Some of the best performing stocks this year have been Chinese online gaming companies. Established stocks like Shanda Interactive (SNDA), and Netease.com Inc. (NTES) have generated significant profits for the ZachStocks Growth Model, and the newly issued Changyou.com Limited (CYOU) offers potential for a new position in the near future. The majority of Changyou.com is actually owned by Sohu.com Inc. (SOHU) who controls 68.5% of the company.
This week has been volatile for the China gaming companies as both Sohu.com and Changyou.com announced earnings. The numbers for SOHU came in above Wall Street expectations and above company guidance while Changyou.com reported very close to inline with expectations. However, both stocks traded lower as CYOU announced that they would be delaying the launch of three new games.
The martial arts game “Duke of Mount Deer” was expected to be available in the fourth quarter of this year but now appears to be pushed to the third quarter of 2010. ”Immortal Faith” was expected to already be live, but will now be released in the first quarter of 2010. Finally, the fantasy game “Legend of the Ancient World” appears set for release in the second quarter of next year. While it is disappointing to see these names be pushed back a bit, keep in mind that we hav historically seen successful games have profitable lifes of several years so it is probably worth a delay in order to make sure the quality will support an extended life cycle.
For the second quarter Sohu.com earned $0.89 per share, and analysts are expecting full year earnings to reach $3.72. Looking towards 2010, earnings are expected to come in at $4.16 and yet the stock is only trading in the low $60’s. The price represents a meager 15 times expected 2010 earnings. At the same time, CYOU is trading more than 20% below its recent high, in the mid to high $30’s. This, despite the fact the company is expected to earn $2.72 this year and $3.25 in 2010. For the amount of growth we are seeing in these stocks, I am a bit surprised the multiples aren’t in the low to mid 20’s.
Gaming growth may be lighter than in 2007, but is still robust and predictable
Looking at the industry, there is significant historical growth which is expected to continue over the next several years. While we may not see 70 or 80% industrywide growth, expansion in the high teens to low 20’s (as an annual growth percentage) is actually fairly impressive. It may be that investors are disappointed with the slower growth rates, but considering the overall global economic picture, this industry is more stable and offers more growth than we can see in many other areas.
The recent weakness in these two stocks may turn out to be a great buying opportunity. SOHU is also getting some bad press because of the weakness in its brand advertising business. It is clear that this part of the company is under pressure as ad spending has been soft. Yet, the majority of future growth will likely come from the gaming side, and there may be an opportunity for SOHU to spin off the less exciting business or sell it to a more competitive player like Baidu Inc. (BIDU)
Options on both CYOU and SOHU are relatively pricey due to the high level of volatility. As a short-term investment, one could currently buy SOHU at $63.30 and sell the September $65 calls for $3.70. This gives you an 8.5% return in seven weeks if the calls are exercised, and gives you a bit of protection if SOHU trades lower.
Similarly, one could buy CYOU for $37.35 and sell the September $40 calls for $3.00. If the calls are exercised the return is 15% in just seven weeks and $3.00 of protection on this stock is helpful as $35 looks to be a pretty firm support level.
Covered call writing is a great tool that we use at my firm Sound Counsel Investment Advisors in order to mitigate some of the risk and increase income. Depending on your risk tolerance, tax status and other factors, it may be an attractive way to reduce risk in your portfolio. But when trading options, you must understand the benefits and drawbacks in order to determine if the process is right for you. Please email me if you would like more information on this investment process.
The Chinese online gaming industry is evolving fast and finding new attractive ways to generate profits. At this point it appears we are far from market saturation but quality games will end up taking the lions share of gamers attention. So it is important for CYOU to create a quality product, and then market it skillfully to reach the broadest audience. I think that the talented management team is up for the task.
FD: Author has a long position in SNDA and NTES in the ZachStocks Growth Model
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July 30th, 2009 at 10:00 pm
That’s a great analysis. Is there any way for US investors to participate in Chinese IPOs?
July 30th, 2009 at 10:07 pm
You can participate if they are offered on US exchanges. For instance, CYOU was offered as an IPO and trades on the NASDAQ. The toughest thing about getting in on an IPO is making sure you have a relationship with the underwriter. The fund that I manage has actually had to spend years developing relationships with an assortment of different firms in order to get access to most deals.
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