CHANGYOU.COM LTD CYOU
January 20, 2016 - 5:44pm EST by
rc197906
2016 2017
Price: 19.00 EPS 0 0
Shares Out. (in M): 52 P/E 0 0
Market Cap (in $M): 1,000 P/FCF 0 0
Net Debt (in $M): 350 EBIT 0 0
TEV ($): 690 TEV/EBIT 0 0

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  • China
  • Gaming
  • Computer Games
  • Online gaming
  • Spin-Off
 

Description

CYOU is one of the leading online game developers and operators in China, with a focus on developing and operating multi-person online roleplaying games (MMOG).  CYOU was a business unit operating the MMOG business within the Sohu Group and spun-off in 2007 into an indirect wholly-owned subsidiary of Sohu and subsequently listed as an ADR in 2009. 

 

Online gaming business which represents over 80% of revenues is based off of MMOGs, web games, and mobile games and operate under the item-based revenue model, where players usually play games for free but pay for virtual items.  CYOU also owns and operates an online game portal which generates ~8% of advertising revenues. 

 

The stock has dropped from its high of $40 in 2013 to $18 today.  Main headwind the company has faced has been the aggressive investment program embarked by former CEO to diversify the company away from its single most important MMOG game, Tian Long Ba Bu (TLBB), which generates ~65% of the company’s total revenues, as well as a step-up in promotions in new games and mobile products. COGS which is composed primarily of game development costs increased from 17% of revenues in 2012 to ~27% in 2014 while operating expenses grew from 27% of revenue in 2012 to 80% in 2014.  As a result, gross margin declined from above 83% to 73% while operating profit went from close to 60% in 2012 to negative in 2014. 

 

After the disappointing results, CEO stepped down at the end of 2014 and CFO and president of the company took co-CEO roles. Since new management appointment, an increased discipline on cost control has been implemented and spending has been tied to the performance of mobile games (more budget allocated for marketing if the game performs well and vice versa) and company will scale up R&D efforts without further headcount increases.  As a result, COGS are expected to go down from ~27% in 2014 to ~20% in 2015 and SG&A will go down from ~80% to ~50% in 2015. 

 

While there is still a lot of work remaining to do on rightsizing the expense side, the balance sheet and cash-cow legacy game portfolio provides significant downside protection. Net cash on the balance sheet is at ~$350MM today, making up 30% of the market cap.  Company bought a 14,950 sqm office building in August 2009 for $33MM and then entered into a $171MM contract to purchase and develop 56,549 sqm headquarters in 2010.  Since 2009, commercial property in Beijing has gone up significantly; as such, the current buildings are worth a lot more than the initial purchase price.  Assuming $350MM of real estate value, that’s another 30% of market cap, which leaves with the entire gaming and advertising business worth $300MM. Another source of hidden value is the 17173 web portal catered to gamers in China. Advertising revenue tied to this platform has almost doubled in 4 years to ~$60MM.  Given the growth embedded in this platform and minimal costs to maintain this portal, one could see this valued at least for ~$200MM.  

 

As a result, its gaming portfolio is only valued at $100MM.  While its game portfolio is highly concentrated on TLBB, TLBB still generates $500MM in revenue (CYOU is expected to generate $100-$130MM of operating profit in the next couple of years).  Although TLBB has been in the market for ~8 years, very successful games in China have been in the market for over 13+ years and continue to be strong.  CYOU’s development team has been successful in developing additional expansion packs to maintain user interest in the game. CYOU gives away virtual items to retain casual gamers (this maintains the game’s ecosystem and retains critical mass which is essential for MMOG lifecycles) and directs its monetization efforts to more loyal gamers. As a result, paying accounts have dropped from peak of 2.4mn in 2010 to ~1.2mn over the last 3 years (part of the drop also includes closing of fraudulent accounts).  Quarterly average revenue per active account has grown sharply from ~200 RMB in 2011 to $600 RMB today.   

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Balance sheet and cash-cow legacy game portfolio provides significant downside protection

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    Description

    CYOU is one of the leading online game developers and operators in China, with a focus on developing and operating multi-person online roleplaying games (MMOG).  CYOU was a business unit operating the MMOG business within the Sohu Group and spun-off in 2007 into an indirect wholly-owned subsidiary of Sohu and subsequently listed as an ADR in 2009. 

     

    Online gaming business which represents over 80% of revenues is based off of MMOGs, web games, and mobile games and operate under the item-based revenue model, where players usually play games for free but pay for virtual items.  CYOU also owns and operates an online game portal which generates ~8% of advertising revenues. 

     

    The stock has dropped from its high of $40 in 2013 to $18 today.  Main headwind the company has faced has been the aggressive investment program embarked by former CEO to diversify the company away from its single most important MMOG game, Tian Long Ba Bu (TLBB), which generates ~65% of the company’s total revenues, as well as a step-up in promotions in new games and mobile products. COGS which is composed primarily of game development costs increased from 17% of revenues in 2012 to ~27% in 2014 while operating expenses grew from 27% of revenue in 2012 to 80% in 2014.  As a result, gross margin declined from above 83% to 73% while operating profit went from close to 60% in 2012 to negative in 2014. 

     

    After the disappointing results, CEO stepped down at the end of 2014 and CFO and president of the company took co-CEO roles. Since new management appointment, an increased discipline on cost control has been implemented and spending has been tied to the performance of mobile games (more budget allocated for marketing if the game performs well and vice versa) and company will scale up R&D efforts without further headcount increases.  As a result, COGS are expected to go down from ~27% in 2014 to ~20% in 2015 and SG&A will go down from ~80% to ~50% in 2015. 

     

    While there is still a lot of work remaining to do on rightsizing the expense side, the balance sheet and cash-cow legacy game portfolio provides significant downside protection. Net cash on the balance sheet is at ~$350MM today, making up 30% of the market cap.  Company bought a 14,950 sqm office building in August 2009 for $33MM and then entered into a $171MM contract to purchase and develop 56,549 sqm headquarters in 2010.  Since 2009, commercial property in Beijing has gone up significantly; as such, the current buildings are worth a lot more than the initial purchase price.  Assuming $350MM of real estate value, that’s another 30% of market cap, which leaves with the entire gaming and advertising business worth $300MM. Another source of hidden value is the 17173 web portal catered to gamers in China. Advertising revenue tied to this platform has almost doubled in 4 years to ~$60MM.  Given the growth embedded in this platform and minimal costs to maintain this portal, one could see this valued at least for ~$200MM.  

     

    As a result, its gaming portfolio is only valued at $100MM.  While its game portfolio is highly concentrated on TLBB, TLBB still generates $500MM in revenue (CYOU is expected to generate $100-$130MM of operating profit in the next couple of years).  Although TLBB has been in the market for ~8 years, very successful games in China have been in the market for over 13+ years and continue to be strong.  CYOU’s development team has been successful in developing additional expansion packs to maintain user interest in the game. CYOU gives away virtual items to retain casual gamers (this maintains the game’s ecosystem and retains critical mass which is essential for MMOG lifecycles) and directs its monetization efforts to more loyal gamers. As a result, paying accounts have dropped from peak of 2.4mn in 2010 to ~1.2mn over the last 3 years (part of the drop also includes closing of fraudulent accounts).  Quarterly average revenue per active account has grown sharply from ~200 RMB in 2011 to $600 RMB today.   

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    Balance sheet and cash-cow legacy game portfolio provides significant downside protection

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