Holding This Small-Cap Chinese Gaming Stock Doesn't Make Sense

Having gained 44% this year, this stock doesn't seem to have any more upside.

Jul 17, 2014 at 11:00AM

So far in 2014, Chinese gaming company Shanda Games (NASDAQ:GAME) has appreciated a remarkable 44%. However, the stock's outstanding performance is not a result of some solid financial results, but due to a go-private offer that it had received from a consortium of buyers in January. However, Shanda hasn't made much progress on this front, and six months down the line, it is still considering the offer.

Additionally, Shanda's results haven't been impressive. In massively multiplayer online (MMO) gaming, its key metrics declined in the first quarter. Its revenue dropped almost 10% year over year to $161 million, missing the consensus estimate of $188 million by a wide margin. Moreover, it looks like Shanda is side stepping the go-private issue to focus on its upcoming games, which is surprising as the stock has been trading at elevated levels for the last six months due to the buyout offer.

In such a scenario, it will be wise to hit the eject button on Shanda and take profits off the table. The MMO gaming space is dominated by the likes of NetEase (NASDAQ:NTES) in China, while in mobile gaming, rival Perfect World (NASDAQ:PWRD) is making its moves for quite some time.

MMO is struggling
Shanda struggled in the first quarter in both its MMO and mobile segments. In MMO, average monthly active users went down to 18 million from the year-ago period's figure of 18.6 million. Average monthly paying users also dropped to 3 million from the year-ago quarter's 3.4 million. This drop doesn't come as a surprise, as Shanda's MMO gaming segment is in a funk since late last year.

The company had to shut down RIFT in the third quarter last year after the game underperformed. Shanda was trying to diversify its revenue stream with this game, but its move failed. The company depends on three titles -- Mir II, Dragon Nest, and Woool -- for around half of its revenue, and all of them are struggling to gain traction. 

Why a comeback might not be possible
Shanda, however, is trying to breathe some life into its MMO gaming segment. It is testing a number of games currently, such as Final Fantasy XIV, which is a fantasy themed 3D MMO game, and Ring of Dragons, a martial-arts-based 3D MMO game. These games might help Shanda bring some stability to the MMO gaming segment. However, it isn't a good idea to expect Shanda's new MMO games to set the charts on fire, as competes with rivals that have deeper pockets and stronger franchises.

NetEase, for example, has done well in a sluggish MMO environment with its in-house games. The likes of Tianxia III, New Westward Journey Online III, Legend of Fairy have performed well. Looking ahead, NetEase has lined up some more games for release in China to bolster its position in MMO gaming. Revelation, a 3-D Oriental fantasy MMORPG, has received positive feedback from users in the test phase, while Crisis 2015, its first-person shooter game, is slated to be launched later this year.

Additionally, NetEase has a partnership with Activision Blizzard to operate World of Warcraft in China. Both companies are extending their relationship with Heroes of the Storm, a free-to-play online team brawler game that's expected to be released in China. 

NetEase is five times bigger than Shanda in terms of market capitalization, and it has a strong portfolio of games as well. All in all, the company has stronger resources to develop more games and hurt Shanda's growth.

Mobile woes
As far as mobile games are concerned, Shanda saw a big drop in performance in the previous quarter. In the previous quarter, mobile gaming revenue was down around 40% year over year. Shanda attributed the drop to "a decline in revenue from several key mobile games which are entering the mature stages of their lifecycles." So, the company will now have to work harder to develop its mobile gaming portfolio, but even then, success is not guaranteed.

Shanda rival Perfect World is investing aggressively in mobile games. In fact, Perfect World is having no trouble in sacrificing its margins to market and develop its mobile games. As a result, the likes of Return of the Condor Heroes and Fantasy of the Immortals are finding good adoption in the market. Looking ahead, Perfect World has lined up Forsaken World, Touch, CrossGate Mobile, and Swordsman Mobile to improve its mobile portfolio.

The company expects to take some more hits to the bottom line in the short run as it promotes its mobile games with gusto, creating more pressure on Shanda's mobile segment.

The bottom line
Shanda has remained stagnant after shooting up remarkably in January. Its results haven't been solid and it is seeing weakness in the business. In such a scenario, it would be a good idea for investors to sell Shanda, book profits, and look at other lucrative options in the gaming industry.

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Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends NetEase.com. 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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