China Internet

Chinese Internet businesses are in a catch-up phase. Considering that its 450 million online population represents only 35% internet penetration, this catch-up will continue for another 2 – 3 years.  CLSA expects that number to increase to more than 800 million by 2013, while a recent study from the consultancy, McKinsey & Co estimated that 6 million people go online for the first time in the country every month. On average, China internet users spend 18.3 hours per week (2.6 hours/day) on internet access and 66% access Internet through mobile phones.

  

 

Historically, with improving economics, education and exposure, East Asians have exhibited obsessive inclination towards tech gadgets.  Japan, South Korea, Singapore, Taiwan, Hong Kong, Malaysia adopted technology faster than economic growth during their expansionary phase. China will be no different and the same will reflect in both gadgetry and internet adoption. Although most of china internet businesses have been clones of US based internet business e.g. Baidd (Google), Sina,Sohu(Yahoo), Dangdang(Amazon), Youku, Todou(Youtube), Renren(Facebook) and many others. However in certain internet aspects, Chinese have been trend setters e.g. Happy Farm’s clear success in the China social games market was the inspiration for Zynga’s Farmville. Zynga has now a speculative $5 billion valuation not because its “_Ville” games were first or original, but because it aggressively advertised/distributed the social games idea on the then fast expanding Facebook platform. Similarly, the expansive use of Sina Weibo (twitter-like micro-blog) and its evolution into a social networking site is a much deeper use of the platform compared to the western counterparts Secondly the Chinese internet users have quite a distinct taste and style of communication. This is further complicated by government regulation on all internet activities and a preference for nurturing local businesses. Thus localized Chinese internet companies have a massive advantage over their western peers and most likely the potential 1.3billion internet market will be shared mostly among local players.    

Important datapoints for 2010 were:

• ·         No. 1 sector in high growth was e-commerce.  User of online shopping grew 48% last year.  Much faster than the overall growth in internet population – 19%.

• ·         Online payment and online banking also grew 45% and 48% – this obviously is to support online shopping.

• ·         Social network continued to grow fast.  User growth rate of Social Network site and blogs was 33%.  Even instant messaging grew 29%.

• ·         Sectors growing slowly were: music, games and video – their users  grew 13%, 15% and 18% respectively.   These were slower than the overall growth in online population – 19%.

• ·         Microblog penetration reached 13.8%.

• ·         Group buying penetration was only 4.1%

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.

Out-sized profits and making the world a better place

Ethica helps you make out-sized profits and simultaneously make the world a better place. 

Ethica is an investment research company. We recommend profitable investments in equity stocks of companies, whose activities lead to a balanced and fair society. This is achieved by focusing on companies that do not engage in practices instrumental in causing wars, weak morality, social inequality and wealth concentration. 

In addition to a profit maximizing investment approach, you will find the following ethical features embedded in our investment universe:

•           The company must not engage in or promote alcoholism, pornography and other social ills.
•           The company must not engage in espionage or military weapons production.
•           The company should have minimum exposure to usury i.e. interest based lending/borrowing.

  

Compliance with above principles does not mean any compromise on generating profitable investment ideas. The US market offers scores of such ethical opportunities e.g. approximately 44% of US listed stocks (50% of  market capitalization in April 2011) and 70% of technology stocks are compliant with our ethical principles. Therefore our first set of research universe is based on +300 US-listed technology stocks and ADRs that are liquid and compliant with our ethical principles. 

Our core performance metric is out-performing the benchmark S&P500 through our model portfolio.