The Valuentum analyst team talks about the Chinese gaming industry and the financials of Tencent (TCEHY) and Netease (NTES), in particular. Both generate strong free cash flow and have solid balance sheets, but there are myriad risks to consider, too. ~5 mins.
Podcast no longer available. Transcript as follows.
Chris Araos:
Welcome to Valuentum’s podcast. This is Christopher Araos, and joining us today is Brian Nelson and Kris Rosemann. Today, we’re going to talk about the MMORPG landscape in China. Brian?
Brian Nelson, CFA:
Thanks for that Chris. I think just to give a little bit of background MMORPG stands for massively multiplayer online role-playing (PC-client) games. Wow, that’s a mouthful. These are very, very popular games across the globe but particularly in China (FXI).
One of the reasons why these are so popular just has to do with the absolute size of China’s population — 1.3-1.4 billion people — roughly half of them online or with Internet access, and the number of people coming online (in China) continues to increase over time, so the backdrop for these MMORPG entities is very, very strong, and two of the companies that I think probably have the largest presence in this arena are Tencent (TCEHY) and Netease (NTES), and these (two) companies are rather solid entities.
They generate significant amounts of free cash flow. They have relatively strong balance sheets, but they do have some risks. I think for Netease probably more so than Tencent, but Netease, for example, has roughly three-quarters of its revenue driven by just a handful of games like New Westward Journey Online, Fantasy Westward Journey and just a handful of others, but there are other risks, too.
Wouldn’t you say, Mr. Araos — with respect to Netease in particular but maybe more broadly across the group?
Chris:
Yes, because due the fact that these companies are required to license the games from abroad, specifically from Activision Blizzard (ATVI).
Going back to 2009, we have The9 (NCTY), which lost the Activision Blizzard licenses…
Brian:
I think they (The9) had the exclusive agreement for World of Warcraft [beginning in] 2005, and they didn’t get it renewed where that license actually went to…
Chris:
Netease.
Brian:
Netease.
So, here you have a situation this business where the fate of a company like The9, ticker symbol NCTY, was in the hands of Activision, and interestingly enough, there’s really nothing to guarantee that Activision is going to stick with Netease (over the long haul) either.
[Activision Blizzard renewed its license with Netease through 2020 in September 2016.]
So there’s not only the concentration risk for the titles that are propelling the revenue behind these companies but the fact that at any particular instance (when licenses come up for renewal) that they could lose a very valuable franchise.
Kris Rosemann:
There’s a bit of a different dynamic going on with Tencent because, as many people know. Tencent has a lot of business with social networking and messaging products as well.
So even though their gaming business is growing at a rapid pace, and there are many of those risks you alluded to — they license many popular games such as Call of Duty, FIFA for the online version of those games in China.
But for example, their (Tencent’s) smartphone gaming business only accounts for about 20% of their total revenue, and we expect that to grow in coming years, but that just gives you a little bit of an idea as to what other things they have their hands in that could buoy their performance should one of those licensing agreements be hurt.
Brian:
I think Tencent tends to be much more diverse in terms of it having social media platforms and its hands in a variety of other things, and when we look at Tencent’s financials–and while Netease’s financials are also very strong, revealing the tailwinds of secular growth in China…
Tencent’s are phenomenal, to put it bluntly — we look at free cash flow over the past several years from 2011 to 2015, or even the trailing three quarters of 2016, it has advanced almost six-fold while the company retains a very strong net cash position and very modest leverage from a total debt-to-adjusted-EBITDA basis.
So while there is some degree of execution, operational risk, concentration risk, from a financial standpoint, these (two) companies tend to be relatively strong, which is very encouraging, especially given some of the market dynamics of operating in China specifically.
Chris:
Thank you for your thoughts, Brian. This is Christopher Araos with Brian Nelson and Kris Rosemann for Valuentum Securities. Thank you for joining us today.
Tickerized for a number of China-based equities trading on the NASDAQ.