Shanda: A Compelling Play in Chinese Web Games

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We believe that this expected growth rate is considerably higher than those for the S&P 1500, S&P 1500 Technology sector, and the S&P 1500 Internet Software & Services subindustry. Essentially, Shanda is less expensive on a P-E basis, yet offers more growth potential, by our analysis.

In fact, we calculate Shanda's P-E-to-growth (PEG) ratio at 0.7 times using estimated 2008 earnings and our 18% growth forecast, which is considerably lower than those we have projected for the S&P 1500 (1.2 times), the S&P 1500 Technology sector (1.1 times), and the S&P 1500 Internet Software & Services subindustry (1.1 times).

Although these comparisons indicate that Shanda is undervalued, we believe more focused peer considerations are the best way to help confirm this assessment and derive an appropriate target price.

We reviewed a relatively broad group of what we consider Shanda's peers, including Asia-based Internet companies whose ADRs trade in the U.S. On average, the ADRs recently had a 2008 P-E of 26 times and PEG ratio of 0.8 times. Shanda's recent P-E was about 50% below this group's, and its PEG was more than 10% lower. Applying these peer multiples to Shanda and weighting the results with our P-E analysis leads to our 12-month target price of $40.

We also think it is relevant to again mention that Shanda has a number of noncore businesses that we think could perhaps be better monetized through some kind of corporate activity. We think the literature portal looks especially interesting in this regard.

Lastly, Shanda had $464 million in cash, cash equivalents, and investments as of March 2008, amounting to $6.32 per ADR.

CORPORATE GOVERNANCE

Shanda has a very complicated corporate structure, in part because of its considerable acquisition activity over the past number of years. It is a Cayman Islands holding company, and has operating businesses domiciled in mainland China and Hong Kong. The company also owns a majority stake in a business based South Korea. In total, Shanda has some 35 separate subsidiaries and investees. We think this complexity detracts from corporate governance and transparency.

The company's co-founder, chairman, and CEO, Tianqiao Chen owned some 43% of company as of March 2008. Around the same time during the prior year, he controlled about 56% of Shanda's shares. While we generally believe it is good for corporate managers and directors to own significant stakes in their companies, therefore aligning their interests with those of shareholders, we find Chen's multifaceted ability to control the company as its leading executive, head of the board of directors and Shanda's by far largest single share owner somewhat worrisome.

As of June 2008, Shanda had nine directors, a majority of which were not company employees. We note that one of the directors was Chen's wife.

The board of directors has adopted a code of ethics that is applicable to its senior managers and a code of conduct that is applicable to all of Shanda's employees. It has also adopted a set of corporate governance guidelines and established a disclosure committee.

Overall, we believe that Shanda's corporate governance is somewhat lacking, but not substantially so, especially compared to peers.

INVESTMENT RISKS

Risks to our recommendation and target price include weaker demand for offerings than we foresee, perhaps related to global economic challenges or China-specific events, such as the May 2008 earthquake in the southwestern part of the country, more significant competition in terms of both companies and offerings, potential business execution issues, especially as Shanda focuses on building its game pipeline and diversifying its operations largely through acquisitions and strategic investments, and possible adverse regulatory developments initiated by the Chinese government, especially related to online content and taxation.

Kessler follows technology stocks for S&P Equity Research .