Ways to Play China's Online Gaming Sector

The online gaming industry in China has grown at warp-speed during the last five years, expanding at a compound annual rate of 50% to CNY 32.7 billion (approximately $5 billion) in 2010, according to third-party researcher iResearch. Rising Internet penetration, falling monthly rates for always-on broadband access, and an explosion of titles have made online gaming an attractive and affordable form of entertainment for tens of millions of young Internet users in China.

Gamers, typically in their teens and 20s and often an only child, seek refuge from their hectic real lives and build friendships in the virtual world by hunting treasures, battling villains, and performing other heroic acts. Over the years, gaming sites have built a massive following in China, which, according to the latest report from the official China Internet Network Information Center (CNNIC), included approximately 304 million consumers at the end of 2010, or 66.5% of the Internet user population in China.

Diverse Gaming Categories and Revenue Models Provide Industry Players with Multiple Growth Drivers
Online games in China fall into three categories: massive multi-player online role-playing games (MMORPGs), casual games, and social networking games. MMORPGs, usually with themes of adventures and martial arts, have contributed the bulk of gaming revenue at major gaming operators such as NetEase (NTES) and Shanda . But given the intensity of the experience and heavy time commitment required to finish each "mission," we believe these games appeal mostly to males in their teens and early 20s. As a result, future growth more likely will come from higher spending per gamer on new releases and upgrades rather than an influx of new gamers.

Casual games and social games, on the other hand, do not require much time and are quite relaxing to play, thus having a much broader appeal. They are especially popular among female gamers. Social games, in particular, have attracted more than 200 million players in China so far and grew revenue at a much faster pace than the overall online gaming market during the last year. These games are mostly provided on social networking sites such as privately held Renren.com and Kaixin001.com to create more interaction among members and increase stickiness of the sites. While currently only a tiny portion of the total online gaming market, social gaming should continue its impressive growth trajectory in the coming years as more people embrace social networking in China, in our opinion.

The prevailing revenue model for online gaming in China is the item-based model, which allows gamers to play for free but charges for the purchase of in-game virtual goods that would provide tricks or additional power to enhance the gaming experience. Widely used by MMORPG providers since 2005 to lower the hurdle for new gamers, the item-based model actually has helped firms such as Shanda and Changyou  generate excellent operating margins of at least 30% in their online gaming businesses. Unable to resist the temptation of extra tricks and equipment that come with a price tag, young gamers often are willing to splurge on virtual purchases that can add up to several times what operators would be able to fetch using a regular time-based model. A notable exception is veteran game operator NetEase, which has stuck to the time-based model for its sought-after in-house and licensed games and has remained profitable as well.

The subscription model is popular in casual games, allowing gamers to sample a wide variety of options for a fixed monthly fee. Internet giant Tencent 0700.HK was able to quickly rise to the top in terms of gaming revenue within a short span of two years, partly due to the successful rollout of a subscription model that tapped its huge user base. Game operators also are experimenting with carefully crafted in-game advertising for both casual and social games, but we think revenues from this model are immaterial at the moment.

Large Gaming Operators Are a Safer Bet for Investors Interested in the Sector
Ten years of uninterrupted growth in online gaming in China has lured hundreds of game developers and operators to the business, resulting in fierce competition for gamer attention and spending. We don't find many individual online gaming firms with economic moats, as gamer preference tends to be fickle, the market is highly fragmented, and switching costs are virtually nonexistent. This makes it extremely difficult for online gaming sites to build durable competitive advantages and consistently deliver good returns. Despite considerable operating leverage and strong cash flows for successful games, gaming operators need to plow the cash back into further research and marketing to sustain the business. Nonetheless, we believe well-established online gaming firms will enjoy strong growth in the coming years, as rising disposable income and more affordable Internet access drive up the number of gamers and their spending. New types of gaming, such as social gaming and mobile games, also open up new revenue opportunities for gaming operators.

We also believe industry-wide consolidation is now under way, which should eventually benefit top gaming operators with a large player base, strong marketing capabilities, and deep pockets. Tighter regulations in recent years have raised capital requirements for smaller game studios and operators, forcing them into the arms of larger online gaming companies. Increasingly sophisticated technical requirements for gaming platforms and the heavy marketing expenses needed to launch new games have led many smaller firms to give up their independence in exchange for support from more experienced and resource-rich firms.

We think the consolidation should not only reduce competition in online gaming as the smaller firms drop out, but also allow the larger operators to pick up good games at attractive prices. Bidding wars are extremely rare for small game studios, as major game operators usually only acquire those that they have worked closely with for an extended period to ensure a smooth integration for game development and marketing. The market share of the top three Chinese online gaming operators--Tencent, Shanda, and NetEase--expanded from 42% in 2008 to almost 60% in 2010, and we believe they are poised to benefit from further consolidation. Acquiring smaller companies would allow the large players to leverage their large user base and marketing scale advantages to quickly generate buzz as well as revenue for the new games. Additionally, as larger online gaming companies build out the number of games they offer--both organically and through acquisition--a network effect could develop. As more consumers become aware of and use the larger online gaming firms, the more valuable their networks become to advertisers or third-party developers. A well-established network can often lead to an economic moat.

Smaller independent online gaming companies are inherently risky for investors, in our view, but large game operators tend to have a diverse portfolio of popular games and a strong game pipeline that provide fair visibility into future earnings and cash flows and can help cushion the impact of a disappointing new game release. The top game operators that we cover--NetEase and Shanda--are both fairly valued, with price to fair value of 1.00 and 0.95, respectively. We think the launch of popular games Wrath of the Lich King and StarCraft II should provide a strong boost to earnings at NetEase in the near future, but the benefits largely are reflected in the current stock price. Shanda has invested aggressively in small game studios in recent years in a bid to refresh its game offerings after struggling with aging games that no longer dazzle players. We think Shanda is capable of translating its investments into solid top-line and bottom-line gains given its track record of operational and marketing savvy.