Shanda Games (fka GAME)

[eastunder]

China Hosts A Virtual Revolution

On Friday May 6, 2011, 2:53 pm EDT

http://finance.yahoo.com/news/China-Hosts-A-Virtual-ibd-3564941566.html?x=0&.v=1

Video game consoles aren't just for kids anymore. The rapidly evolving gaming realm has become a hot topic among investors. China's exploding online gaming market sits atop the white-hot tip of the flame.

China's largest online gaming operator, by revenue, is Tencent Holdings an Internet portal and content provider. It generated an estimated $1.4 billion in gaming revenue last year.

NetEase.com (NASDAQ:NTES - News) was next in line, drawing $749 million in sales from gaming.

Shanda Games (NASDAQ:GAME - News), Perfect World (NASDAQ:PWRD - News) and Changyou (NASDAQ:CYOU - News) filled out the bill.

Among investors, NetEase.com and Sohu.com (NASDAQ:SOHU - News) have been the hot tickets.

The pair has led the advance of the Computer Software Gaming group to the No. 70 slot among IBD's industry rankings on Friday, up from No. 124 at the beginning of the year.

Both companies develop and market games accessed and played online. More traditional game makers, including Electronic Arts (NASDAQ:ERTS - News), Activision Blizzard (NASDAQ:ATVI - News) and Nintendo (OTCPK:NTDOY), produce packaged games that might be played online, but are store-bought and played over dedicated gaming consoles.

Traditionally, those games have required tens of millions of dollars to develop. The big game makers unveil new creations across video store chains, not unlike the gala opening of a blockbuster film.

But enthusiasm for the newer, Web-based online gaming model is quickly expanding beyond Asia, across the industry, disrupting the older business models.

Such PC-based online games, many of which are free to play, are rapidly amassing devotees. The result: Big game developers are zeroing in on fewer packaged releases and focusing on types of games most likely to draw the broadest audiences possible.

And they are stepping up efforts to boost revenue from their online operations. As John Riccitiello, CEO at Electronic Arts, said on his last quarterly earnings conference call, the company's three strategic objectives are to produce "fewer, better, bigger packaged goods games," boost online sales and control costs.

1. Business

At about $60 per game, the bulk of industry revenue still comes from packaged goods. Groups of buyers can play those games online, but must use consoles like the Microsoft Xbox and Sony PlayStation.

Companies like Sohu, NetEase and Shanda offer online games that are free to play on PCs and handheld units. They earn revenue through advertising and from users who pay fees to upgrade their weapons or acquire new territories to explore. While free online games generate less revenue than packaged products, they often bring higher profits. Some of the games have a pay-to-play model, though the trend is moving to free-to-play.

"The packaged-good companies are struggling with that," said David Cole, an analyst at DFC Intelligence, a market research firm. "Gamers are rapidly adopting the virtual item model, where they purchase individual digital components such as virtual currency, items or characters."

The rise of free-to-play online games dragged game-industry revenue down in 2009 and 2010 vs. the peak in 2008, said Cole.

"The free-to-play model is where the disruption is occurring," he said. "It's been the strongest in terms of steady growth but in the short term, they provide less revenue."

• Name of the game: Games companies need to be lean, mean, flexible and creative to maneuver through a changing landscape that is disrupting older business models.

2. Market

The free-to-play trend is nicking industry revenue, but expanding the overall market. That's especially true in foreign markets, where many can't afford a game console, but already have a personal computer.

"The audience for gaming has increased from niche to mass market," said Billy Pidgeon, an analyst with M2 Research.

Social networking sites like Facebook are accelerating that trend. An estimated 290 million Facebook users now play games like "Mafia Wars," "Pet Society" and "FarmVille" an average of three-and-a-half hours per month. The channel has pulled in demographics who wouldn't otherwise touch a game console.

Social networks are performing similar assists in China through up-and-coming plays like the recent IPO Renren (NYSE:RENN - News) as well as industry leaders like Tencent, which is rapidly plumping its social networking offerings.

Nintendo's easy-to-use Wii, introduced in November 2006, also pulled a nontraditional demographic into the gaming fold.

The Wii console includes simple-to-play games like bowling and tennis, as well as games designed to help people exercise. That reached further into a mainstream audience, and generated sales of more than 86 million Wii consoles.

"All of this has had a huge impact on drawing in more players and fueled the expansion," said Pidgeon.

The online game model has also revived the pulse of the PC sector, where software sales had been in decline.

"Companies are finding new revenue streams for PC gaming," said Pidgeon.

The difference between the market for console-based games and more casual free games is volume. It can take hundreds of casual games to match the revenue of one major hit retail product.

The PC-based online market is biggest in Asia and is projected to grow 32% from 2010 to 2014 to $15 billion, according to DFC.

The industry is also getting a lift from games played on smartphones, a small but fast-growing sector.

3. Climate

Games played on social networking sites are now about a billion-dollar market. Revenue from games played on smartphones is less, but growing fast thanks to Apple (NASDAQ:AAPL - News) with its iTunes distribution platform.

"Apple opened up the floodgates of game applications and other companies are following suit," said Michael Cai, an analyst at research firm Interpret.

Price tags for games on iTunes range from $1 to about $10 each. That attracts a lot of users.

"There are some people who have never played a game before and hear about 'Angry Birds' and pay the $1 to get it," said Cai. "Core gamers are getting in on it as well."

"Angry Birds," by Finland-based Rovio Mobile, cost about $400,000 to develop and has been downloaded 140 million times, he said, and was the No. 1 selling game for both iPhone and iPad in 2010. Rovio has also introduced a line of "Angry Birds" toys and has a movie in the works.

"Five years ago video games were seen as a market for young men," said Cai. "That has finally changed and people understand this is a mass-media market."

4. Technology

It has been several years since the Xbox and PlayStation upgraded to more powerful systems. But both continually expand via the introduction of peripheral devices.

One recent innovation in the sector is Microsoft's Kinect, an external motion detector that connects to the Xbox.

The device includes cameras and software that allow game players to control on-screen action with their body movements and voice commands.

Unlike the Wii, they don't need controllers. More than 10 million units have sold at $150 each since its debut.

"The Kinect has been extremely successful, like Wii," said Cole. "But there is still a question as to if it is a novelty or will it have a viable business model. That is an issue the industry is still struggling with."

Sony had previously introduced its own controller-free motion detection device called Move, which sells for $99.

Nintendo also recently launched its 3DS system, a glasses-free, 3D portable gaming system. Nintendo and game publishers are hoping it will revitalize the portable gaming segment, which has seen business shift to smartphones and tablets. The 3DS is the next-generation version of the company's popular dual-screen DS handheld gaming device, first launched in 2004. The system retails for $250.

5. Outlook:

New platforms, new markets and new business models are shaking up the existing power structure, as the market for packaged goods has become less profitable, said Cole. Established players are underserving many of the growing niches, though they are moving in that direction. Consumer spending is growing, but is increasingly spread out among many niche markets.

• Upside: Overall, the market will show fairly steady growth and there is a lot of potential in emerging markets, said Cole. "You'll still have blockbuster games and then all these little niches, but they're not easy to understand."

• Risks: Databases cataloging information for millions of online users lure hackers who like to phish in large schools. The recent attack by a yet-unknown group on Sony's (NYSE:SNE - News) PlayStation network gleaned names, email addresses and possibly credit-card information from a reported 100 million user accounts.

The breach straightened the gaming heavyweight's defensive posture and sent a warning to other providers of online games to crank up security on their networks.