Although the Chinese economy is no longer growing at double digits, there are still many Chinese companies worth investing in. I would like to present to you ChangYou.com, a great emerging market gaming company in China to invest in right now. Listed in the United States, it can potentially give long-term investors double digit percentage returns. The stock has suffered from a massive sell-off due to downgrades in many analyst reports, and I will argue that it should be a buy through qualitative and quantitative analysis.
Business Overview
ChangYou.com (NASDAQ: CYOU) is the leading developer and operator in the online gaming segment of Mainland China. It is a subsidiary of Sohu.com (an internet giant in China). CYOU owns 7Road.com (game developer), 17173.com (gaming forum), and a recently acquired company called Raidcall (a free social communication platform).
The games that they develop and operate are split into 3 segments:
-MMORPG (Massively Multiplayer Online Role-Playing Games)
-Web-Based Games
-Mobile Games
In essence, the revenue model of CYOU is very simple. CYOU designs, develops, and operates games for free to give the games more exposure to the general population. There are virtual in-game credits these gamers can purchase with real money in online stores: these payments represent the majority of CYOU's revenue. In-game credits can allow players to do actions such as purchasing a "better weapon" in the game or letting players change into different costumes. Regardless of what these gamers choose to do, the virtual credits allow a customizable gaming experience and enhance gameplay.
Other stream of revenue comes from advertisements.
Investment Thesis
Due to the latest earnings miss and forecasted margin compression, CYOU has taken an unjustified dip in its stock price. With an excellent selection of games, sustainable competitive advantage with its relationship with Sohu, and a great free cash flow that could potentially lead to special dividends or other incentives that benefit shareholders, CYOU is fundamentally undervalued with a great potential for upside.
Internal & External Analysis
Category of Games:
The games CYOU develop and operate can be separated into 3 categories:
-MMORPGs
-Web-Based Games
-Mobile Games
MMORPGS stands for Massively Multiplayer Online Role-Playing Games. It is a genre of games that allows a large amount of players to interact with one another within a virtual game world. One example of a game from this genre operated by CYOU would be "TLBB" (Tian Long Ba Bu), one of the most popular games in China involving 3D martial arts adopted from a famous Chinese novel. In this game, the gameplay allows users to have several occupations, hundreds of skills, and countless missions to get through. There had been 25 major expansion packs, and the latest major expansion had been released October 28th.
Web-based games consist of single or small multiplayer games that are not too complex and players can play directly without installation. These are targeted towards casual gamers that are looking for a simple gaming experience and do not intend to spend much time/money in games. An example of a game in this category would be "DDTank", created by CYOU's subsidiary, 7Road. This game is competitive and addictive, featuring thousands of costumes and accessories. It was released in 19 languages and it has won the title of "Baidu Outstanding Web Game".
Mobile games will be more significant to CYOU in the near future - currently, their revenue does not depend much on it. As gaming companies enter into the mobile gaming segment in China, CYOU has been keeping up by continuously developing this segment and it currently has a couple upcoming mobile games in its pipeline. One example of a mobile game from CYOU would be "Wartune". It is a successful PC game that earned the title of "Most Anticipated Game" prior to launch and "Baidu Outstanding Web Game".
One of the reasons why CYOU has been so successful in attracting new players and retaining old ones is not only just the quality of gameplay - "network effect" had a significant impact as well. To make things simplified, "network effect" indicates you will be more likely to play a game if many of your friends do. This effect snowballs significantly into a large population of CYOU gaming regulars over time. In many cases, gamers are a lot likely to socialize over games than to grab coffee nearby and catch up. Retention of gamers at CYOU is comparable to Facebook users' "stickiness factor" - gamers are more likely to be attracted to the games if their friends are already playing with each other. The stickiness factor has enabled CYOU to monetize on these games because the gamers are engaged with the games, meaning they are more likely to pay for a game that they visit/play often.
CYOU demonstrates a strong performance and growth in the segments that they operate in. With 37-39 million monthly active users for its games, CYOU attracts more people playing their games than the entire population of Canada.
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As seen from the graphs above, CYOU's paying user accounts and their sales/net income have increased significantly over the past 5 years. The net income margins have expanded from around 6% in 2008 to around 27% in the past 2 years. This indicates the economies of scale that CYOU has been able to successfully achieve. As CYOU increases one more paying gamer, it is able to retain much of those sales as the variable cost from one more paying account added becomes more insignificant.
17173.com:
This website is the "go-to gaming forum" for Chinese gamers. It is essentially CollegeConfidential to high school students looking for American college information. CYOU generates advertising revenue from this website and it has the potential to drive traffic to games. Although this is not the core business of CYOU, it certainly is a great compliment to their existing business as it allows CYOU to gain critical feedback on games and understand gamers through statistical collection. In any event, CYOU can monitor the general sentiment of the gaming population and this will enable them to better adapt to any potential changes to gamers' preference of games.
User Growth and Retention Strategy:
CYOU effectively uses feedback to improve the gaming experience of its users. This is done through the utilization of surveys, customer service, feedback, and 17173.com.
The product development team is more than just dedicated. There are new game updates every 1-2 weeks and major expansions released every few months for the existing games. Through this, CYOU is able to increase player interest and enhance the overall gaming experience. In addition, the management team has worked together cohesively for the past 7 years. Even through the world recession (mortgage crisis) and the implementation of stricter policies from the Chinese government on gaming, they have been an excellent team that navigated CYOU to grow its revenue 270% from 2008 to 2012. It would be safe to say that going forward, the management team will continue to steer CYOU in the right direction.
Q3 and Future Direction:
Poor performance in Q3 has depressed CYOU's stock price significantly. Here are some of the reasons why:
-Monthly active users down significantly for the quarter
This is mainly due to the result of a lack of updates over the quarter, especially for "TLBB". Nonetheless, this should only be a one-time event due to the release of a massive update on "TLBB" in late October. The product development team has worked extensively on the "TLBB" update and it is part of the reason why there has been a lack of updates last quarter. In the DCF Valuation, the number of monthly active paying users for existing games including "TLBB" are inputted to decrease and the upside is still attractive afterwards.
-Weak forward guidance, compressed EBIT margins (leading to downgrade in many analyst reports)
Along with the drop in monthly active users, investors were overreacting to the management's indications of a lower margin in the upcoming quarters due to a massive marketing campaign to advertise for the 9 new games that will be released into the public throughout 2014. As a result, many analysts downgraded CYOU from their existing positions and that fueled the dip in the stock price. Nonetheless, for long-term investors, the investment that CYOU is making into the marketing of the 9 new games benefits the CYOU shareholders in the long run. If CYOU doesn't see the marketing expenses capitalize, management has already indicated in the call transcript that they will stop this massive marketing expense, making the EBIT margins return to normal state. On the other end, if CYOU is able to successfully market the new games in their pipeline, then over the long run they will be able to capitalize on the returns.
-"TLBB" decline
Although "TLBB" is still a very popular game among the gamers with new updates/expansions being released on a regular basis, games do get old and players may get sick of the game one day. As a result, the network effect for certain games will be eventually washed away with time. That being said, in the DCF valuation, "TLBB" is expected to decline in the upcoming years and it has been taken into consideration in the model.
Despite these negative outlook by the analysts, there are some positive things to look forward to. First of all, CYOU has released a relatively new MMO game called "Dou Po Cang Qiong". Although it has only been in the market for less than a year, it already has material impact on CYOU's revenue. In addition, advertisement revenue is growing significantly at a CAGR of 27%. This growth rate has been even higher for revenue as well as users. Furthermore, CYOU still has an excellent brand reputation, which drives users to the new games that they release. Their relationship with Sohu allow them to have access to Sohu's 290 million registered users' portal, which represents a huge user base that CYOU still have an opportunity to capitalize on.
Economic Factors:
Let's take a look at the economic environment that CYOU operates in, which is largely dependent on Mainland China. China has an enormous internet user base and a very fast growing gaming population. Continuous development in infrastructure and growth in the living standards has allowed more and more Chinese access to internet. This will enable more people from the rural areas to play games that are operated by CYOU.
In order to play CYOU's web games, a PC is needed. Contrary to the rest of the world - where PC demand is dropping due to smartphones and tablets - the Chinese PC demand is still expected to grow at a rate of 3-4%. Much of this growth will be driven by an increasing number of people in the rural areas being able to afford PCs and have internet installed in their homes.
Additionally, although mobile gaming is quite a mature industry in Western countries, it is less so for China. CYOU has many mobile games in their pipeline and they are trying to fully utilize this somewhat unexplored market to help them further capitalize on the user base.
Valuation:
Comparable Analysis:
When selecting the universe of companies to compare with CYOU, I have narrowed down the list by geographical location and the category of games these companies make to MMOs. The geographical location of these companies mainly locate in China. Additionally, these companies have been broken down into pure play companies and broad companies. Pure play are more associated with MMORPGs or related, while broader companies refer to companies that are involved with gaming but their business isn't solely dependent on gaming (i.e. Tencent). There are some statistics that I haven't been able to obtain such as LTM EV/EBITDA for the broader companies - as a result a few metrics may have an abnormally high average. All of the statistics are as of December 21st, 2013. Taking a look at the comps table, in all EV/EBITDA, P/E, and EV/Sales, CYOU is evidently undervalued by the market for reasons that I have already mentioned. Fundamentally speaking, the company's core business model have not changed. Nonetheless, the market is pricing CYOU significantly below its peers - this represents a possible entry for long term investors that are not concerned with the short-term fluctuation of the stock price.
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Discounted Cash Flow Analysis (DCF):
Although comparable analysis tells us that CYOU is undervalued among peers, there is still a possibility that their peers are simply overvalued as a whole. Therefore, we must perform a DCF analysis in order to see if CYOU is fairly valued. A discounted cash flow analysis takes the present value of the total free cash flow that CYOU can generate in the future and discount it by the cost of capital; this will give us a ballpark of what the intrinsic value of CYOU is approximately at especially after we take a look at the sensitivity tables.
To break down just how much revenue will impact CYOU, I have created a revenue schedule. In short, the schedule is broken down into revenue that is generated from CYOU's existing games (with continuous upgrades and major expansions) and revenue that is expected to be generated from CYOU's new games. These have been further broken down into the number of paying users from existing games/new games and the average revenue per user.
The average number of users from the existing games are expected to decrease, even with continuous support of updates and major expansions from the production team. Games such as "TLBB" and "Wartune" are likely to face such situation in the future, and I have taken that into consideration in the DCF revenue schedule. The percentage decrease in the number of paying users for the existing games have been decreasing over the years at rates that range from 5-10% depending on years. Additionally, average revenue per user for the existing games are expected to increase. This should be logical given the declining number of users - with less number of paying users, the more loyal paying users (also the ones that pay the most for the game) will have more proportion in the total amount of sales that CYOU generate from users.
On top of the revenue generated from new games and old games, advertisement revenue is expected to increase at around 12-14%.
After creating the revenue schedule, it is time to calculate the unlevered free cash flow. Although depreciation, working capital, and debt paydown schedules could have been constructed to attempt for a more accurate estimate, for the sake of simplicity, I decided to take the shortcut (still gives a good ballpark). Additionally, for the year of 2013, I did not calendarize each quarter.
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At a WACC (Cost of Capital) of 12.1%, CYOU's base case indicated an implied upside of 58.4%. WACC was calculated by taking the CoE and adding it to the synthesized CoD. The CoD method needed to be changed as I couldn't obtain the latest information about CYOU's debt. Instead, I used NYU professor Aswath Damodaran's method. You can search for the method on his online website.
Although this figure is good, what happens if some scenarios change? The true value of a DCF lays in the sensitivity table and below you can see how the implied upside varies with changes in WACC and the exit multiple.
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Looking the different scenarios, we can see that the implied upside ranges from 34.9% to 85.5% varying different exit multiples and WACC. Since the base case is already relatively conservative, it is safe to say that this stock will give investors a great margin of safety and provide excellent cushion to risk - that is not to mention their previous dividend was 13%.
In addition, a bear case scenario has been constructed to see how bad the stock price can really get without changing the fundamentals of the business. The worst case scenario has been inputted into the model and the implied share price still gave a decent 14% return.
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Here is the calculation of the implied return in the bear case scenario:
Here is the sensitivity being performed varying different WACC and exit multiple:
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As we can see, even with the bear case scenario, the implied return is at worst a loss of 2.8% with a much bigger opportunity for greater upside.
In conclusion of valuation, CYOU is significantly undervalued compared to its peers through the comparable analysis and DCF analysis. Its intrinsic value in the base case scenario indicates 58.4% implied upside with little downside.
Risks:
-Rising labour and marketing expenses, causing long-term margin compression
As mentioned before, CYOU is expected to face compressed margins mainly due to large spending on marketing for the near future in order to increase the publicity of their upcoming pipeline of games. If management has already indicated that if they don't see the marketing expenses capitalizing (i.e. directly generating more sales or number of users), they will stop this expense and the margins should return to its previous level. This is not to mention that these marketing expenses could potentially make one of their upcoming games popular. Regardless of what happens, I have already included margin compression into the DCF model throughout the projection period and it still shows decent upsides - a great sign for margin of safety.
-Dependent on a few games such as "TLBB", "DDTank", and "Wartune"
The reason why CYOU has been able to increase its revenue substantially over the years is because of these major games that hit homerun. Over a long period of time, people do get tired of older games and want to change to new ones. Although CYOU face these problems just as many gaming companies in the industry do, CYOU has an excellent brand name and a loyal fan base that they have generated over the years of consistently delivering games/updates with quality. Their 17173.com website will help them monitor the latest trends and general sentiment of games through regulation and statistical collection. Although it is impossible to forecast the future, with the management's direction, the expertise of the product development team, and the special relationship with Sohu, I strongly believe that CYOU can continue to develop major games that will add substantially to their top line. Worst comes worst, the scenario of a declining number of paying users for the old games and an event of new games being unpopular has already been taken into account from the base case of the DCF for the sake of being conservative - it still gave a sizable return.
-New games become unsuccessful/old games become unpopular
Although there will be games that become an utter failure and there will be those that become popular, CYOU does have the possibility of having unsuccessful new game launches. Like I have mentioned previously, it has already been taken into account for the DCF model even if it wasn't successful. It would take some unusual circumstance to really significantly decrease CYOU's popularity among gamers.
Catalysts:
-Margin expansion after cyclical marketing expenses return to normal
Regardless of how the marketing efforts turn out for CYOU, margins should be able to return to the past as CYOU is currently facing a phase where a lot of their games are just waiting to be released. In order to increase publicity of the games, CYOU has decided to throw cash into the marketing department. After the release of these games and into the future, we can expect the margins to return to normality. This is not to mention if these marketing expenses do make a couple games popular, CYOU's revenue will be added significantly. Long term investors should really take note of this point as CYOU's compressed margins should only be temporary.
-Cash pile rewarded to shareholders
Even after the recent acquisition of Raidcall, CYOU still has a ton of cash, in which they can rightfully reward the shareholders a special dividend, declare additional stock buyback, or reinvest this cash into the business to grow and over time stock price will appreciate. Take note that the latest cash dividend was a staggering 13% of the share price.
-Capture of mobile gaming
I have already mentioned before, and I will mention again: CYOU still has a lot of room for growth in the mobile gaming segment as the Chinese mobile gaming industry is not as mature as the West. Their margins will not be affected as virtual currencies are the same price on a PC or a mobile.
In conclusion, CYOU is significantly undervalued especially after the recent dip in stock price due to a massive sell-off caused by short-term margin compression. With a weaker forward guidance, many sell-side analysts downgraded the stock and investors have been bearish on CYOU's future outlook. Nonetheless, through qualitative analysis, comparable analysis, and a DCF model (implied upside of 58.4% base case scenario), there is no doubt that CYOU has the ability to continue to prosper going forward and long-term investors should take this opportunity and capitalize on the intrinsic value of the stock.
Disclosure: I am long CYOU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. (More...)
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