China's Not-So-Jolly Gaming Giants


By Bruce Einhorn What has zapped China's highflying online game companies? China has 103 million Internet users, and some of the biggest beneficiaries of its booming Net population have been companies that offer Chinese the chance to adopt online identities and travel through ancient landscapes to slay beasts, rescue fair maidens, and fight evildoers.

In China, the key part of a game is kept on the server, so it's not easy to counterfeit. By contrast, games played on Microsoft's (MSFT) Xbox or Sony's (SNE) PlayStation are accessed via disks that, like computer software, are prone to piracy. Since that makes China an unattractive market for PlayStations and Xboxes, China's peddlers of such titles as World of Warcraft and Fantasy Westward Journey have the gamer market largely to themselves.

And a lucrative market it has been -- for both the companies and investors. Indeed, it wasn't that long ago that the U.S.-traded shares of companies such as Shanda Interactive (SNDA) and NetEase.com (NTES) were some of the hottest stocks on Wall Street. In 2004, Shanda was the best-performing Nasdaq stock, up over 200%. Until recently, NetEase was on track to be one of Nasdaq's stars for 2005, with the stock price up 73% for the first nine months of the year.

LIVING ONLINE. But recently, investors betting that sort of performance would continue have had a rude shock. Shanda's stock price has plunged this year, dropping from $40-plus in late June to under $19 as of the closing bell on Nov. 15. NetEase is still up for the year, but has taken a hammering of late, with the stock falling some 30% in less than two months. On Nov. 15 alone, it shed $4.14, closing at $57.30. Another online gamer, Shanghai-based The9 (NCTY), operates one of the most popular new games, but that hasn't stopped investors from hammering its stock, too. The9 is down 29% since the end of June.

The problem, according to many who follow the industry, is fatigue -- of two sorts. First, there's game fatigue. Some of the more popular games have been around for a few years and they're no longer providing the same rush. NetEase's games are "showing signs of age," wrote Safa Rashtchy, an analyst at PiperJaffray, in a Nov. 8 report following the release of NetEase's disappointing quarterly results.

Having to deal with gamers who are no longer jazzed by the latest offering is bad enough. But China's gaming operators have another kind of fatigue to contend with. The government has been up in arms about reports of game addicts spending their lives online -- or worse.

The official Chinese media have been running alarming stories about online gamers becoming so twisted that they kill themselves, attack fellow players, or commit other crimes. Beijing therefore has recently decreed that the online-gaming companies must act against their own interest by discouraging people from using their games for too long. The government-mandated scheme, known as the Fatigue System, is designed to cut the number of hours players spend in front of their computer screens by, for instance, eliminating incentives to stay online for hours on end and gain experience that can be used to win virtual currency.

QUICKER QUESTS. While the Fatigue System was implemented only last month, NetEase Chief Financial Officer Denny Lee already blames it for some of the company's disappointing numbers in the third quarter. NetEase reported a sharp increase in revenue, to $54.8 million, for the quarter. But that increase of 8% was lower than the 13% or so that many analysts had been expecting. Moreover, NetEase on Nov. 7 said that it expects revenue for the last quarter of the year to increase just 2% to 4%.

One reason for the fall, according to Lee, was anticipation about the Fatigue System, which went into effect Oct. 1 but had been announced several months earlier. "People think, 'We might as well stop playing for a longer period of time now,'" Lee says.

Indeed, game companies have relied on keeping users online as long as possible, since people often use prepaid cards that charge by the number of hours the game is played. For the gamers, it's worth spending the money: The longer you're online, the better your chance of accumulating points that you can use to improve your character's performance.

Now, in order to accommodate the bureaucrats, NetEase and other companies may have to change the way their games operate. "If there's an [in-game] assignment that used to require more than four hours to complete, we can change it to require three hours, so people can still have time to finish it," said Lee.

While such changes may satisfy the government, some analysts are concerned. "The full magnitude of the impact of the Fatigue System...has yet to be seen," wrote William Bao Bean, a Deutsche Bank analyst, in a Nov. 8 report. However, he warned, "the system could lead to [a] decrease in playtime," among other problems.

VIRTUAL LANDSCAPE. Still, there could be an upside. The government rules may help the operators by removing the stigma surrounding online games. According to a report by Dick Wei, an analyst with J.P. Morgan in Hong Kong, "under the Fatigue System, more parents will allow their kids to play online games -- a positive for the game companies."

Since there isn't much a company can do about the government-mandated rules, NetEase is now concentrating on solving the first fatigue problem by freshening up its games. Next year will see the launch of a 3D game as well as what it calls a 2.5D game -- one where the background is two-dimensional but the gamer's character is in 3D. NetEase is also hiring more engineers for its R&D team, with the goal of increasing the current headcount of 600 by at least 20% next year. "The competitive landscape is becoming more crowded," Lee says.

For NetEase and other Chinese gaming companies that enjoyed early success, the challenge is to fight fatigue on all fronts.

Einhorn is Asia Economics Editor for BusinessWeek


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