INTRODUCTION MARKET OVERVIEW

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1 CHINESE ONLINE GAMING 216 Essex Street, Salem, MA (978) (800) 888-MGMT Nearly 100 million people in China are playing online games. These users spent about $6b (USD) last year. A pretty impressive start to a market, and yet it only works out to about $5 per gamer, per month. In our view, that leaves plenty of room for growth. Written by: Craig Goryl, CFA Equity Analyst INTRODUCTION Many people would be surprised to learn that China has the largest online video game market in China is the largest in the world. In fact, it represents one-third of the entire global online video game market. A young, connected, and giant population has made China a leader in this space. China s gamers bypassed the consoles (like Playstation, Xbox, and Nintendo) that still dominate US gaming. Instead, the Chinese gaming market developed as PCcentric and online, and more recently has branched into more mobile games. Online games, which generate revenue through hourly fees or by selling virtual goods, can t be victimized by software copying - in fact, more copies help the business. That is a key feature in a country where piracy of shrinkwrapped software is rampant. MARKET OVERVIEW We ll start at the top, with the number of Chinese internet users (only a subset of whom play online games). There are about 550 million Chinese who use the internet (some 90% use broadband). For comparison s sake, the entire population of the US is only about 320 million. And yet, two-thirds of Chinese citizens are not yet online. Cabot Money Management, Inc. Page 1

2 Out of those online, about 15% are considered gamers. This percentage has been declining slightly over time in other words, perhaps 10% -13% of NEW internet users in China become gamers. Why? Likely this is a result of demographics- many new users are older, or perhaps female, and less like to play games. Those people most likely to play games were early internet adopters. Nearly 100 million people in China are playing online games. These users spent about $6b (USD) last year. A pretty impressive start to a market, and yet it only works out to about $5 per gamer, per month. In our view, that leaves plenty of room for growth. There are some cultural differences that make this market attractive. Compared to the US, Chinese media consumption is much more heavily skewed toward the internet (both video and non-video) and mobile. The Chinese spend far less time watching TV than Americans. Cabot Money Management, Inc. Page 2

3 WHAT ARE THEY PLAYING? TWO MARKETS At the core of the online gaming market in China are Massively Multiplayer Online Roll Playing Games, acronym MMORPG. These games have been around a long time and include strategy games or may have first-person navigation (the user sees the world through the eyes of a game character.) This genre has experienced remarkable growth for a decade. It is still growing nearly 20% per year. The games tend to be long-lived. That is, MMORPG companies will come out with expansion packs, new territories, or other enhancements to renew interest in a game after it has been out for a while. Westward Journey Online II, still one of the most popular games, has been around since 2002, thanks to continued investment by its owner NetEase. However, a competitive genre - casual and social games- has been getting a lot of attention from industry analysts. These games are simple to play and addictive in the short term. They are consumed like snacks- whenever a person has a few minutes on the train, in the doctor s office, at the café. They are attracting users that wouldn t have considered themselves gamers. This is similar to the phenomenon in the US, where simple games like Zynga s Farmville have achieved a massive player base among Facebook users. Many of those players are not gamers in the traditional sense. Thus they are expanding the market. Social/mobile games are growing much faster than the older MMORPG games. However, it is doubtful that social games are stealing gamers from the MMORPGs. Cabot Money Management, Inc. Page 3

4 It is more likely they are finding new users who wouldn t otherwise be engaged with games. You can see these two genres bifurcating the market in the next two charts, which compare gaming habits over a year. The proportion of gamers playing more than 5 hours per month increased to 17% from 13.4%. And the proportion of people playing less than 2 hours per month increased more dramatically, from 17.8% to 34.9%. Both hard-core gamer and more casual snacker cohorts are growing. EVOLVING BUSINESS MODELS From the early 2000s to around 2008, the prevailing revenue model in the gaming space was known as time based. Users paid by the hour to play games. And then the item-based model arrived and has proved very popular. Today most games allow unlimited play and make their money by charging for virtual goods, such as a special sword or health points. The time-based model stimulates usage by letting the user try a game at no cost. However, it leaves itself open to freeloaders who play extensively then move on to another game without ever paying. For this reason the highprofile and expensive-to-produce MMORPGs still use the time-based model. For instance, when Activision partnered with NetEase to bring Activision s international hit MMORPG, World of Warcraft, to China, payments were time-based. The cost, translated into USD is $0.06 per hour. THE INDUSTRY LANDSCAPE NetEase (NTES) was a pioneer in MMORPGs, and still holds the dominant position in that genre. Giant Interactive (GA) and Perfect World (PWRD) also have hits. However, the rising popularity of casual games, where Tencent specializes, has made Tencent the industry king. Even with this many players, margins in the business are very healthy. Cabot Money Management, Inc. Page 4

5 A DOSE OF SKEPTICISM The space is not without its detractors or risks. Industry pundits seem convinced that MMORPG players are abandoning the genre for snacky casual games that don t make much money. or that other online pursuits like microblogging or social networking will siphon gamers away. Some investors are suspicious of the complicated variable interest entity (VIE) structure that US-listed Chinese media companies use to circumvent foreign ownership regulations. Cabot Money Management, Inc. Page 5

6 And of course, there is a more recent drumbeat of concerns about China s economy slowing down. Barron s recently crowed about a Chinese hard landing that would mean 3-4% growth (sounds good to the US!) However, the video game has proven well insulated from economic cycles historically. In some cases it has been counter-cyclical, increasing in popularity by providing inexpensive and escapist fare during troubled times. CONCLUSION Understanding the Chinese online gaming market s distinguishing features is vital to investing in the industry. However, we re confident that many of the hallmarks of this space- growth in online users, strong margins and barriers to entry, trends in Chinese media consumption, economic resiliency make it worth considering within the equity allocation of our clients portfolios. Cabot Money Management, Inc. is a wealth management firm based in Salem, MA, with additional office space in Boston. As a firm with nearly 30 years of experience, Cabot has a national clientele and is a frequent contributor to CNBC, Bloomberg, The Wall Street Journal, The New York Times, and other local, national and international media. Cabot provides highly customized global investment management services coupled with tax, estate and financial advice for individuals and their families. Contact us at (978) or send your to info@ecabot.com if you have any questions regarding this white paper. Any advice or suggestions are provided for informational purposes only and is not a solicitation to purchase any investments or services described herein. Please consult your advisor to determine if an investment strategy is appropriate for you. Past performance of either the domestic or international markets or any specific investments is not predictive of future results nor will diversification alone protect from loss. Cabot Money Management, Inc. Page 6