On Monday evening SIG analyst Zhao Chunming downgraded Tencent from positive to neutral over concerns about its valuation in the face of a slowdown in the Chinese online game market. 48% of Tencent’s revenue comes from online gaming, and in the last several weeks Perfect World, Shanda Games, Giant Interactive and Netease have all issued disappointing earnings results and/or forecasts.
Clearly something is going on in China’s online gaming market, and Zhao has the best explanation I have yet seen. From Zhao’s note:
1) User growth slowing down. Given the fact that new Internet users are mainly coming from older age groups, rural areas, and mobile users, we are forecasting a slower growth rate (10.6% five-year CAGR) in the number of gamers vs. total web users (15.9% five-year CAGR) (see Figure 1).
2) Competition from multiple fronts, most notably social network games. We believe social network games are competing against MMO games for users’ time. Chinese Internet users now have more diversified entertainment means than before, causing high-monetization MMO games to lose growth momentum.
3) Intensifying competition among game companies. Tencent has been a fast share gainer during the past two years, which led to slower growth in the rest of the online game companies. However, due to a more mature online games market, Tencent may face growth concerns as well. Major game companies have seen talent losses to rivals or VC-invested start-ups, resulting in an across-the-board increase in engineer and designer costs.
4) Market filled with homogeneous content, lack of innovations. We believe the stickiness of games has come down, due to games “learning” from each other in game play and monetization features. Based on our talks with gamers, we think the average play time for an average game is less than nine months. It is increasingly difficult to produce blockbusters in this market.
5) ARPU growth significantly slower, raising questions about the item-based model. We believe there have been bubbles in the monetization of item-based games. Expensive functional items have led to imbalance, user loss, and regulatory oversight (e.g., treasure box features). When high ARPU is unsustainable, companies scale back monetization to retain users. In our opinion, the monetization incentives behind the item-based games have caused deviation of game usage, i.e., chasing virtual items rather than the core entertainment purpose.
I’d also add that increased competition has hurt margins through increasing marketing costs and there are growing concerns about further regulations that may impact revenue.
Zhao questions how Tencent, already the third most valuable Internet company in the world, can increase its market capitalization in a meaningful way. He suggests that Tecent consider buying Sina or Perfect World:
The question is, how can Tencent add another ~$10 bln market cap from here? Tencent is currently trading at US$36 bln market cap, ranking #3 among global Internet names. To make a 30% return on its shares, we need another US$10.8 bln market cap. This is equivalent to 0.4x BIDU, 7x SINA, 3.7x NTES, or 10.5x PWRD (based on their EVs). We are unable to find where this large valuation can come from, considering new growth drivers still being too small in their growth stages. In our view, Tencent should consider an acquisition of PWRD or SINA.
All of these companies have growth rates, revenues, profits and cash balances that most Internet companies can only dream of. They are, with perhaps the exception of Giant Interactive and The9, still quite healthy, just maturing. But the era of explosive growth may be ending.
