The Chinese government is still worried about video games. Back on August 3, state-affiliated media in China said that playing online games is addictive and went so far as to call online games ‘spiritual opium’. As a result, children under the age of 18 under playing video games on Chinese servers were restricted to three hours of gaming per week.
There is a workaround, though. State-owned CCTV reported that, for Tencent (00700)’s blockbuster game Honor of Kings, users can pay a rate of CNY 33 per two hours to rent accounts and get around the restriction. Subsequently, game developers like Tencent and NetEase (09999) were summoned for a talk with the state officials. The talk weighed on the market’s ailing confidence in Chinese stocks. Chelsey Tam, senior equity analyst at Morningstar, says there’s more to glean from the talk than mere hour limits. “To us, most notable during the discussions are new requirements around antimarket concentration, strengthening controls of in-app purchases, and game designs that induce addiction.”
Ensuring Fair Play
In Tam’s opinion, the authorities want a level playing field in the gaming industry. For years, to maximize the reach to players, game firms usually sign deals to onboard their games onto partners’ platforms. Platforms that own a massive base of active users and traffic may ask for exclusivity for the popular games. One of such channels is Tencent’s all-in-one social media platform, WeChat.
In recent years, Tencent and TikTok operator Bytedance have competed for exclusive agreements for games. As such, the exclusive nature of game distribution has caused regulatory concerns about monopolizing the market and revenue. From an antitrust standpoint, Tam says she sees limited evidence showing Tencent abusing its market power. By gaming revenue derived from the Chinese market, Tencent took up 56% in 2020. “We think the government is most likely to limit Tencent from extending its power via mergers and acquisitions among gaming peers, both upstream and downstream.”
At this stage, Tam retains the fair value estimate and uncertainty rating of Tencent, NetEase and CMGE Technology Group (00302) under Morningstar’s coverage as the base case scenario for these game providers does not factor in a substantial threat from the potential monopolistic behaviors.
Different from Education Stocks
In addition to the weekly limit to the youth from playing online games, the government also reiterated that “the gaming industry should not focus on profit but should also focus on protecting minors”. This line resurfaced worries caused by the slump in education stocks. The two are not alike.
Education providers capitalize primarily on pupils in school seeking additional tutoring. In contrast, games attract users of all ages, but monetization is heavily leaned towards adults. According to Tam, gamers of 16-year-old or below accounted for 2.60% of Tencent’s Chinese gaming revenues in the second quarter. NetEase disclosed that users that are under 18 contributed to less than 1% of its overall gross revenues.
After the waves of regulatory consolidation, Tam retains her estimates of revenue contribution from the young gamers to stay around low single digits.
“We think there is some downside from cracking down on minors that use adult accounts to play games but given minors do not have income, they are unlikely to generate a material amount of gaming revenue,” says Tam, who expects to see mix shift toward offline games, for example, certain single-player games that can offset some of the impacts.
Longer-Term Views
At Morningstar, we emphasize a long-term investment horizon that takes into account valuation and the future opportunities for the stocks. Tam believes it is more likely than not that these stocks will bounce back in a few years. She underscores some upside potential that is overshadowed by investors’ panic, reflecting in the beaten-down share prices.
She envisions that the increasingly stringent requirement at home would encourage these game developers to look beyond the border. “The long-term potential for these quality game designers and distributors is to cross the border to diversify their business focus. While risks continue to loom around the domestic market, gaming firms may put international expansion in a higher priority than prior and speed up building their franchises on the mobile and PC gaming stores overseas.”
Before the official’s talk with the game companies, NetEase received a significant increase in fair value estimate at the end of August, to HK$217 per share from HK$142, or an 52.8% rise. Tam, who assigns the estimate, says she maintains her outlook. “The bulk of the increase comes from our updated outlook for higher long-term growth and profitability in the gaming segment. The overreaction by the market to the recent risks shows that the market is somewhat overlooking the firm’s long-term opportunities overseas.” Morningstar views the narrow-moat company, which closed HK$138.1 on Friday, as undervalued.
Wide-moat Tencent’s fair value estimate remains unchanged. The HK$4.98 trillion company, the largest Hong Kong-listed company by market cap is trading at HK$490, 40% under its fair value of HK$800. CMGE Technology Group is trading HK$ 3.58, versus its fair value estimate by Morningstar of HK$7.0.
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