We have seen some interesting research on the highly under-followed online gaming sector in China from the research team at Auriga.  Some of the trends will be very disturbing for growth investors who chase 8% and 10% GDP just because “it is China.”  Companies such as Giant Interactive Group, Inc. (NYSE: GA), Netease.com Inc. (NASDAQ: NTES), Perfect World Co., Ltd. (NASDAQ: PWRD), Shanda Games Limited (NASDAQ: GAME), Shanda Interactive Entertainment Ltd. (NASDAQ: SNDA), and Changyou.com Limited (NASDAQ: CYOU) all hang in the balance.

Auriga noted that the investable stocks are those with a content advantage, such as Neatease.com with a Buy rating, Perfect World with a Hold rating, and Shanda Games Ltd. with a Buy rating. The caveat on Shanda Games is that its pipeline has to work out.

The research team noted, “We believe the recent weakness in the business performance of China’s online game companies is more an industry trend rather than an individual company’s story. Based on our research, we believe China’s online game industry is undergoing a fundamental change – a transition from one of early stage, fast-paced growth to a more mature market.”

The first factor is that gamers are becoming more sophisticated and they no longer just play any game on the market.  The second reason is that disadvantages are showing up in the item-based revenue model, shortening the lifecycle of a game.

A good example was Giant Interactive’s game, Giant Online and version of ZT recycle, which has a good amount of the original content, so there could be longer times needed to develop new content for a game. One other case is Perfect World with the strongest in-house R&D company, where the average development time has increased to 12-24 months from 6-9 months.

This item-based model may be falling off the cliff… Auriga notes that China’s game operators have experimented with both item-based and time-based revenue models, with the item-based model appearing to gain traction. However, recent weaker than expected performance and guidance among all China online game companies (PWRD, NTES, CYOU, GA, and even GAME/SNDA) point to the negative side of this model.  The notion is that the item-based model is a trade-off between time and money, making developers have to develop games faster and more often.

Then there is the new bear market taking place now in both speculative and normal stocks, which is being magnified in the speculative Chinese stocks.

Giant Interactive Group, Inc. (NYSE: GA) is actually up marginally on the day at $7.12, but the 52-week range is $6.24 to $9.57.

Netease.com Inc. (NASDAQ: NTES) is off by 4% and the $28.62 price compares to a 52-week range of $26.16 to $48.50.

Perfect World Co., Ltd. (NASDAQ: PWRD) is down 0.6% at $25.28, and its 52-week range is $18.37 to $50.49.

Shanda Games Limited (NASDAQ: GAME) is down almost 4% at $5.47 and its 52-week range is $5.25 to $13.00.

Shanda Interactive Entertainment Ltd. (NASDAQ: SNDA) is down 1% at $39.65 and its 52-week range is $38.07 to $65.00.

Changyou.com Limited (NASDAQ: CYOU) was a hot IPO that fizzled.  Its stock is down over 4% at $26.33, but the 52-week range is $26.41 to $48.37.

Tough times are abound.  As we have seen in the United States, video games were thought to be recession-proof.  That turned out to not be the case.

JON C. OGG

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