Fool on Call: CDC Is Just Getting Started

Since last August, when I last looked at CDC (Nasdaq: CHINA  ) , the company's stock rose from $5 and change to a high of more than $11. It has since settled in the $9 range -- a nice return over the past seven months.

When I wrote that article, CDC's stock had already provided shareholders a 100% return in the previous 14 months. But based on my analysis of remarks made in the conference call, I concluded that even better times might lie ahead. That was an easy call to make, especially given the CEO's optimism: "We continue to believe the Company harbors additional value not currently reflected in our stock price."

After the run-up, is it now too late for prospective investors to take a nibble? Let's turn our attention to the company's latest quarterly earnings conference call, looking for clues to what awaits CDC in the coming months.

Game on in China ... and beyond
CDC is still a relative unknown to many investors, and those who know of it are most familiar with its CHINA.com operation. But as my colleague Rick Aristotle Munarriz points out, most of its revenue comes from its software segment, and only a third of its sales come from the Asia-Pacific region. Given its enterprise software business, another colleague of mine, Will Frankenhoff, described CDC as a high-growth investment with a defensive twist.

CDC's main attraction, however, is by far its growth opportunities in China. For that reason, we'll focus our attention there, with a specific interest in electronic gaming.

CDC has launched a three-pronged attack on the Chinese market: online gaming, mobile applications, and Web portals. Its broad operations invite many competitors, including Shanda Interactive (Nasdaq: SNDA  ) , The9 (Nasdaq: NCTY  ) , and NetEase (Nasdaq: NTES  ) on the gaming side, as well as Baidu.com (Nasdaq: BIDU  ) in the portal and search biz. Unlike Baidu, which has tailored its search engine specifically for the complex Chinese language, CDC's CHINA.com has partnered with Google (Nasdaq: GOOG  ) to provide its search functions.

Because of its diversified operations, CEO Peter Yip believes the company is very well-positioned to succeed in China. Several strategic moves in its online gaming segment particularly illustrate how CDC is positioning itself for continued success.

The company's first major free-to-play, pay-for-merchandise online game was Yulgang. Though it's been live since July 2005, it's still hauling in healthy double-digit revenue growth. In the fourth quarter, sales from Yulgang increased 27% compared to Q3 2006, while registered users rose by 16%. Because of the game's continued popularity, the company has decided to extend its licensing agreement to 2010.

Strategic investments in gaming developers
Yulgang's success compelled CDC to make another strategic move: CDC is now the largest external investor in MGame Corporation, Yulgang's developer. Its equity investment in MGame gives CDC the exclusive rights to the company's next major massively multiplayer online role-playing game (MMORPG), titled Wind Forest Fire Mountain (or WFFM). According to Xiaowei Chen, CEO of CDC Games, WFFM is one of the "10 most anticipated games in China."

MGame isn't CDC's only recent investment in electronic gaming. Gorilla Banana, Auran Fury, Possibility Space, and Abandon Mobile have also received CDC equity. The partnerships not only give CDC more depth in the Chinese online-gaming segment, but also strengthen its position in mobile gaming, thanks to the inclusion of Abandon Mobile. The mobile partnership is particularly intriguing, because much of Abandon Mobile's content is sports-related, diversifying CDC from its traditional RPG category. Additionally, Abandon Mobile's sports games are branded with a well-known and easily identifiable license in GE's (NYSE: GE  ) NBC Sports.

Strategic investments are part of a bigger plan
In its conference call last August, CDC announced that it would be moving from its traditional licensing structure to include game development. At the time of the announcement, I was a bit skeptical of the move, given the complexity of developing games these days. But in this call, CDC shed more light on the initiative, setting my mind at ease. Instead of building a gaming development enterprise from scratch, the company has smartly earmarked a certain dollar amount specifically for investing in established developers. CDC has now expanded its initial $20 million fund to $100 million.

The video game development business will be run under a subsidiary called CDC Games Studio. Intriguingly, its mission extends beyond Chinese borders. For example, through its investment in Gorilla Banana, CDC has obtained exclusive rights to distribute Red Blood (one of Korea's top five most anticipated games for 2008) in China and India. "We view India as the world's next emerging game market," Chen declared.

We won't start to see more of the fruit from this initiative until 2008. This year, expect CDC to introduce four new licensed games in China, a market now estimated at a remarkable 100 million gamers. The new titles' popular heritage should encourage big sales to gamers right out of the gate. Special Force, for instance, was the top-ranked online game in Korea for 52 consecutive weeks. Stone Age 2, based on its prequel's success, has been "voted [the] most anticipated game of 2007 by game players in China." And Lord of the Rings Online pretty much speaks for itself.

CDC is just getting started
CDC's recent strategic investment activity makes good business sense, so long as the company doesn't overpay for the investments. The partnerships not only give the company exclusive rights to hotly anticipated titles, but also enable CDC to tap into other markets. Better yet, shifting from licensing to developing will let CDC pursue higher gross margins.

The math looks simple: Strong sales plus anticipated accelerating profit margins equals a winner. My colleague ran the numbers and expects a stock price of $13 to $14 over the next 12 months. I don't know where the stock will trade a year or two from now, but I'm rather confident in the direction CDC is taking.

"The environment is right and the stars are aligned for our business units," CEO Yip concluded. It looks like I'm not the only one confident in CDC's prospects.

NetEase and Shanda Interactive are Motley Fool Rule Breakers recommendations. To find out why our Foolish advisors favor these Chinese companies, try a free 30-day trial of the newsletter.

Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.


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