Computer games aren’t just for geeks anymore. Online games have proven themselves a vital form of low-cost entertainment for a broad swathe of thrifty Chinese consumers, and the sector has been resilient throughout the financial crisis.
Over the past two years, internet portal Sohu.com (NASDAQ:SOHU) has emerged as a rising star in the online games sector. In early April it cashed in on some of its success, spinning off online gaming unit Changyou.com (NASDAQ:CYOU) in a NASDAQ listing that raised US$128.3 million.
Changyou, in which Sohu holds a 68.5% stake, has been a crucial contributor to the portal’s bottom line. Sohu’s net profit for the first quarter rose to US$44.6 million from US$21.6 million the previous year. This would have been impossible without Chang-you, which saw its first quarter net profit grow by 120% to US$33.5 million.
The current slowdown in China’s online advertising market might tempt investors to shift their dollars to Changyou. Not so fast. While Changyou may be a stylish stock pick for the moment, risks inherent in the online gaming business may favor Sohu in the long term.
“We always suggest investors should invest in Sohu rather than Changyou because if [Changyou’s] new games don’t work, its growth will be slower than expected,” said Elinor Leung, an analyst with CLSA in Hong Kong. She has an “outperform” rating on Sohu’s stock.
Market watchers say Changyou is effectively run, with a strong brand. Its success is largely built upon one flagship game, the in-house-developed Tian Long Ba Bu (TLBB). The game has demonstrated staying power; in the first quarter, TLBB’s peak concurrent users grew by 875,000, a 48% year-on-year gain.
“TLBB’s momentum remains strong so it will not start aging until probably two years later,” said Wendy Huang, an analyst with Royal Bank of Scotland in Hong Kong. She has a “Hold” rating on Sohu’s stock.
Nonetheless, Chang-you’s future depends on whether the next products in the pipeline will prove to be blockbusters. While Changyou plans to release a new game, “Duke of Mount Deer” (DMD), later this year, analysts say it’s difficult to anticipate how users will respond to it.
Guo Chenggang, an analyst with consultancy JLMcGregor in Shanghai, said the market is unlikely to rave over DMD given its resemblance to TLBB. “Duke of Mount Deer is also based on a famous martial arts novel. I don’t think this new game will have the same or even similar attraction of TLBB,” he said.
Guo noted that Chang-you’s product pipeline appeals mostly to a male demographic, making it a riskier proposition compared with internet powerhouse Tencent – which boasts a wide variety of games for all users, including women and even retirees.
According to CLSA’s Leung, an investment in Sohu offers both exposure to Changyou’s growth potential and protection from the associated risks. In addition to online gaming, Sohu can always rely on advertising revenues. Leung expects these to grow by 10-15% over the next few years.
“While online advertising isn’t having a good year due to the economic downturn, long-term it has good prospects in China,” she said.