E

aPRil 6, 2009

THE WALL STREET

TRANSCRIPT
Questioning Market leaders For long Term investors
ThE FOllOwing REPORT is EXCERPTED FROM THE WALL STREET TRANSCRIPT ANALyST INTERVIEW

ADAM KREJCIK Roth Capital Partners, LLC

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The China Online Gaming Industry

a D a M k R E j C i k R O T h C a P i T a l P a R T n E R s , l l C

AdAm KREjCIK is a Research Analyst at ROTH Capital Partners, LLC, focused on the gaming and entertainment industry. He joined ROTH Capital in 2006 as a Research Associate covering the casino gaming sector. Prior to joining ROTH, he spent two years at Banc of America Securities, LLC, Equity Research department, where he covered the leisure and business services sectors. He received his BA degree in Business Economics from the University of California, Santa Barbara. SECToR LEISuRE All of the companies under coverage are still en(AAD802) TWST: You cover the Chinese side of joying significant growth, and despite market turthe gaming equation. Why China and whats moil here in the US and a fairly pronounced going on there in terms of the gaming market? slowdown in China, these companies so far have Mr. Krejcik: China is actually a focus of been showing pretty amazing resilience. our firm right now. We TWST: Is onare doing a lot of work line where most of the Highlights in this area. Companyactivity takes place in wide we see this as one China? Adam Krejcik covers the Chinese online gaming industry and says the companies are still enjoying significant of the most interesting Mr. Krejcik: growth and showing amazing resilience to the slowing emerging markets, and For investors who are economic environment. The console market has not yet been established in China so whereas in the US video a couple of years ago not familiar with the game sector, people play on consoles like PlayStation we opened an office in industry, I would comand Xbox, the dominant platform in China is the computer which allows users to log onto the Internet Shanghai and have pare it to the US video and play games concurrently with thousands of other since been building game sector; however, players. This is a cheap form of entertainment and the that out. So my sector instead of playing on reason why companies are so profitable isnt because of the price points they charge users, but the scale of the of focus is the China consoles, i.e., PlayStagames. The massive number of customers who play the online gaming industion, Xbox, and Ningame is what really drives the revenue. Valuations are very depressed right now but the companies have a try, which I cover with tendo, the dominant significant amount of cash on their balance sheets and my associate Nick platform is the comno debt, so for investors trying to avoid companies that Ning, who works out puter, which allows are overlevered or facing financing issues, this sector fits that profile. of our Shanghai office. users to log onto the Companies include: NetEase.com (NTES); Shanda We think this is an inInternet and play games (SNDA); Perfect World (PWRD); Activision Blizzard (ATVI); The9 Limited (NCTY). teresting growth sector. concurrently with thouCopyrighted material: For reproduction permission contact Kenneth Wolfrath (212) 952-7400

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sands of other players. Now, these types of games fictional characters and control that characters acexist in the US, but its much more popular in tions. The games are characterized by high quality China for a number of reagraphics and immersive enThis is a pretty cheap form of sons, one being that the convironments and usually apentertainment. So if you look at it as a sole market has not yet been peal to hardcore gamers. percentage of total disposable consumer discretionary income, its established in China. This is One of the most popular actually a very small amount. It primarily due to pricing isMMORPGs of all-time is doesnt cost much for someone over there to go out and spend a small sues and piracy concerns, World of Warcraft, which amount of money to get quite a few which we believe will be hours worth of entertainment. The was developed and is operreason why these companies are very difficult to overcome ated here in the US by Acprofitable isnt because of the price points they charge customers, but the any time soon. As such, ontivision Blizzard (ATVI). In scale of the games; the massive line games have become one China, the game is operated amounts of people who they can get to play the games concurrently is what of the most popular forms of by a local company called really drives revenue. entertainment in China as The9 Limited (NCTY). they offer a compelling value Casual games refers proposition and avoid many piracy issues. to a category of games that appeal to the mass market trivia, puzzle, board games, things of that 1-Year Daily Chart of NetEase.com nature. A third category of games has also emerged called advanced casual games, which includes elements of both casual games and MMORPGs. TWST: As you look at this market, how sensitive is it to whats going on in the Chinese economy? Mr. Krejcik: We think so far its been pretty resilient to the issues going on over there and there are a number of reasons why we think thats the case. Number one, this is a pretty cheap form of Chart provided by www.BigCharts.com entertainment. So if you look at it as a percentage of The acronyms for total disposable consumer the industry can be fairly discretionary income, its acIts a safe way to play China. I wont argue that these companies dont face confusing, but basically ontually a very small amount. It company-specific risks, and we line games are divided into doesnt cost much for somementioned that it really comes down to being able to develop and successfully two major categories one over there to go out and launch new games, but from a broader MMORPGs, which stands spend a small amount of macro perspective, these companies offer a great way to play Chinas for massively multiplayer money to get quite a few growing Internet population. online role-playing games, hours worth of entertainand casual games. MMORment. The reason why these PGs or persistent world games consist of a large companies are profitable isnt because of the price number of players interacting with one another in points they charge customers, but the scale of the a virtual world. Players typically take the role of games; the massive amounts of people who they can

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get to play the games concurrently is what really number of Internet users has been growing at a drives revenue. rapid pace in China and now exceeds that of the So from an individUS despite a penetration rate ual customer standpoint, we The key to future growth is updating well below ours. We see no existing games by offering expansion think its a great deal be- packs and developing new games. Right real slowdown in Internet now a lot of the operators are ramping cause its readily available, growth in the next five years. up on their R&D staff in order to a cheap form of entertainNumber two, GDP growth is generate new ideas and develop new games because if you can find ment and can serve as disleading to a rise in the stansomething new that appeals to a large traction from more pressing number of players, then the revenue and dard of living, which should earnings opportunities are huge. issues that may be occurtranslate into to greater levring. So we really have not els of disposable discretionseen much of an economic ary income. This will impact on this industry likely for the reasons eventually lead to higher price points and user mentioned above. spending within online games. So we think the macro trends are pretty favorable, and while you 1-Year Daily Chart of Perfect World could argue that the spending levels may slow down here in the near term depending on how severe this economic downturn is, we believe the longer-term trends are very promising. TWST: Are there any government restrictions that are going to limit what goes on there, given censorship issues and things of that nature? Mr. Krejcik: Yes, absolutely, thats one Chart provided by www.BigCharts.com of the bigger risk areas, and the government gets involved in a number of ways. They require all TWST: What kind of growth do you ex- the game companies over there to hold a number pect to see in the next couple of years? of licenses from different government ministries, Mr. Krejcik: The inwhich can get fairly condustry has been growing at a fusing, but essentially the There are a number of publicly traded companies that have ADRs and are listed pretty staggering rate. I think government has a lot of on the major exchanges here. The companies include Shanda, a pure play the five-year CAGR through control over the industry. online gaming company and one of the 2008 was 60%. Going forAll game content essenlargest in terms of the amount of revenue they generate. NetEase.com is another ward we expect the industry tially needs to be approved company, which in addition to their online to grow at an annual rate of by the government, espegame business, also runs an Internet portal, so they also have some exposure 20%-30%, which is still very cially if it comes from overto the online advertising market. impressive. The two main seas. The government has drivers of the industry are, explicit restrictions in terms one, a growing Internet population and two, an of the amount of violence, sexual content, etc., increase in consumer disposable income. The that is allowed.

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In terms of people actually playing the games, Mr. Krejcik: A lot of it. Our thesis is that there are also regulations on that because its become content is king, and by that I mean, if you can deso widespread and popular. A velop a good game, the revWe like Perfect World. The stock has few years ago the government enue and earnings potential really come under pressure here and its implemented what they call is substantial. What weve actually trading at a significant discount to the peer group, which we an Anti-Fatigue System, noticed is the largest games think is unwarranted. A lot of the selling pressure recently is the result of which limits the amount of in China right now are also external factors and not necessarily time you can spend playing some of the oldest games business fundamentals. games. This was brought and many of them share the about in part because of stosame storyline/concept. Part ries in the media about people actually dying after of the reason for this is, once a game reaches a playing a game for 36 hours straight. certain scale, there is a large appeal to it, because people are playing these games not only for the 1-Year Daily Chart of Shanda purpose of advancing to the next level or gaining certain status, theyre also playing as part of a network and as part of a community to socialize with their friends or meet new people. So once a game reaches a certain user level, it can have a very long life span and will generate a significant amount of cash flow for the company. The key to future growth is updating existing games by offering expansion packs and develChart provided by www.BigCharts.com oping new games. Right now a lot of the operators are ramping up on their R&D staff in order to genTWST: Thats not good. erate new ideas and develop new games because if Mr. Krejcik: No, so they have the Anti- you can find something new that appeals to a large Fatigue System in place now. They also ban mi- number of players, then the revenue and earnings nors, anyone under the age opportunities are huge. of 18, from entering Inter- NetEase is what we consider to be one TWST: Whats the of the more stable operators in China. net cafes. So there are cerrisk in this space? They have a number of legacy games tainly some government that continue to perform and generate a Mr. Krejcik: The restrictions. We havent significant amount of cash flow, as well biggest risk is not gaining as a pretty interesting pipeline of seen anything new as of late any traction with new games games, including some licensed games from Activision Blizzard, which we dont and we dont expect the and or losing players from think will enter the market until 2010. government to impose any existing games. The phrase major restrictions in a time used in the industry is hit when they are really trying to promote businesses or miss, because essentially what you see is that a and economic growth. game either becomes successful and drives increTWST: How much of the growth in this mental earnings and cash flow or the game is unindustry depends upon developing new games? successful, in which case the company has either

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incurred a loss of development dollars creating the game or if they licensed it from an overseas partner, they will unlikely meet those minimum guarantees associated with it. Not to mention, these companies are now spending millions of dollars in marketing new games and expansion packs. So the biggest downside risk comes from the development of a new game that fails to gain traction. Finally, the competitive landscape is fierce; with so many operators offering different games its very difficult to develop a new game that really stands out and can reach a critical user base to drive incremental profits for the company. Even if you have developed one or two hit games, its very difficult to consistently release good and succesful games. TWST: Where is most of the development work being done? Mr. Krejcik: Historically, a lot of the operators in China would license their content from US developers and/or South Korea. South Korea was really the hotspot for the online gaming market and still represents an important market. More recently, the technology and the talent pool in China has improved to the level where they are now beginning to develop a lot more games domestically, and when you can do that, its a lot more favorable in terms of the earnings power because you are not required to pay any ongoing royalties or large upfront license fees. Generally speaking, most operators in China are really making a strong effort to develop more games locally. TWST: In this space, are there going to be any technological changes? Mr. Krejcik: I think youre seeing a gradual improvement in game technology, and it really depends upon which part of China you are referring to. The way we look at it is via different tiers, so you have your tier one and tier two cities that

are considered the most advanced in terms of technological capability and those are your main coastal cities. As you move inland to more rural suburbs, which are considered tier three and tier four cities, the technological capability is not as advanced and so you see lower quality games. So the technology is improving, but from a customer standpoint, it really depends on where you are in China in terms of how technologically advanced the games are. TWST: Are we likely to see the standalone game consoles that have been so successful here develop over there as well and take some of those away? Mr. Krejcik: I dont think so just from the standpoint that this form of entertainment is already established and very popular in China, and Im still not sure how you get around the piracy issues. What youre seeing from the US developers and publishers is they are increasing their exposure in the region by trying to license more content and also partner with local operators. TWST: How do investors play the space? Mr. Krejcik: There are a number of publicly traded companies that have ADRs and are listed on the major exchanges here. The companies include Shanda (SNDA), a pure play online gaming company and one of the largest in terms of the amount of revenue they generate. NetEase.com (NTES) is another company, which in addition to their online game business, also runs an Internet portal, so they also have some exposure to the online advertising market. Some of the newer companies include Perfect World (PWRD), which IPOd in late 2007, and Giant Interactive (GA), which also IPOd in late 2007. TWST: Are you finding any investor interest?

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Mr. Krejcik: I think there is a significant amount of investor interest. Its true that all these companies have been dragged down by the broad market selloff and challenging economic environment. However, when you examine these companies and you look at their balance sheets, they are very appealing in our opinion. So I think there is significant demand and while some investors may be on the sidelines perhaps waiting for this market to reach a bottom, we think when things do turn and sentiment improves, this sector is poised to outperform. Valuations are also very depressed right now in the group; the average multiple now on 2009 numbers is roughly 8 times EPS. They all have a significant amount of cash on their balance sheets, no debt, so for investors trying to avoid companies that are overlevered or possibly face financing issues, this sector also fits that profile. TWST: What are they going to do with the cash? Mr. Krejcik: They do a number of things. Just about every single company has a share repurchase program anywhere in the range of $100 to $300 million. You are seeing some companies paying dividends or a special dividend, and then some are keeping that cash for possible M&A opportunities acquiring local game studios and/or IP from third parties. This is not a very capital-intensive business, so cash can grow very quickly. TWST: So there is some ability to use the cash effectively. Mr. Krejcik: Yes. What weve noticed is a lot of these companies do like to have a pretty sizable cash position on their balance sheet, and I think thats fine, especially in this type of environment. However, if you begin to hoard your cash and never really put it to use, you could argue that youre not going to get much credit for that cash. I think to some extent these companies

have been punished for that in the past; however, I dont think too many investors are complaining about having such a large cash position now. TWST: Whats it going to take to get these stocks moving up again? Is it just a general economic improvement? Mr. Krejcik: I think youre beginning to see some positive news and commentary coming out of China, and I think this a very interesting group of companies and sector to focus on. So once people feel like they have a handle on what the true growth rate in China is going to be and market sentiment begins to improve, I believe you will see a lot more investor interest in this group. We believe this sector offers a much more attractive risk/reward opportunity in the next 12-18 months versus the US video game sector. TWST: And it sounds like a relatively safe way to play China. Mr. Krejcik: Yes. I think its a safe way to play China. I wont argue that these companies dont face company-specific risks, and we mentioned that it really comes down to being able to develop and successfully launch new games, but from a broader macro perspective, these companies offer a great way to play Chinas growing Internet population. TWST: In general, are the management teams pretty good? Mr. Krejcik: Yes. I mean, it depends upon the company, some are better than others, but for the most part I think these are pretty decent management teams. TWST: Who is at the top of your list? Mr. Krejcik: The first of two names that we like right here that we have buy ratings on is NetEase. They are what we consider to be one of the more stable operators in China. They have a number of legacy games that continue to perform and generate a significant amount of cash flow, as

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well as a pretty interesting pipeline of games, including some licensed games from Activision Blizzard, which we dont think will enter the market until 2010, and these games have the potential to really differentiate themselves from some of the existing games that are offered right now. They also have exposure to Chinas online advertising market, a solid management team, a significant amount of cash on their balance sheet, a meaningful share repurchase program and pretty compelling valuation, trading at roughly 10 times our 2009 numbers. The other name we like here is Perfect World, a newer company. The stock has really come under pressure here and its actually trading at a significant discount to the peer group, which we think is unwarranted. A lot of the selling pressure recently is the result of external factors and not necessarily business fundamentals. One of their largest equity holders, a private equity firm called SOFTBANK Asia, has been facing redemptions. They were a 25% owner in the company and have since cut their position in half; given their large ownership, the flood of shares to the market has created significant selling pressure. TWST: Is the selloff done now? Mr. Krejcik: They reported Q4 earnings recently and the stock dropped over 20% on disappoint-

ing first quarter guidance. They guided below our and Street expectations. Since then, however, the stock has rebounded off those lows. We think investors are now looking past a challenging Q1 and toward 2H09, which looks much more promising. We would also note that the company has a pretty significant share buyback program in place, which should also provide support here. TWST: Why the reduced guidance? Mr. Krejcik: It comes down to the performance of one of their games as well as their release schedule. One of their newest games, Pocketpet Journey West, has seen a pretty substantial decline in users this quarter. Additionally, the company has no new game releases until Q2. That said, with the stock trading at nearly a 50% discount to peer group, we think a lot of this is baked into the share price now. TWST: Thank you. (TJM) Note: Opinions and recommendations are as of 3/27/09. ADAM KREJCIK Roth Capital Partners, LLC 24 Corporate Plaza Drive Suite 200 Newport Beach, CA 92660 (949) 720-7187