Shanda Games shows its wrinkles
By Sherman So

HONG KONG - Investors looking to celebrate after buying into the US$1 billion Nasdaq listing of Shanda Games, the largest US-listed initial public offering (IPO) in more than a year, were left mystified late last month, their fingers burnt as the share price turned flat.

Shanda Interactive, China's largest online game company, did all right for itself in spinning off Shanda Games, taking the unit to market at the top of an indicated range of $10.50-$12.50, and increasing the amount of shares offered by over 30%.

But by the end of the first day's trading, buyers of the stock were counting their losses as the shares closed down 14% to $10.80, with little in the way of recovery since then, the price hovering at

 

around $11.01- $11.70 and closing on Monday at $11.26.

That baffled many investors who were looking for a repeat of the success earlier this year of Changyou.com, a similar games-division spin-off by Sohu, China's second-largest portal. Changyou shares surged 25% on their first day of trading on the Nasdaq in April.

"Shanda Games' poor performance came as a surprise to many market observers, who had expected the deal to do well," Lynn Cowan wrote in the Wall Street Journal, summing up investors' bewilderment. Smaller Changyou "was well received in April, and that stock is the best-performing IPO since inception this year, currently trading up 126% from its IPO price."

For sure, Shanda Game's share sale dwarfed that of Changyou, which raised a mere $120 million. The Sohu unit's spin-off also came shortly after the market bottomed in March, while Shanda's sale came as market sentiment was cooling following a six-month rally.

The Dow Jones Industrial Average hit its recent peak of 9,820 on September 18, as Shanda Games was preparing for its September 25 Nasdaq debut. The benchmark index has since declined, hitting 9,487 at the end of last week's trading. The Nasdaq Composite Index had declined to 2,048 by last Friday from 2,146 on September 22.

Yet optimistic buyers of Shanda Games shares, looking for a copycat share surge, may have overlooked differences in the two companies more fundamental than the scale of their IPOs and variations in market sentiment.

"Changyou's game, Tian Long Ba Bu [TLBB], is at the early stage of its life cycle," said Tony Tan, senior analyst at digital marketplace researcher IDC China.

As a rule of thumb, most online games have a life cycle of four to six years, said Tan. A successful game will experience strong growth in the number of users in the first 18-27 months after it is launched, little or no growth in the next 18-27 months, and a decline, likely significant, in numbers after three to four-and-half-years of commercial operation.

TLBB, which accounts for more than 90% of Changyou's revenue, was launched in May 2007. In the past 28 months, the number of players attracted to the game has risen quickly, with more than 875,000 playing at the same time during its peak hours in the first quarter this year. As a result, Changyou's first-half revenue increased 44% from the same period last year and net income surged 45%.

On the other hand, "Shanda's games, Mir II and Woool, are at the late stage of their life cycle," said Tan.

Investors have good reason to seek a share of the China-based online games sector, in which Shanda Interactive has been a pioneer. By 2008, the value of the online game market in China had swollen to $2.69 billion from practically nothing in 2001, according to researcher IDC. That easily overshadows the $1.93 billion in total China online advertising revenue last year. At the end of 2008, six of the 10 largest Internet companies in China operated online games as an important part of their business.

Mir II was the first major online game launched in China, in November 2001. Three years later, Shanda Interactive was able to list on Nasdaq based on the strong cash flow that the game, created in South Korea, generated. Its success inspired a whole generation of game companies in China, which either licensed new games or developed their own.

After Mir II's success, Shanda developed and launched its own sequel, Woool, in 2003, which also became a hit. The company has since introduced many new titles, but those first two games still account for about three quarters of its total revenue. The eight-year-old Mir II contributed 56.4% of Shanda's Games' revenue in the first half of 2009, while six-year-old Woool contributed 20.6%.

"This showed Shanda is very good at extending the life span of its old hits, but it also showed Shanda is not very good at introducing new titles," said Tan.

Shanda has been extending Mir II's and Woool's life by introducing new upgrades and expansion packs. In late 2005, it also countered a decreasing trend in revenues from the two games by no longer charging users to play but offering the games for free, instead charging users only if they wanted better costumes or weapons. The two games have since been able to continue to increase revenues.

Other adjustments have helped to maintain Shanda Games' revenue growth - first-half sales this year were up 43% from the same period in 2008. "It introduced a side story for Mir II, which has been able to attract many former users to play the game again," said a former Shanda executive.

Heavy promotion may also be adding paying customers, despite a relatively old games portfolio. "When you do a search in [Chinese Internet search engine] Baidu about online games, you can find many ads on joining Shanda as VIP members," said Wallace Cheung, research analyst of Credit Suisse for Internet, media and telecom equipment.

The ads encourage players to register and pay as little as 1 yuan (14.6 US cents) into their accounts, entitling new members to benefits such as extra experience points and fast upgrades of their characters.

The question is how long such a trend can continue. After all, unlike Changyou's TLBB, which is still at its prime, Mir II and Woool are relatively old titles, with outdated technology and poor graphic interface.

"In fact, there are not many new users playing Mir II or Woool nowadays," said Cheung of Credit Suisse, "We track many different channels, including search engines, computer program download sites and Internet cafes. There is not much activity on the two games, unlike other popular online games."

Core players of Mir II and Woool are a stable group, with many of them factory or business owners in small cities who have been playing the games for a long time and have achieved top status in the games (kings, queens and top warriors), said the former Shanda executive.

"For them, spending a few thousand yuan a month is not a problem," said the executive.

Credit Suisse estimated the average spending on the two Shanda games is the highest among major online games in China. Average revenue from Mir II players reached 729 yuan in the second quarter of 2009, and 520 yuan from Woool fans. In comparison, Changyou's TLBB attracts a much more modest crowd. Its users paid on average 173 yuan in the second quarter, estimated Credit Suisse.

Shanda has so far managed to keep its core group of players spending an increasing amount on Mir II and Woool. The post-IPO share price may give some indication of how long, in the view of more knowledgeable market investors, it can sustain that trend.

Shanda Interactive, whose shares have gained about 75% this year and which derived practically all of its revenue from games in 2008, still retains 71% of Shanda Games' stock but now intends to focus on becoming a platform for digital entertainment.

Recently it acquired for $46.2 million a 51% stake in another Nasdaq-listed firm, Hurray, which offers ringtone downloads to mobile phone users in China. It is also investing in small online game companies via its "18 Fund" - so far, more than $40 million is invested in over 30 companies. Other acquisition and investment are in process.

Income from last month's IPO will give the Shanda Interactive an even stronger base for such expansion, even as buyers of the Shanda Games shares look at those burnt fingers.

Sherman So is a Hong Kong-based correspondent and co-author of the soon to-be-published book, Red Wired: China's Internet Revolution.

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