Should Shanda Games Play a Role in Your Portfolio?

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While Shanda Games is in a hot industry, and its spin-off getting lots of buzz, we think there are too many issues surrounding its long-term prospects to give this IPO an endorsement. Parent company  Shanda Interactive Entertainment  is spinning out Shanda Games in a gigantic $1 billion deal Friday. There's no doubt that Shanda Interactive management saw the success of the Changyou IPO from March 2009 and wanted in on the action. The IPO priced at the top of its range of $10.50-$12.50 per share. Morningstar equity analyst Iris Tan brings us up to speed on the company and the offering:

"Shanda Games (GAME) is an online gaming company that develops, operates and licenses massively multi-player online role-playing games (MMORPGs) and advanced casual games in China. Over the past few years, Shanda has been the number one player by revenue in the Chinese online gaming market. The company adopts the item-based model for substantially all of its games, where basic features of the game are free to play and players may choose to buy virtual items to enhance the playing experience. After the spin-out, its parent company will control roughly 75% of Shanda Games, which will rely on one of its parent company's divisions, Shanda Online, for the provision of integrated platform services including online payment, customer services, data support and pre-paid card marketing and distribution.

"Shanda leads the Chinese online gaming industry with its creative business model and strategies. The company was the first to transform from a subscription-based model to a free-to-play model in late 2005, which is now the prevailing revenue model in China. It also initiated an in-house venture capital fund to invest in fledgling independent online game studios. Unlike many of its peers, which operate games mainly through in-house development or external licensing, Shanda is actively looking to enrich its gaming portfolio through investment and acquisition, co-development and cooperation. This strategy has helped the company build the largest game portfolio in China with 20 MMORPGs and 11 advanced casual games. Furthermore, Shanda has another 16 MMORPGs and eight advanced casual games in the pipeline. Given its large player group of over 9 million active accounts as well as a strong product lineup, we think Shanda could be well-positioned to capitalize on the largest online game population in Asia.

"While Shanda is currently a leading company in this lucrative and fast-growing market, there are several factors that make us wary of the company's longer-term prospects. The company hasn't shown consistent strength in game development, as licensed games still represent about 70% of revenue. Also, despite a robust product lineup, over 55% of its total revenue is generated from one licensed game, Mir II (launched in 2001) and another 20% of revenue comes from one self-developed game, Woool (launched in 2003). Furthermore, after the spin-off, the company's game operations will share the same entertainment platform (Shanda Online) with online games and other entertainment content such as online music and literature, provided by either Shanda or third-party providers. This will inevitably elevate competition on the platform and could serve to distract players. Finally, Shanda Games remains under the firm control of Shanda Interactive, which will control roughly 97% of the voting rights, which both hampers strategic flexibility as well as shareholders' interests. Shanda has not stated what it will use the IPO proceeds for, and we see the move as a way to diversify business risk in the increasingly competitive online gaming segment, as Shanda's dominance in the gaming market is now coming under fire from other top-ranked players, including Tencent and  NetEase (NTES)."