Business Strategy and Outlook
CMGE is one of the earliest Chinese game companies focusing on intellectual property, being the first to bring Disney and Toei IPs into China. According to Analysis, as of the end of 2020, CMGE was the Chinese gaming company that has the most mobile IP games. We think that games with well-known IPs should attract some players, at least at the initial launch, because these titles already have their own loyal fan following whether they are based on films, TVs, or novels.
Other than CMGE developing licensed IPs from popular manga and Chinese comics into games, the company also obtained some well-tracked PC and video game IPs through their acquisition of a 51% equity interest in Beijing Softstar, a developer of successful PC games such as the series of Legend of Sword and Fairy. To revitalize Softstar’s IPs, CMGE will also develop pan-entertainment products such as soft toys, figurines based on its proprietary IPs, explore partnerships with companies in industries such as motion picture, manga, animation, novel and music through licensing, coproduction and codevelopment. For example, CMGE licensed its IPs for the development and operation of a TV series, hotels and theme parks.
To enhance its mobile game ecosystem, CMGE maintains partnerships with game developers and invests in developers and IP companies. Some of the cooperation with game developers were under a contract term of at least three years. CMGE has invested in a number of game developers that possess a good track record, such as Love Games, Huanyu Jiuzhou and EZFun. Apart from third-party developers, the company also possesses in-house development capabilities through Beijing Softstar and Wenmai Hudong. The latter developed several popular MMORPGs such as The World of Legend--Thunder Empire. A majority of game revenue will still come from licensed games in the future, in our view. CMGE is a limited partner in the CPC Fund, which invests in IP owners, IP incubating platforms and vertical platforms. CMGE can license IPs from the portfolio companies invested by CPC Fund. CMGE will also expand internationally with games such as SNK Top Battle and Dynasty Warrior.
Fresh Takes on Three China Internet Stocks; Our Top Picks Are Tencent and NetEase 03 Jan 2022 We have taken a fresh look at wide-moat Tencent, narrow- moat NetEase, and no-moat CMGE, and our top picks are Tencent and NetEase. We believe the market has dramatically overreacted to recent regulatory risks while overlooking two firms' long-term revenue opportunities and margin upside. As we start to see signs of a stabilizing regulatory environment going into 2022, we have confidence that fears will subside as investors gradually understand headline risks do not represent fundamental game-changers to our long-term investment theses. Among the three names, NetEase and CMGE are pure gaming plays, while Tencent has about 40% of operating income exposure to games, with the rest coming from multiple other sources like advertising and fintech. On the game side, Tencent and NetEase are China's largest and second-largest publishers, respectively. Both companies own a vast number of well- known franchises that captivated multiple generations-- Tencent is the owner of internationally renowned video game franchises like PUBG, Clash of Clans, League of Legends, Honor of Kings, and Fortnite (through Epic stake).
At the same time, NetEase specializes in publishing Chinese domestic titles like Fantasy Westward Journey, Onmyoji, Identity V, and Naraka Bladepoint. We believe both firms will continue to capitalize on the success of existing franchisees while leveraging their capital and influence to develop next-generation titles.
Despite their promising long-term outlook, both Tencent and NetEase witnessed major sell-offs in share prices over the last months following several regulatory changes. While we understand that some of these changes give investors flashbacks to what has happened in the Chinese education sector, it is essential to understand that recent Internet regulations are not designed to wipe out the Internet industry or the private sector, nor will they erode the competitive advantages enjoyed by Tencent and NetEase.
This is the reason why we think the duo can still comfortably achieve 15% to 20% earnings CAGR over the next five years, even after adjusting for negative impacts from policies.
Going into 2022, we expect a stabilizing, or perhaps even improving, regulatory environment. Based on a combination of discussions with industry sources and company management, we think the current suspension in new game licenses (which began in July) was done to implement minor protection measures. Combined with our understanding that the National Press and Publication Administration, the license approval agency, did not stop taking in new license applications, we have a strong conviction that the agency has not stopped the review process, and it should soon start issuing licenses. Assuming everything else equal, resumption of license approvals will benefit NetEase the most, given all its profit comes from games. Tencent will also benefit from improved grossing visibility but to a lesser degree, due to its more diversified revenue stream.
We also see early signs of positive regulatory developments outside of games, and we believe a continuation of these positive trends will ultimately ease investor concerns over Tencent. We got one positive sign from comments that came out of the latest Politburo meeting, where "anti-monopoly" and "preventing disorderly expansion of capital," which made their first appearance in last year's December meeting, were taken out this year. We view this as an indication that anti-monopoly will no longer be a top government priority in 2022. Furthermore, we think regulatory revamp over the past year might have helped Internet firms win government contracts, evidenced by Tencent Cloud's recent winning of the Beijing government's multi-million-dollar blockchain project. The fact that government is now comfortable with private companies handling its data suggests that there is not only an increased level of trust, but it also reaffirms the government's commitment to creating a vibrant private sector--a notion that came under question over the past months.
　　Following a revisit to three companies' long-term assumptions, we raise Tencent's fair value estimate to HKD 837 from HKD 778 while maintaining NetEase and CMGE's fair value estimates unchanged. The bulk of the increase in our fair value estimate comes from our updated profitability outlook for Tencent's gaming business. Our sum-of-the- parts analysis assigns 30 times 2022 P/E multiple to Tencent's game business--a valuation equivalent to 36% of total group valuation. Advertising, fintech, and a list of other businesses contribute to 48% of the total valuation, while investments outside of the core make up the remaining 18% of the valuation.
　　Tencent's share price is currently at an historical trough, trading at a forward price to earnings multiple of just 21 times. We forecast the firm growing earnings at a 15% five- year CAGR before assuming any new revenue streams that are likely to emerge from the WeChat ecosystem. Our conviction in long-term growth is underpinned by three long- term secular trends: rising value proposition of online games (easy to access and highly engaging way to enjoy with friends), rapidly growing disposable income bodes well for advertising spend, and surging demand for cost-effectiv enterprise solutions provides ample of headroom for cloud services growth.
　　NetEase is well positioned to capitalize on opportunities outside its home. The firm has already demonstrated that it can build high-quality and longstanding mobile games for the Japanese market. We expect the firm to achieve moderate success at expanding its footprint in the U.S. and Europe. We expect the company to record a five-year revenue CAGR of 16%. Earnings expansion should outpace that of revenue, growing at 21% CAGR, as the business expands into more profitable overseas gaming markets. Our
　　valuation implies forward 2022 P/E of 23, below the above 40 times earnings Pitchbook consensus multiples demanded by global peers like Take-Two.
　　We expect continued strong revenue performance at recent game launches (Harry Potter and Naraka Bladepoint) to lend credence to the firm's ability to sustain a steady income stream from high-quality and long-cycle games, thus eliminating some of the uncertainty in the traditionally low visibility business.
　　Fair Value & Profit Drivers 03 Jan 2022 Our fair value estimate for CMGE is HKD 7 per share, which implies about 16 times price to 2021 earnings. We think CMGE will be able to deliver sustained long-term revenue growth for a few reasons: 1) CMGE’s continued shift to long-cycle games will provide a relatively steady income stream, gradually eliminating some of the uncertainty in the traditionally low visibility business. This is evidenced by the firm’s recent launch of One Piece The Voyage (mobile), where we see a much b etter b alance b etween player experience and monetization, positioning the game for long-term success, 2) we also incorporated some effects of the projected 2022/23 release of Sword and Fairy Zero (mob ile), a massive multiplayer online, or MMO, remake of an all-time classic-- Sword and Fairy. Currently, we model in just modest revenue because we do not know enough about the game play and its exact launch date, but we believe Sword and Fairy Zero has the potential to be one of the top-20 grossing games for an extended period. The upcoming release of Sword and Fairy 7 (PC) should drive anticipation for the mobile MMO remake, and 3) recent tie-up with Bilibili (7% shareholder of CMGE) grants CMGE the priority rights to create games based on Bilibili’s IPs, helping CMGE to further tap into younger audiences. This provides us a bit more visibility beyond the existing two- year pipeline, resulting in higher confidence in long-term revenue opportunities.
　　All things considered, we now model in a five-year revenue CAGR of 8%, in line with China’s mobile game industry growth. But with the company doubling down on R&D investments (increased R&D headcounts from 400 to 800), we expect some cost pressures, but this spending should support higher-quality, more frequent content in coming years. While we concede the mobile game industry is extremely competitive and player churns are often very high, CMGE’s strategy to build mobile games off existing IPs should keep a lid on user acquisition costs. Therefore, our midcycle operating margin assumption stands at about 13%, in line with the firm’s three-year historical average.
　　As a result, we forecast CMGE to record a five-year operating income CAGR of 9%.
　　Scenario Analysis Our bull-case fair value estimate for CMGE is HKD 10.10 while our bear-case fair value estimate is HKD 4.70.
　　In the bull case, we expect five-year revenue CAGR to be 13%, led by the success of long-cycle games, improved monetization of Softstar’s IPs, and more exclusive licensing deals with prominent game distribution platforms.
　　Operating profit grows at a CAGR of 17% as staff costs are under control and marketing expense ratios run at a lower level due to more exclusive licensing agreements.
　　In the bear case, we expect five-year revenue CAGR to be 4%, due to the worse-than-expected performance of the key games such as Legend of Mir series, sluggish monetization of Softstar’s IPs and reduced exclusive licensing agreement with large traffic platforms, and the inability to churn out popular games at CMGE. Operating profit should grow at a compound annual rate of 1% over the five-year explicit forecast period.
　　Economic Moat We assign CMGE a no-moat rating because it does not own any long-cycle titles, nor do we think it has the resources to develop these titles to sustain ROICs above WACC over the next 10 years. Over the last few years, the mobile game marketplace has become increasingly competitive with larger publishers such as Tencent and NetEase consolidating and buying competitors. Due to this increased competition along with the inconsistent performance of the company’s games, CMGE’s ROICs have slid over the past couple of years. While we project the company’s returns on invested capital to surpass its cost of capital for a few years of our explicit forecast period, the uncertainty around the longevity of its current franchises and whether the company can develop new titles to stay relevant casts doubt on CMGE’s long-term returns.
　　However, we perceive that currently, no game launched by CMGE has demonstrated exceptional monetization capability for the past decade, unlike those launched by Tencent or NetEase. Furthermore, the success of future games to be published under the famous IPs acquired from Beijing Softstar may not be warranted given intensifying competition and uncertainty of the games’ quality.
　　About 70% of CMGE’s revenue comes from publishing mobile games developed by other studios. We do not believe CMGE’s publishing is a moatworthy business because 1) it does not own the games nor the IPs of which these games are developed upon, 2) CMGE doesn’t have the player traffic that would allow it to establish strong bargaining power against the games developers, and 3) there is a lack of visibility on whether the developers will stick to CMGE as publisher.
　　Among the many CMGE games, none has enjoyed continuous success for over five years, with most seeing their grossing fade after just one year. CMGE’s monthly active users, standing at 19.1 million in June 2021, is minimal compared with moaty peers like Tencent, suggesting that the firm does not have a strong network of players to sell games into. Lastly, most of the games published by CMGE are RPG, and collectible card games focus more on single-player adventures, so there is minimal network effect even if a game turns into a hit.
　　Around 30% of CMGE’s revenue comes from developing and licensing out in-house IPs, but we also don’t think this segment has a moat. CMGE got into game development in 2018, when it acquired a 51% stake in Beijing Softstar and Wenmai Hudong. Following the takeover of Beijing Softstar, CMGE obtained exclusive rights to five franchisees, namely Sword and Fairy, Xuan Yuan Sword, Richman, Stardom, and Empire of Angels. We believe the Sword and Fairy franchise is perhaps the strongest in terms of historical fan followings, but its reputation and player rating have declined, and there is not a lot of certainty on whether CMGE can revive this once great franchise.
　　After many years of anticipation, Sword and Fairy 7 (already in the development process before CMGE acquisition) was released in October 2021. Despite pulling in decent sales initially, feedback has been mixed--with only 69% of positive reviews. Adding to the fact that this franchise has seen sales decline after 2016, we need to see major signs of changes before considering assigning a moat.
　　Another reputable IP that came with the acquisition is Xuan Yuan Sword. This was another legacy franchise that achieved great success in the 2000s but has since declined.
　　Therefore, we think that the future of this franchise is also looking grim. As for the Richman series, it is a solid franchisee but with a very niche and steady player base, making material earnings contribution unlikely in the foreseeable future.
　　Licensing is a straightforward business in the sense that CMGE receives a royalty for licensing its IP for any non-game content (mainly movies and TV shows). While CMGE was able to generate very high returns on these deals in the past (because there are basically no financial costs in licensing out), there is a lack of visibility on how sustainable this revenue stream will be long term. The minimal revenue contribution (approximately 4%) from this segment means any potential moats here will still be irrelevant to the overall company’s competitive position.
　　Moat Trend We believe that CMGE has a stable moat trend. On the publishing front, CMGE is still holding over 100 IPs (42 licensed IPs and 68 proprietaries), and we think these IPs are sufficient to support the company’s competitive positions over the next couple of years. On the development side, the decade-long history behind its owned IPs such as Sword and Fairy and Xuan Yuan Sword means we shouldn’t expect any material changes to their popularity over the next five years. From a financial perspective, these two IPs will contribute to a stable share of revenue and profit to CMGE.
　　While the management is keen to further monetize these IPs, there simply isn’t strong enough evidence to say whether these efforts will translate to a stronger competitive position for these franchisees.
　　Bulls Say
　　OCMGE was one of the first game companies to announce a metaverse project based on its legacy Sword and Fairy franchise.
　　OWith most of its games created out of popular IP from film, TV, and manga, CMGE can quickly acquire players with minimal marketing spend.
　　OCompany management is very keen to share latest information with investors.
　　Bears Say
　　The lack of a strong game development track record remains an overhang on the sustainability of CMGE’s current business model.
　　OThere is no guarantee that CMGE can always renew its IP licenses at reasonable costs.
　　OVideo game pure-plays like CMGE will remain susceptible to potential changes to the government’s attitude toward games.