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China Online Games Sector
SECTOR REVIEW
Virtual world becomes real business
Search traffic of top-five online game operators*
-
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08 Dec 08
The9 Sohu Perfect World Shanda Tencent
12-week cumulative searches
Source: Baidu, Credit Suisse estimates * 12-week cumulative search traffic
■ The Ministry of Culture (MOC) has been assigned as the ultimate
government entity to regulate the online games sector. We expect the
MOC to launch new policies to promote and regulate the industry’s
long-term development, which is particularly positive for domestic
games. We also believe that the assignment of the MOC has sent a
strong signal to capital markets that online games is a sizeable market
with sustainable growth. The Chinese government’s stance on online
games has removed investor concern about the long-term
sustainability of the online games sector in China.
■ We expect China’s online games market to grow 24% YoY in 2009. The
2009 growth rate is expected to be lower than in 2008, because:
1) China’s economy is slowing, which is likely to lead to less spending;
2) some game operators and online games have been over-monetised
and 3) many leading game titles are old and growth is likely to slow.
■ Since the launch of the Credit Suisse China Online Game League Table
in June 2007, Tencent has grown from being the fifth operator in early
2007 to the top player in early 2008. It deserves a premium due to its
huge community size and diversified business models. Trading at 0.8x
2009E PEG, we believe Tencent is attractive and we rate it
OUTPERFORM. We also rate NetEase OUTPERFORM and it is our top
sector pick, due to its attractive valuations at 6.2x ex-cash 2009E P/E,
an 8% FCF yield and strong fundamentals. Perfect World is also rated
OUTPERFORM due to its attractive 7x 2009E P/E, strong R&D
capability and its diversification.
Virtual world becomes real business
New regime to promote games industry
Based on our talks with government officials and industry sources, we believe that the
Chinese government has recognised the importance of China’s Internet sector as a media
for general public entertainment and information access as well as a cultural and
ideological product to provide appropriate public education. Due to “Big Ministries” reform
policies, Ministry of Culture (MOC) functions have been re-aligned. As a result, the MOC
will be the ultimate government entity regulating and promoting the online games sector.
As the leading government entity to supervise the industry, the MOC aims to promote its
long-term development. We expect the Chinese government will continue its policy of
preferring domestic games. Despite allowing imported games, the China government
should set up quotas for imported games and a review process for imported games with
new expansion packs of imported games generally being longer than domestic games.
The government’s stance on online games has removed investors’ concerns about the
long-term sustainability of China’s online games sector. We believe the MOC’s assignment
as the key entity governing the online games industry sends a strong signal to the capital
market that: 1) the government recognises online games as a sizeable independent
market to govern and 2) China’s online games market is expected to grow sustainably in
the long run, under MOC guidelines.
2009 Outlook
We expect China’s online games market will grow 24% YoY in 2009E. This is likely to be
lower than in 2008, because: 1) China’s economy is slowing, which is likely to lead to
lower spending, 2) some game operators and certain online games have been overmonetised,
e.g. Giant’s (GA, $5.97, not rated) revenue was down 49% YoY and 3) many
leading game titles are old and growth is likely to slow. We expect Massively Multi-player
online games’ revenue to grow 17% YoY in 2009E, driven by new Internet/online gamers
and new games, but with less monetisation. In 2009E, we expect Tencent, Perfect World
and a listed domestic game developer to take revenue market share due to new game
launches and the improving monetisation of existing games. We expect casual games
revenue (including both advanced casual games and board and chess games) to grow
51% YoY in 2009E, driven by new Internet/online gamers, the launch of new blockbuster
games (e.g. FIFA Online 2 and NBA Street Online) and improving monetisation. In 2009E,
we expect Tencent to increase its revenue market share due to new game launches, the
sustainable growth of board and chess game platforms and the continual growth of
existing games.
The game operators’ marathon
Since the launch of the Credit Suisse China Online Game League Table in June 2007,
Tencent has grown from being the fifth operator in early 2007 to top player in early 2008
due to: 1) strong growth of the keyword “QQ” traffic (we define QQ gamezone comprising
20% of QQ traffic), 2) multiple new game launches and 3) strong demand of new games,
e.g. D&F and Cross Fire. The online games business has become a key growth driver in
2008 and should continue to be in 2009E, despite being a latecomer in the games
business. With potentially seven new games for launch in 2009, Tencent deserves a
premium due to its huge community size and diversified business models. Trading at 0.8x
2009E PEG, we rate Tencent OUTPERFORM. NetEase is rated OUTPERFORM and is
our top sector pick, due to its: 1) attractive valuation at 6.2x ex-cash 2009E P/E and 8%
FCF yield and 2) strong fundamentals, i.e. high visibility, healthy cash flow and strong
balance sheet. We rate Perfect World OUTPERFORM due to its: 1) attractive valuation at
7x 2009E P/E, 2) strong R&D capability and 3) diversification strategy.
New regime to drive games industry
Importance of Internet being recognised
In China, media/TV used to be monopolised by government mainstream media, e.g. CCTV
(not listed), the largest TV platform, the People’s Daily (not listed), a national newspaper,
Xinhua Agency (not listed), a news publication agency). Government key messages and
policies were centrally disseminated from mainstream media to general public.
Since the late 1990s, the Internet has been penetrating China at a very fast pace. The
China government also understands that the information flow between itself and the public
is more decentralised or flattened, and such a trend cannot be reversed.
President Hu Jintao has emphasised the importance of Internet.
• On 24 January 2007, Mr Hu said China should manage and use the Internet sector
proactively while a “healthy” Internet platform was essential to national security
• On 20 June 2008, Mr HU participated in an online forum, hosted by the governmentowned
Peoples.com and answered questions from China’s Internet users. His
participation in an Internet forum, the first time among Chinese government officials,
signalled that the government has recognised the importance of the Internet as a
platform for communication.
Based on our discussions with government officials, we understand the government
recognises the importance of the China Internet sector and has the following view:
1) The Internet sector is a media for general public entertainment and information access.
2) The Internet is a cultural and ideological product and can provide appropriate education
to the public.
Ministry of Culture – the key entity to govern games
After the 17th National Congress of the Communist Party of China (CPC), the China
government implemented the new policy, “Big Ministries” reform, by merging ministries
into a mega ministry. The government is aiming to run a system with a number of
ministries and to have better cooperation within ministries, a faster response to the
economy and new industry developments, and greater efficiencies.
After discussions with various industry sources, we understand that the China government
intended to establish a mega ministry to govern the cultural and entertainment industry
and merge the MOC, the General Administration of Press and Publications (GAPP) and
State Administration of Radio, Film and Television (SARFT). But, due to the complexity of
the responsibilities and functionalities of these departments, the mega ministry for the
cultural industry was not established in 2008.
Despite the absence of mega merger, these three ministries/departments have consented
to realign their functionalities in 2008. According to our discussions with MOC officials, we
understand that, after realignment, MOC will be responsible for governing the following
Internet sectors, including: 1) online games, 2) Internet cafes, 3) online music and
4) comics. The MOC will be responsible for developing policies to promote development
and govern these industries.
Before realignment in 2008, each government department was assigned a unique role in
governing cultural products. For instance, SARFT was responsible for movies, television
regulation and approval, GAPP for book publications and the MOC for the approval of
cultural content and product distribution (e.g. CDs/DVDs). But, functions of these
departments overlap and in many cases, each cultural product requires two to three
department approvals. For instance, any company selling CDs/DVDs needed GAPP to
issue a publication number for the CDs/DVDs (as GAPP-classified CD/DVD printing is
similar to book printing) and also had to seek approval from the MOC for distribution. The
overlapping functionalities become a more serious issue after the proliferation of the
Internet, as the Internet is a unified platform for all kinds of cultural products. It is common
that several ministries have commented on the same issue about the Internet and
intervened over the same Internet products.
According to our industry contacts, the MOC, GAPP and SARFT have successfully
realigned their responsibilities in the Internet and video-related products as follows:
• The MOC: 1) Internet – online games, Internet cafes, online music and 2) comics
• SARFT – TV, movies, online videos
• GAPP – movies, VCD/DVD publications
Figure 9: The Ministry of Culture’s responsibilities
Main responsibilities
1 To research and develop policies, laws and regulations on culture markets, cultural goods and
cultural entertainment activities, and to oversee the implementation;
2 To manage the theatrical performance and cultural entertainment markets;
3 To manage the works of the art market, including import and export operations;
4 To manage the audio-visual products’ market, including wholesaling, retailing, rental, and screening;
5 To manage the import of audio-visual products;
6 To research the cultural market, and guide movie distribution and performance;
7 To supervise day-to-day operations of electronic games;
8 To supervise and monitor the content control of cultural products and internet services
9 To be responsible for animation and games market management.
Source: Ministry of Culture website
After realignment, departments and ministries will coordinate and communicate regarding
the governance and regulation of Internet and video-related policies. In the past, several
departments can comment on market development at the same time. But, in future, we
understand that only one government department will have the ultimate role of regulating a
certain Internet/video segment. In the case of the online games market, the MOC will be
the ultimate government entity for regulating and promoting the sector.
Certainly, besides online games, the MOC also governs multiple traditional cultural market
segments, e.g. art performance, concerts and music publishing. But we understand that
the MOC treats improving the management and promotion of online games and Internet
cafes as its work priorities.
Online games market regulation
After discussions with MOC officials, we believe that the MOC has a positive stance on the
China online games sector and aims to promote the sector. But, at the same time, the
MOC will release a new regulation to ensure healthy development in the longer term.
The MOC views the China online games market as having two unique advantages:
• China is the largest online games market in the world with long-term growth potential.
• Over 120,000 internet cafes with official licences make it the largest scale in the world.
Credit Suisse forecasts China’s online games market size in 2008 at US$2.6 bn, larger
than our estimated Korea online games market size of US$1.2-1.5 bn. The MOC views
online games as high technology software-based cultural products. As a result, they
believe the sustainable growth of the online games market in China would lead to several
advantages:
1) The incubation of large numbers of domestic online games companies, supporting a
large value chain of lots of companies and providing large tax income
2) The hiring and training of large numbers of software engineers, thus strengthening
software development capability in China
3) The export of games outside of China and the building up of globally competitive games
companies in the world. We believe that the MOC will develop policies to encourage
games exports.
Separately, the MOC sees the large-scale Internet cafe market leading to a new lifestyle
among the public and likely to lead to a new value chain. Also, the MOC is encouraging
larger scale M&A among Internet cafes.
Licensing regime of online games companies
We understand that the licensing regime is divided between the China online games
operation and development. The China government allows any company, including both
the domestic and international company, to set up game studios in China in order to
develop games, without specific licences.
Regarding games operations, the government only allows two types of companies to
operate in China: 1) China domestic enterprises and 2) Hong Kong and Macau companies
under the Closer Economic Partnership Arrangement (CEPA) and based on our
understanding, only one Hong Kong company has applied to operate games in China.
Separately, the government has not interfered in any M&A activities by foreign companies
in order to acquire the appropriate legal operating status.
China’s online games operation entities only require two industry specific licences:
1) A China Internet culture operating licence (industry people call it a “VATS” or 网络文化
经营许可证 in Chinese) issued by the MOC;
2) ICP licences issued by the Ministry of Industry and Information Technology (MIIT).
VATS is a licence applicable to all Internet businesses, including portals, online games,
online videos. The MOC has set up various approval criteria for various businesses.
Regulation of online games
When a new online game is planned for launch on an open beta test, the game operator
has to get approval from: 1) the MOC and 2) a game publication number, released by
GAPP. According to industry sources, the approval procedures are similar to the previous
procedures. But, after the realignment, MOC will be the key entity reviewing the content
appropriateness and legality of the online games, instead of GAPP. Internally, the MOC
sets up teams, with online games professionals, to review all games on a recurrent basis,
in order to monitor frequently updated virtual items, game packs as well as gamer
activities. It is expected that the larger effort will definitely focus on online games with large
user bases.
Besides new games, the MOC has emphasised that certain expansion packs of online
games, e.g. WoW’s Burning Crusade, need to be reviewed with the criteria depending on
the amount of new maps, new activities, new characters and new tributes.
The MOC views the following key content as are under supervision:
1) Violence – to avoid game activities and graphics involving any form of violence
including soft violence
2) Pornography or activities leading to pornography: to restrict online games from
providing pornographic information or providing a platform leading to real life pornography.
3) Gambling: to avoid online games as a platform for gambling. The MOC has found that
many game activities are gambling related. For instance, some game activities require
gamers to deposit a certain amount of game points. After winning that activity, gamers can
win multiple amounts of game points.
4) Political and religious-related content
Despite these guidelines mentioned above, it is difficult to explicitly define types of
activities and content in violation of MOC guidelines. All content has to be reviewed
independently. As such, game companies with a better understanding of MOC principles
would be subject to lower risks.
Taxation on virtual asset trading – difficult to be executed
As reported by Yangcheng Evening News on 1 November 2008, the total scale of virtual
currency in China amounts to several billions renminbi in 2008, with an annual growth rate
of 15-20% YoY. The popular formats of virtual currency include QQ Coins (Tencent), WoW
Gold (Blizzard Entertainment (private company)/The9 THE9 Ltd (NCTY.OQ, $11.54,
NEUTRAL, TP $13.30), POPO Gold Coins (NetEase), and Baidu Coins (Baidu), which are
primarily used within certain IM systems or online games, and now extend to other online
goods and even real world trading activities.
On 28 October 2008, the State Administration of Taxation passed the proposal raised by
Beijing Local Taxation Bureau about initiating individual income tax on profit from virtual
property trading in the Beijing area. On 10 November 2008, the Beijing Local Taxation
Bureau announced the details of taxation policy on virtual property trading:
• The tax rate is 20% of profit, or equivalent to 3% of revenue;
• Individuals should report income tax to the local Taxation Bureau by the 7th of the next
month after receipt of the income from virtual property trading; and
• Beijing Local Taxation Bureau has already opened the window for virtual property
trading tax reports
We do not see a visible impact on games operators from the above mentioned policy
changes, because:
• A virtual item is not equal to virtual currency. Some virtual items are not entertainment
related and cannot be traded.
• The success promulgation of virtual items taxation rules would imply that the value of
virtual properties is officially recognised by the China government for the first time. In
order to ensure the virtual property taxation rules can be executed, virtual property
protection legislation is the precondition. But definition of virtual property is
complicated. Developed countries, such as the US and Korea, have not developed
any applicable laws to govern virtual property trading. We do not expect any virtual
property protection laws to be promulgated in the near term.
• Practically, it is difficult to track the process of virtual property trading. As a result of
the nature of online virtual property trading, the location, amount and real identities of
buyers and sellers are difficult to be defined. Also, it is costly to collect all due taxation
on virtual items.
• Even if the virtual property trading taxation is finally promulgated, the impact on games
operators is limited. The new rule would be likely to lead to fewer gamer activities and
lower game revenue in the short term. Since the secondary market for virtual items and
other game items may reduce the profit of games operators, we expect top-tier games
operators to change games and activities to attract gamer spending.
Despite the difficulties of execution, the China government is expected to continue to
review virtual item trading activities. During the Beijing Internet EXPO in October 2008, the
Deputy Director of Culture Market Division of Minister of Culture, Tuo Zuhai, stated the
regulators’ intention of restriction on certain games in order to restrict excessive virtual
property trading. We expect the MOC and Taxation Bureau to study potential new policies
or rules on virtual item trading. But, we do not expect any virtual property trading policies
released in the near term, e.g. not in 1H09E.
Other potential new games market rules
According to Sina IT channel, the China government would be developing a new online
games rating system, similar to the movie rating system in Hong Kong or electronic games
rating system in the US. After discussions with government officials, we understand that
the online games rating system in China is more complicated because: 1) online games
are frequently updated and it is difficult for online games to be monitored by the MOC on a
timely basis. Thus, the rating of online games may be changed from “suitable for children”
to “for aged 18 or above only” overnight; 2) as online games are also a communication
platform, it is not easy for games operators to track all gamers’ conversations and monitor
their activities, which may violate government rules.
Internet and games addiction has been an issue of concern to the public in China. After
discussions with officials, we learned that: 1) it is difficult to define the standard of online
addiction; 2) GAPP has implemented an Anti-fatigue system in 2006 (please refer to the
CS report “China Internet sector - Positive message from China games conference: antifatigue
system for gamers aged below 18 only” dated 13 Jan 2006), but addiction cases
are still being reported by mass media. Thus, simple administration measures may not be
the most effective way. We expect the China government to be studying this subject but
do not expect any new policies to be released soon, at least in 1Q09E.
Policies to promote games industry
After discussion of our contacts, we do believe China government has recognised the
importance of the online games industry in China. As the leading government entity in
supervising the industry, the MOC aims to promote the long-term development of the
industry. We expect potential new policies positive for industry players to include: tax
benefits, a professional training programme for the industry and financial incentives for
exports. Thus, the government’s stance on online games has removed investors’ concerns
that online games are only a short-term peripheral industry in China.
Also, we expect the government to continue its policy to prefer domestic games. According
to the MOC, under World Trade Organisation (WTO) requirements, the government
welcomes high-quality imported games in China and imported games will be reviewed
under a similar process as domestic games. But, we expect that the government should
set up quotas for imported games and review the process for imported games as well as
new expansion packs of imported games being generally longer than domestic games.
Online games rating system
– not easy to implement
Internet and games
addiction – not resolving
soon
The government has
recognised the importance
of the online games industry
Supporting domestic games
development
Regarding game consoles, we expect this to be a complicated issue in China and less
likely to be launched over short period of time, at least not in 2009. The China government
has recognised game consoles as being very popular in tier-1 cities and can be easily
bought through C2C portals and e-commerce websites. It estimates illegal imported
PlayStations in China amounting to 300-400,000 units in 2008.
Windows and PCs are an open platform, whereas consoles, in particular console
operating systems (OS), are closed platforms. Game console companies are not willing to
open console OS for review and approval. Separately, if game consoles are going to be
launched in China, both the China government and console companies have to fight
against piracy issues in China. Console online games could be a future trend, but game
console companies are not yet ready to launch online games on a massive scale in China.
Benefits under the new regulatory regime
In sum, we believe the new role of the MOC to supervise online games will be positive for
the longer term growth of the sector because:
• After realignment, the MOC should be the key entity in driving new policies to promote
and regulate the online games sector, thus improving the efficiency. We expect the
MOC will encourage domestic games development, favouring companies with strong
domestic development teams.
• The licensing regime of games operators and games licensing procedures are similar
as before. But, obviously, the MOC approval is more important than before. Games
operators, both domestic and international, need to understand MOC policies better,
instead of spending enormous times on communicating with multiple departments.
• We expect games operators with portal business to understand MOC policies and
communicate with MOC better, as portal management should be good and there is l
likely to have been considerable experience in communicating with the MOC for years
thereby providing better guidance to games operation teams.
• Investors have had concerns over the long-term sustainability of the online games
sector in China. Some investors even think China’s government will ruin the sector,
due to continuous negative media news flow. We believe that the MOC’s assignment
as the key entity for governing the online games industry has sent a strong signal to
the capital market that: 1) the China government has recognised online games as a
sizeable independent market to govern and 2) China’s online games market should
grow sustainably in China in the long run, under MOC guidelines.
2009 outlook
Credit Suisse approach to games revenue forecasts
We forecast all online games based on the following:
1) Bottom-up: we use game-by-game forecasts. We assume each game, similar to any
product in the world, should have a limited game life (in terms of number of years). Also,
every game will have the highest PCU (peak concurrent users) level in certain quarters.
Basically, an online game is similar to a project, with a triangular revenue shape.
2) Top-down: We compare the revenue market share of each online game operator.
3) New revenue (as a percentage of total revenue): We do not believe every new game
can be launched successfully. Given the economic slowdown, we expect new games
revenue to be at or below 30% of next year’s revenue.
For instance, we have assumed a ten-year game life for Mir II and eight years for Woool,
among the longest life for games in the market, and both games will be terminated by
2011. We would extend the game life of both games, depending on our tracking and
company reported revenue. If the reported game revenue remains on an uptrend, we are
likely to extend the game life.
Online games market review
China’s online games market has been growing fast over the past few years. We project
China’s online games market size to grow 75% YoY in 2008E, in terms of revenue (from
Figure 14), and up 25% in 2008E, in terms of search traffic (from Figure 10). Since June
2007, we have launched the Credit Suisse China Online Game League Table and we
expect the game keyword traffic of search engines to be a timely and comprehensive
benchmark of games market activities. (Please refer to report The China online game
compass, dated 27 June 2007). We expect the growth trend of the online game market will
continue in 2009E.
In early 2000, the China online games market was dominated by foreign games. Given
supportive government policy and improving development capability of domestic games
operators, domestic games have been gaining market share. From Figure 11, the number
of domestic names in the top 50 of the league table has been growing and reached over
50% in 2H08. Also, the total amount of search traffic for domestic games has been rising
and was close to 45% of total. The decline of paid search traffic in 4Q08 is due to the
recent decline of the keyword “QQ” (we assume QQgamezone accounted for 20% of
game keywords). As mentioned in our report Game Compass dated 27 June 2007, the
League Table has a negative bias towards games focusing on lower tier cities, which are
typically domestically developed games. Thus, we believe the actual popularity of
domestic games is likely to higher than the % indicated by the domestic game search
traffic line in Figure 11. In sum, we expect market share for domestic games will be further
increased in 2009E and positive for listed domestic game developers.
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