In the not-too-distant future, China figures to be the world's most dominant economy. The crystal ball also suggests that online gaming is the way of the future. These two possibilities are why investors can't seem to contain their enthusiasm for CDC (NASDAQ:CHINA).
The latest results for the software specialist were solid, posting double-digit revenue growth and earnings that surpassed analyst expectations. My colleague Rick Aristotle Munarriz pointed out that while the company's core business segment in enterprise software has been a slow grower, the same can't be said for its China.com portal and associated online gaming initiatives.
Rick highlighted several other players in this fast -growing industry, including Shanda Interactive (NASDAQ:SNDA), The9 (NASDAQ:NCTY), and NetEase (NASDAQ:NTES), but CDC's innovative online billing structure makes it an appealing alternative to the competition. In this latest roundtable discussion, Hank Schofield, Bodhi Zappa, and I will analyze CDC's latest quarterly earnings conference call to find out how the company plans to further expand its online gaming presence.
Game on
Jeremy: Online gaming in China is on fire, as evidenced by CDC's China.com division results. Second-quarter revenues in this category were up 67% -- not from a year ago . from a quarter ago! That's astounding growth. Although much of it came from its an increased stake in 17 games, organic growth from the company's online gaming business was also a major contributing factor. Bodhi, what's working for CDC in this segment?
Bodhi: Yulgang, its latest online game, is kicking butt and taking numbers. In 2005 it was the fastest-growing online role-playing game in China, becoming the second most popular game in this genre out of more than 50 new titles launched in the past year.
Jeremy: The aforementioned innovative billing model, referred to as the "free-to-play/pay-for-virtual-merchandise business model," is one reason for the game's growing popularity. CDC was the first to apply this model in China, and according to management remarks in the call, now some of its competitors are adopting the same philosophy.
Hank: I must admit the free-to-play approach makes this old-school entrepreneur quiver when I think of the monthly subscription revenues CDC is losing out on. That said, the model appears to be working -- registered users now total 30 million, an increase of 35% from the first quarter. Plus, 21.4 million units of virtual merchandise were sold in the quarter, an increase of 187% over Q1.
Bodhi: You're turning soft on me, Hank. You're right, it is hard to argue with the numbers.
The good news is that CDC has a couple of other titles lined up that are also expected to do well. It acquired the license to Special Force, which is ranked as the most popular game in Korea's Internet cafes. Additionally, the license to Stone Age 2 was obtained from Japan. Since Stone Age 1 was a hit in China, management is hopeful for similar results from the sequel.
Banking on licenses?
Hank: These are licensed games, however. And there are all kinds of concerns about relying on such a licensing strategy, just one of which is that given the hot commodity online games have become, a bidding war to secure licenses of attractive titles will erode profits. Look at the bidding war that took place with Electronic Arts (NASDAQ:ERTS) and Take-Two Interactive (NASDAQ:TTWO) over the NFL license.
Fortunately, the company recognizes this pitfall and has made it a priority to reduce its "reliance on licenser" while "actively looking into developing and/or acquiring development capabilities."
Jeremy: The bad news?
Hank: The bad news is that acquiring such a capability won't come cheaply. And there's no guarantee that what one develops in-house is going to be well received by the gaming community. CDC could end up spending millions in order to develop its own games only to find out that no one cares to play them. This is a real risk.
Bodhi: Yes, but it should be noted that CDC isn't dumping its licensing efforts altogether. The company simply doesn't want to put all its eggs in one basket. A mix of strong licenses as well as in-house products is the right way to balance the maximization of growth while minimizing risk.
Hidden value?
Jeremy: During the call, leadership at CDC didn't provide any early estimates for the cost of building a gaming development infrastructure within the company. One can only imagine the effort will not come cheaply. In the meantime, it has a hot title already on the market with two more set to release in the near future. This will buy the company time as it determines whether to embark on its own in-house development.
It is an exciting time to be a CDC shareholder, and a profitable one at that, with the stock up more than 100% in the past 14 months or so. The good times may just be getting started. CFO Verome Johnston had this to say about the company's recent stock price: "We continue to believe that the Company harbors additional value not currently reflected in our stock price."
The company is putting its money where its mouth is. Last month, it completed its first $20 million stock repurchase program. A second $20 million program was just approved by the board of directors. Should you be a buyer as well? At the very least, CDC warrants a closer look and an addition to the watch list.
For more Foolish reading:
Shanda Interactive and NetEase are Motley Fool Rule Breaker selections. Electronic Arts is a Motley Fool Stock Advisor recommendation.
Fool contributor Jeremy MacNealy has no financial interest in any company mentioned.
