Can This Gaming Stock Regain Its Mojo?

Online gaming weakness and stiff competition in mobile are holding this company back. Can it break free?

Mar 3, 2014 at 10:00PM

The online gaming landscape is changing, and it is changing pretty fast. Users are now playing more games on their mobile devices rather than spending time in front of their computer screens as they did earlier. Driven by this shift in the gaming landscape, Chinese online gaming company NetEase (NASDAQ:NTES) is now making aggressive moves in mobile, but the transition is not proving to be easy.

The weakness in Activision Blizzard's (NASDAQ: ATVI) World of Warcraft, which NetEase operates exclusively in China, and the presence of tough competitors such as Glu Mobile (NASDAQ:GLUU) in mobile gaming is making NetEase's transition all the more difficult.

According to T.H. Capital analyst Tian X. Hou, the popularity of massively multiplayer online role-playing games, or MMORPG, in China is fast waning as mobile gaming gains traction. The number of MMORPG gamers in China increased less than 1% in 2013 to 338 million users from the year before. At the same time, mobile game users in China jumped an impressive 54%, year over year, to 215 million in 2013. 

What gives
Since NetEase was busy investing in online games, its results and outlook have taken a hit. Its gaming revenue was up 14% in the recently reported fourth quarter, down from 21% growth seen in the third quarter. Moreover, NetEase's gross margin also fell, declining to 71.3% in the previous quarter from 74.1% in the third quarter. Revenue growth slowed down considerably, to less than 10% in the quarter, a stark difference from the 21% growth that it had seen in the third quarter.  

The problem with NetEase is that it had started focusing more on self-developed games after Activision's World of Warcraft, or WoW, started losing steam. This was a pretty good move as it helped NetEase mitigate the negative effects of declining subscribers in WoW for some time. At one point of time, Activision had more than 10 million subscribers for WoW, but they started diminishing over time as gamers found more alternatives.

Being the exclusive licensee of WoW in China, NetEase was seeing good growth due to its relationship with Activision. But all that changed last year as WoW's subscribers dropped significantly. In the previous quarter, Activision reported 7.8 million subscribers for World of Warcraft, a marginal increase from 7.6 million in the preceding quarter. The game has declined from its peak and growth is sluggish, but Activision is looking to keep its user base intact with expansion packs in the future.

Activision is set to release another expansion pack for the game -- Warlords of Draenor. However, with the user base not as great as before and mobile gaming gathering steam, NetEase investors shouldn't count too much on this expansion pack, as it might not provide a meaningful boost to its performance.

NetEase's self-developed games, which it had focused on to reduce dependence on WoW, could lose steam as online PC gaming in China loses its popularity. According to NetEase, self-developed games such as Kung Fu Master, New Westward Journey Online II, Heroes of Tang Dynasty II and Ghost II delivered solid performances in 2013, but they seemingly waned off as the year ended. The company has also released expansion packs to keep interest alive in these games, and it will continue to do so going forward.

NetEase is focusing on the shooter genre, releasing Burst Sky in the previous quarter. Looking ahead, it will be launching Crisis later this year, while Revelation is scheduled for testing later this year. 

Changing strategies
NetEase continues to be optimistic about the Chinese online gaming market, which is why it will continue attacking it with new launches and expansion packs. However, it is aware that it needs to focus on mobile to increase its user base. So, it is making certain moves in the mobile market to make up for slowing online gaming revenue. 

NetEase currently has three mobile games on the market. Without going into specifics, NetEase management stated that they are going to "launch a number of new mobile games" as 2014 progresses. The company will develop new games for mobile and launch mobile versions of its popular online games.  This strategy sounds promising, but NetEase might see a slowdown in revenue growth until the mobile initiative gains steam -- if it does.

Stiff competition in mobile
However, making a mark in mobile isn't going to be easy. The space is already crowded and there are more experienced players such as Glu Mobile in this arena. Glu Mobile already has a strong mobile gaming portfolio, including games such as Contract Killer, Frontline Commando, Eternity Warriors, and Deer Hunter. The company is looking to double the revenue of the new games in these franchises by delivering improved gameplay and social engagement among gamers.

In addition, Glu is already quite popular on leading mobile platforms such as iOS and Android, which puts it in an advantageous position when compared to newcomers. However, mobile gamers have fast-changing preferences, and if NetEase manages to churn out some successful games, it could hit gold in this market. Mobile gaming is expected to grow to $22 billion by the end of 2015, according to Gartner, so the opportunity ahead is quite big. 

The bottom line
NetEase did very well in 2013, but shares are down so far this year. Even then, the stock has gained close to 40% over the past year. So, investors should consider booking profits in the stock and waiting on the sidelines till NetEase's mobile initiative is in full flow.

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Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and NetEase.com. The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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