Shares of Changyou.com (NASDAQ:CYOU) tumbled about 40% this year due to an ongoing slowdown in its core gaming business, a government-mandated freeze on new game approvals, a depreciating RMB, and general concerns about Chinese stocks amid rising trade tensions between the US and China.

Yet the sell-off reduced Changyou's forward P/E to just 8, and value-seeking investors might be wondering if this stock is oversold. Changyou recently reported its third quarter earnings, which beat expectations but also revealed major headwinds. Let's dig deeper to see if Changyou's stock can rebound over the next few quarters.

A gamer plays a PC game.

Image source: Getty Images.

Its gaming business is fading

Changyou generated 81% of its revenue from PC and mobile games during the quarter. Its total average monthly active accounts for its PC games stayed flat sequentially and annually at 2.3 million during the quarter. Total paying accounts for its PC games rose 14% sequentially but stayed flat annually at 0.8 million. Changyou attributed the unit's sequential growth in paid users to improved in-game monetization efforts for its flagship title TLBB.

Total average monthly active accounts on its mobile games rose 16% sequentially but fell 29% annually to 3.7 million. Total paying accounts on its mobile games stayed flat sequentially but tumbled 50% annually to 0.7 million. Changyou attributed the unit's sequential growth to a launch of a new game during the third quarter, and its annual declines to the "natural declining life cycles" of its aging flagship title Legacy TLBB Mobile.

Changyou's gaming business faces two main headwinds: the suspension of new gaming approvals (which could last until early 2019), and tough competition from Tencent (NASDAQOTH:TCEHY) and NetEase (NASDAQ:NTES), which dominate China's mobile gaming market. Tencent and NetEase publish nine of the top ten highest-grossing iOS games in China according to App Annie. Tencent also publishes Changyou's mobile titles, but the latter's biggest mobile title -- Legacy TLBB Mobile -- ranks 25th in App Annie's rankings.

A group of people use their smartphones.

Image source: Getty Images.

Changyou's total online gaming revenue fell 28% annually to $96 million during the third quarter, compared to a 23% drop in the second quarter. For comparison, Tencent and NetEase's online gaming revenues rose 6% and 7% year-over-year, respectively, during their second quarters.

Its other businesses are shrinking

The rest of Changyou's revenue comes from cinema ads, online ads, and internet value-added services (IVAS). None of these businesses fared well during the third quarter.

 

Q3 revenue

QOQ growth

YOY growth

Cinema advertising

$16 million

36%

(34%)

Online advertising

$5 million

(12%)

(20%)

IVAS

$1 million

(8%)

(58%)

Source: Changyou Q3 report.

Changyou's cinema ad revenues were distorted by the acquisition and sale of some advertising resources. The annual drop reflects that strategic shift, and the sequential growth reflects a recovery in some of those revenues.

Its online ad revenue growth was throttled by fewer ads for games on its 17173 gaming website, which was likely caused by Beijing's freeze on new game approvals. Its IVAS revenues were also dragged down by lower sales of PC and mobile internet products. Simply put, revenues from Changyou's secondary businesses won't offset the weakness of its gaming unit anytime soon.

But its earnings are improving

Changyou's total revenue fell 29% annually to $118 million during the quarter, which still beat estimates by $10 million.

Changyou's gross margin (both GAAP and non-GAAP) dropped six percentage points annually to 67% during the quarter. However, the company also slashed its operating expenses by 67% annually to just $50 million, which boosted its operating margin of nearly 25%, compared to a negative operating margin last year.

That improvement boosted Changyou's non-GAAP net income to $54 million, compared to a loss of $5 million a year earlier. That translated to $1.01 per ADS, which crushed estimates by $0.59.

For the fourth quarter, Changyou expects its revenue to fall 17%-24% annually, and for its online gaming revenue to decline 13%-22% as Beijing's "video game winter" continues. The company expects to post a non-GAAP net profit of $0.43-$0.52 per ADS -- but that would still represent a 19%-33% drop from the previous year.

Avoid this underdog (for now)

Changyou's stock looks cheap, but investors are ignoring it because a turnaround won't happen anytime soon. Bigger companies like Tencent and NetEase are already struggling to stay afloat in this tough market, so it doesn't make much sense to buy the battered underdog.

Leo Sun owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends NetEase and Tencent Holdings. The Motley Fool has a disclosure policy.