, respectively. Changyou’s registered accounts also rose 41% to 223.5 million users.

Changyou expects its fourth quarter to be softer, due to higher operating expenses for promoting four new online games, and an expansion pack for its flagship game Tian Long Ba Bu.

Looking Forward

Changyou will report its fourth quarter earnings on Feb. 4. It expects non-GAAP fully diluted earnings between $1.29 and $1.33, on revenue between $166 million and $170 million. Analysts forecast Changyou to earn $1.33 per share on the same basis, on revenue of $160.4 million.

Analysts at Oppenheimer & Co. have grown bullish on Chinese online gaming stocks, stating that many of the top industry players are trading at a 51% discount to the country’s other sectors.

Strength Versus Industry Competitors

Changyou (market cap $1.58 billion) primarily competes with Shanda Games ($843.73 million) (NASDAQ: GAME), Giant Interactive Group ($843.73 million) (NYSE: GA), Perfect World ($565.09 million) (NASDAQ: PWRD), Giant Interactive Group ($1.49 billion) and market leader NetEase (NASDAQ: NTES) ($6.14 billion). Let’s do a simple comparison of earnings and revenue growth from these five companies over the past five years.

<img src="http://media.ycharts.com/charts/d0dcc3ced3bbc14f1858af7224eccb10.png" />

CYOU Revenue TTM data by YCharts

<img src="http://media.ycharts.com/charts/626ac64719fcf2fd964dc00f6b90f2bf.png" />

CYOU EBITDA TTM data by YCharts

Netease and Changyou are consistently at the top of the heap, while Shanda Games and Perfect World are posting some serious declines in diluted earnings per share. Giant Interactive, the company closest in size to Changyou, has held relatively steady.

Let’s also compared the current debt to equity ratio of these five competitors.

<table> <tbody> <tr> <td> <p><span><span><span><strong>Changyou</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Shanda Games</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Giant Interactive</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Perfect World</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Netease</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span>41.11</span></span></span></p> </td> <td> <p><span><span><span>73.87</span></span></span></p> </td> <td> <p><span><span><span>N/A (no debt)</span></span></span></p> </td> <td> <p><span><span><span>19.16</span></span></span></p> </td> <td> <p><span><span><span>N/A (no debt)</span></span></span></p> </td> </tr> </tbody> </table>

Changyou is clearly at a disadvantage here, as Giant Interactive and NetEase both have pristine balance sheets. Changyou currently has $340.62 million in cash and $239.18 million in debt.

The Bottom Line

The Chinese online video game market is growing, while game sales are slowing across the rest of the world. That’s why major publishers such as Activision and Electronic Arts are partnering with local companies such as Changyou and Tencent to push their franchises into this final frontier of online gaming.

Changyou is far from a perfect stock - its debt to equity ratio is high, and it could be hit hard by macro factors such as a Chinese slowdown or increased regulation of U.S.-listed Chinese ADRs. But it still deserves a spot on your watchlist of undervalued growth stocks.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Giant Interactive Group and NetEase.com.You can follow Leo Sun on Twitter at https://twitter.com/leokornsun for more investing ideas.

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