The Chinese government has lifted a decade long ban on the sale of gaming consoles in China. This decision on the part of Chinese government could have far reaching impacts on the many local online gaming companies in China. The most prominent among these companies are Tencent (OTCMKTS: TCEHY), NetEase (NASDAQ: NTES), Shanda Games (NASDAQ: GAME) & Changyou.com Ltd (NASDAQ: CYOU)
Rapid growth of the Chinese gaming industry
The Chinese online gaming industry has seen robust growth over the last decade. The industry has grown from $163 million in 2003 to over $11 billion today. The phenomenal growth has led to a number of Chinese online gaming companies springing up and benefitting from the growing desire of the Chinese population to game online. However the industry did not face competition from console games as the sale of gaming consoles was banned by the Chinese government for close to 13 years. The Government’s recent announcement to lift the ban on gaming consoles came with one accompanying condition. The consoles could be sold on the Mainland if and only if they are manufactured in the Shanghai free trade zone, due to be launched soon. The announcement has implications for the current players in the Chinese online gaming industry as well as for console manufacturers like Nintendo, Microsoft, Sony, etc.
Global console games against PC/online games
The Chinese gaming market will now be thrown open to gaming console manufacturers putting a question mark against the extraordinary growth the Chinese online games developers have been experiencing. In order to estimate the impact of console games on the Chinese PC/online games companies, we shall take a look at the global performance of the two gaming segments over the last 6 years.
The above chart shows a clear trend of the increasing popularity of online/PC games vis-à-vis console games. However the absolute value of PC games is still very small at just under 7% currently. The Chinese market will also see a significant number of gamers shifting to console gaming as console games from Nintendo and Microsoft (NASDAQ: MSFT) have an added advantage over online/PC games due to motion sensor/virtual reality kind of technologies. This will result in a slowdown in the revenues of online/PC games companies. While it will take some time for the console games to gain acceptance in a market which is currently entirely dominated by PC games, we estimate that the console games will not be able to replicate their global popularity in the Chinese gaming market due to a number of factors.
Barriers to console manufacturer’s entry into China
We see the following risks which will be faced by any game console manufacturer in the Chinese market:
Rampant Piracy in China
The Chinese markets, popular and famous for their fast paced growth are also infamous for the rampant piracy which exists in these markets. The console manufacturers have greater exposure to the negatives of piracy as compared to online games. Therefore, in-spite of the huge opportunity the Chinese market represents none of the leading console manufacturers have announced any plans to set up shop in China.
Huge popularity of current games
The console games had been absent from the scene for over a decade. Ironically the last decade saw a huge increase in the desire of Chinese online gamers, which led to the pent up desire being channelled into the online PC games industry. This resulted in huge acceptance of PC games launched by local gaming companies which experienced phenomenal growth in revenues. The huge popularity of the online games in China has been reflected in the stock price gains of the various companies. NetEase stock has gained over 27% in the last one year even as Changyou.com Ltd has registered over 32% during the same period.
Costs of setting up manufacturing facilities in China
The Chinese government’s condition making it mandatory for console manufacturers to manufacture consoles locally in order to sell them in China, will lead to increased costs for the manufacturers. The costs of setting up new facilities, when considered in tandem with the rampant piracy and the current dominance of PC games, could prove to be a huge discouragement for any console manufacturers to announce their China plans.
A conservative estimate
The online PC games currently hold close to 100% of the Chinese gaming market, which is in stark contrast to the global gaming scenario. The industry is expected to grow over 30% in 2013. Considering that the Console manufacturers do set up shop in China, we estimate they could capture close to 20% of Chinese gaming market share resulting in the PC games market growth slowing down to levels close to 8% to 10% from its previously expected 30% growth.
Impact on NetEase
NetEase, one of our earlier top picks had a target price estimate of $74.27 in our first coverage of the stock on Jul 29th close, against the then price of $63.92. Our next coverage of the stock on Sep 10th saw the stock replaced by YY Inc. in our top stock picks. The Netease stock price closed Sep 10th at a price of $73.29, registering a gain of 14.65% since our first coverage of the stock. The calculations at the time were based on the then expectations of growth and earnings. Our latest analysis factors the impact of the potential entry of Console games into the Chinese market resulting in slower growth and lower future earnings. The company generates advertising revenues as well as revenues from its other online services and its recent entry into the mobile space with the launch of Yichat hedges the company’s revenues to a small extent. However the company generates over 85% of its revenues from online games and we no longer find the stock attractive considering the increased risks the Chinese online gaming industry faces.
The three pure-play Chinese online gaming companies listed on NASDAQ saw their stock price fall during the last trading session. NetEase stock has lost over 3% in the last week to close the last trading session at $ 71.69. The other Chinese gaming industry stocks like Shanda Games lost 2.68 % and Changyou.com Ltd lost 3.58% in the last trading session.
To see Netease’s latest stock price movement, click here (NASDAQ: NTES)
Disclaimer: We do not hold any stake in the aforesaid stocks. For detailed disclaimer, please click here.