Giant Interactive: Game Over for Investors?

Gamers in an Internet cafe in China. DigitalTrends.com

World of Xianxia is an online role-playing game that has taken the Chinese market by storm in the last few years. With a user base of over 2.05 million players, this and other games have placed Giant Interactive (GA +0.00%) as a leader in Chinese online gaming industry. Disciplined financial management helps to explain why Giant Interactive has the highest profit margin in the industry at 49%. Investors have taken note; if you invested in Giant Interactive along with me one year ago, you would also have been happy to see a 111% capital gain on your investment, as well as gaining from the company's generous 5.90% annual dividend yield.

Unfortunately, you may have missed your chance at playing this company for much longer. The company is in negotiations with one of its board members who has offered to buy the company and take it private. The quoted payout per ADR was quoted at $11.75 at the time of the initial offer, though multiple American legal firms are pushing to move that price higher before the deal is finalized.

Are there still other good plays in the field? Compare the other major Chinese companies in the industry.

The big player: NetEase
NetEase (NTES +0.59%) is the biggest player, with a market cap that is almost four times the size of Giant Interactive. However, the current price above $81, near its 52 week high, is also large. The company's P/E, at nearly 16, is the highest in the field. However, the company backs up their price with continuing revenue growth, up 18% in the third quarter over the same quarter last year. Revenue increases, up from the previous quarter as well as year over year, come from both online and mobile gaming.

With plenty of cash on hand and a wide employee base, NetEase looks poised to continue its dominance in a market that is evolving with new technology. NetEase has announced continuing development of a 3D fantasy gamed called Revelations, which is set to hit the Chinese market, and expand into Korea in the next year. With 200 employees focused on the project since 2009, gaming analysts expect the game to be a definite industry winner.

Another strong point for NetEase is their partnership with the U.S. gaming company Activision Blizzard. The partnership allows NetEase to distribute Activision's mega hits such as World of Warcraft in China. In a press release earlier this year, Activision announced their excitement to continue working with NetEase as they recently licensed another game to NetEase on a three year contract.

The growth player: Perfect World
By contrast to NetEase, Perfect World (PWRD +0.00%) is the smallest player in the market, at less than $900 million market cap. However, the company has seen high growth in the second half of 2013, as the company has been gaining revenue from a strategy of releasing expansion packs to their already well selling games. The company was able to crush estimates of $0.25 revenue per share by reporting $0.39 per share in third quarter. Here is another Foolish take on the company's recent gains that might make it underpriced.

Cheap plays: Shanda and Changyou
Perfect World is encountering competition in the mobile space coming from Shanda Games (NASDAQ: GAME) and Changyou.com. With their most recent earnings release, Shanda games has noted that their revenue has been helped in a large part by their gains in mobile gaming. However, the company still missed expectations, and until new titles are released next year, the company seems to be on the decline. Much like Shanda, Changyou.com also seems to be little threat to the likes of Perfect World and NetEase. These companies might look attractive to investors merely for their low P/E ratios, but Fools will do well to heed Warren Buffett's advice that "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." 

Foolish move: keep playing
Giant Interactive will continue growing and will likely be an even more dangerous competitor when it's private, as management has more leeway to make quick, market-orienting decisions. There are also many industry shaping start-ups, just as there are in the United States, that are constantly threatening the industry leaders with new ideas, focus, and technology that could go viral at anytime. Take away: be careful of competition in this industry and continue to research the best plays for your money.

However, the industry is rapidly growing. There were 68 million online gamers in China 2009. In 2014; the number should reach 141 million. Most companies are in a great position for a growing Chinese market, especially as Chinese youth are increasingly arming themselves with smartphones and tablets, allowing for even more play on the go. The key to winning in this market: start playing.

Is China going to dominate this market?
Gaming, much like most industries, is taking advantage of the growing market in China. Auto stocks are also set to surge.