PWRD 1Q2011 - Not impressive

Q1 results went beyond analyst expectations. +10% revenue beat and resultant operating leverage led to +40% EPS beat. The upbeat results were due to monetization by forcing players to pay-up for various digital goodies. This milking caused ACU (average concurrent users) to decline to 905,000 in 1Q '11 as compared to 999,000 in 4Q '10 and 993,000 in 1Q '10. Since management plans lesser monetization for Q2, guided revenue was flat qoq. Thus it was a give and take sort of quarter and the stellar financial performance did not impress much as some long term concerns have arisen.

Decline in ACU becomes more critical, in the context of two new games. Forsaken World and Empire of Immortals had full quarter contribution. That means gamer enthusiasm towards new games was not there to balance the monetization efforts of the company. This is an alarming sign for game popularity and future monetization potential. A news article on Forsaken World communicated the same feelings.     

The company has been heavily investing to develop new games. Management announced that it will add another 700 people to the current 2200 R&D employee base – i.e. a 32% increase. Considering ACU was not able to defend against the monetization efforts, the increased R&D does not seem to be efficient or effective.

Tactical Strategy: PWRD would continue its downward journey for some time, till it become a value-buy between $20 - $22. News flow with regard to Forsaken World and Empire of Immortals remain critical for stock price performance and we recommend no position till such news flow emerge.

GAME - Putting social in games

Shanda Games is a pure-play online gaming company and was spun-off by the consumer portal Shanda (SNDA). It has an extensive range of 46 games with 38 MMORPGs and 8 other games, but the top three games account for 40%, 18% and 17% of the total game revenue.  Its most successful games are Dragon Nest, Mir II, Maple Story. Relatively new launches are AION & Hades Realm II.

The company is launching a series of games in 2011 with major ones being Legends of Immortal, Final Fantasy XIV & Dragon Ball Online.

Legend of Immortals has been built around a social network platform that fully integrated this game with a full set of social features to allow gamers to share their status and achievements with their friends on a real time basis. Players can enjoy social network games (SNGs) and other applications provided by third party in this platform. In addition, the platform also has links to third-party social network service (SNS) sites such as Facebook and Renren so that gamers can share their information with their friends outside of the game. At the end of the first open test day in May, the registered accounts of the SNS of "Legend of Immortals" exceeded 3.5 million, reflecting the prospects for this unique approach.

Catalyst: News flow on performance of AION, Hades Realm II and most importantly Legends of Immortal.

Like most Chinese online games GAME has a low valuation i.e. 9.5x NTM PE and a Cash adjusted NTM PE of 8x. The company has 12% FCF yield. The target buy / sell range currently is estimated at $6-6.5 and $8-8.5.

NTES - Mainly gamecraft

NetEase operates a consumer web portal that not only generates advertisement revenue (12-13% of total revenue) of its own but also serves as gateway to numerous MMORPG offered by the company. The company is planning to diversify into e-commerce and e-payment platform as well. However success seems far-fetched on that front, as the company did not succeed much in growing its portal fast and vast enough. The company earns 88% of revenue from its online games and that has a higher gross margin (75%) compared to 54% gross margin in advertisement business. Its most popular game World of Warcraft is licensed to it by Blizzard Entertainment. NTES recently licensed the popular strategy game i.e. Starcraft II from Blizzard as well.

NTES had a tremendous 47% growth in Online Games revenue in 2010. It was mainly attributable to the combinations of the first full year of operations of World of Warcraft and the impact of large scale promotions for company-owned games Fantasy Westward Journey, Tianxia II and Westward Journey Online II, as well as the launch of Heroes of Tang Dynasty in April 2010.

The company commercially launched Starcraft II in April and intends to use it as a platform for developing new game types or new features to play. The pipeline for 2011 has major expansion packs i.e. newer versions of the above games. Notable launch is Cataclysm System expansion pack of World of Warcraft. However it should be in the latter part of the year. Excluding extraordinary marginal revenue from Cataclysm System or Starcraft II, Netease revenue growth in 2011 will face head-winds due to higher base effect.

Catalyst: Newsflow on success of Cataclysm System and Starcraft II.

NTES has NTM PE of 13.6x  and a Cash-adjusted EV/EPS of 10.3x. This highest relative valuation among Chinese Online gaming companies is mainly due to the World of Warcraft franchise. Since 2010 was the first full year of operation for the game, 2011 would suffer from the higher base effect and thus difficult comps. The important differentiators to counter slowing revenue growth could be success of Cataclysm System and Starcraft II.

Target Buy / Sell range would be $40-44  -   $55-60

GA - Growth at very reasonable price

GA has an immensely popular game ZT and two relatively less popular games i.e. Dragon Soul and Golden Land. However its newer game ZT Online 2 has received a great response and it is expected to contribute significantly to 2011 revenue. The official closed beta testing of ZT Online 2 in the second quarter achieved a PCU of 300,000 and next goal is to raise the PCU to 400,000 peak concurrent users.

The future pipeline for 2011 is also very promising and the odds of another hit are high. A 3-D MMORPG i.e. Spirits of the Warriors is expected to commence limited closed beta testing in mid-2011 and thus should start contributing revenue by year end. Finally, two licensed games i.e. Elsword and Allods Online have entered preliminary engineering tests and thus confirm the pipeline to be very healthy.

ACU for the company was 586,000 in the latest quarter, a 0.4% sequential increase and 0.3% decrease year-over-year. . PCU was up 11.9% sequentially and up 18.9% year-over-year to 1.916 million.

GA has a 2.5% yield and $4.1 Cash/share i.e. almost 50% of its $8 market price. Thus a 12.5x NTM PE, gets reduced to a 6x cash adjusted PE, the lowest among all China internet names. GA is thus a Growth at Reasonable Price play. Depending upon continued game success, GA should easily be trading above $10, implying a 25% upside.

Catalyst: News flow on ACU of the new game ZT Online 2 and launch date of impending game Spirits of the Warriors.

CYOU - Not a one-trick pony

CYOU is a pure-play online gaming company and was spun-off by the advertisement portal SOHU as a majority-owned subsidiary. It was a one-trick pony i.e. its popular MMORPG game TLBB and thus the stock did not move much in 2010. However the stock has considerably appreciated YTD due to continuous TLBB performance. The following two growth drivers are expected to keep investor attention in 2011.

CYOU is launching a new MMORPG game DMD (Duke of Mount Deer) with unique server technology. It enables social network features whereby, two servers can form an alliance against competing teams of servers so that larger communities of player can compete. In most 3D games currently, the battles are restricted to a couple of thousands of people within a server against another. But with DMD, given the server versus server, it allows two servers to form alliances and compete with or against competing alliances of servers. This expands the battles into allowing for up to 10,000 people to compete with another 10,000 people, and so this expansion in the community and interactivity of the game allows for more interaction.

PWRD - Revenue growth and Margin expansion

2010 was a lackluster year for PWRD as margins and revenue both showed decline due to no major game launch. However the investment in 2010 resulted in 5 new games for 2011 launch and is expected to grow revenue and margins. PWRD is also a leader in China game-licensing business for exports and exports account for approximately 10% of revenue. ACU for games under operation in Mainland China was approximately 999,000 in 4Q '10, as compared to 733,000 in3Q '10 and 1,157,000 in 4Q '09.

    

Core games i.e. Perfect World II and  Zhu Xian have traditionally accounted for majority revenue(no break-up available). No major breakthrough game was launched in 2010. However 2011 would account for full revenue from the 3 games already launched (Forsaken World, Empire of Immortals and Dragon Excalibur). Among these 3 games Forsaken World became a hit among gamers and was third revenue driver in December quarter. In addition there are three more games in pipeline (Heaven Sword & Dragon Saber, Swordsman Online and XAJH) and a single hit among them would be additional revenue driver.

R&D expense was significantly increased in 2010 to develop the above games and that reduced operating margin from high of 50% to below 25%. With revenue growth back in picture and stable R&D expense margin expansion would also add to bottom-line.

Considering above, NTM PE at 9x and Cash-adjusted PE at 7x, the stock price has no growth scenario built into it. With growth coming back and expansion in operating margins, a cash-adjusted 9x PE is easily possible and would bring the stock price above $30, implying a 25% upside.

Catalyst: Upcoming results on May23, 2011 would be an important catalyst to assess progress. However I would wait for earnings for investment timing.

China internet gaming

China gaming sector will benefit from convergence of three China themes i.e. increasing wages, rising consumption and massive online population (+450mn and growing) in China.   

The online games market grew 25% in 2010 and forecasted by Pearl Research to exceed $8 billion in 2014.  Online gaming dominates consumer internet in China and generate recurring revenue streams. These games (MMORPG i.e. massively multiplayer online role playing games) are hosted on company servers. Customers pay to access the digital game world on a usage-based or time-based system.  They have shifted video gaming experience from individuals to becoming a social one i.e. ideal for internet platform.

Top game operators for 2010 were Tencent (H-share) with $1.4 billion in revenue, Netease (NASDAQ: NTES) with $749 million in revenue, Shanda Games (NASDAQ:GAME) with $680 million, Perfect World (NASDAQ: PWRD) with $374 million and Changyou (NASDAQ: CYOU) with $327 million in revenues. NTES, PWRD, GAME, GA and CYOU are pure play China on-line gaming companies with ADR. The business enjoys very high Gross Margin (60– 80%) and Operating Margin (30 – 60%). Revenue growth is mainly dependant upon growing game portfolio and paying player bases. ACU (Average concurrent users) and PCU (Peak concurrent users) are primary drivers, while ARPU and APU are secondary drivers.

New game pipeline of PWRD, GA and CYOU for 2011 is extensive and should benefit from low base effect. High ACU in beta trials indicate that 2011 and 2012 should be growth years for revenue. After a successful 2010 NTES and GAME have a high base effect in 2011. Investment timing should depend upon game related news flow and general China economic strength. 

Following are current Buy – Sell Price range for each and could change as per news flow:

Ticker                          Buy range        -           Sell range

PWRD                         $22-25                        $30-36

CYOU                         $35-42                        $52-58

GA                               $7.5-8                        $10-12

NTES                          $40-44                        $55-60

GAME                         $6-6.5                        $8-8.5

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