Can Anything End's Slide?

Shares of (NAS: CYOU) hit a 52-week low on Thursday. Let's take a look at how it got there and see whether cloudy skies are still in the forecast.

How it got here
What do you get when you add the inherent distrust of earnings results from Chinese companies and weak sales figures out of the gaming sector? The answer: bad news for shareholders.

The China-based multiplayer-online-game producer, which is majority owned by (NAS: SOHU) , hasn't exactly been lighting things up in the growth department recently and is succumbing to the trend of lower margins and higher development expenses that's currently attacking its parent Sohu and rival SINA (NAS: SINA) .

In Changyou's latest quarter the company's reported a 30% rise in sales year over year as it added 62% more aggregate users to reach 188.5 million users. Unfortunately, this rise in revenue and a huge jump in aggregate users didn't translate into bottom-line results as non-GAAP EPS increased by only 10% over the previous year. Or, to put that in even simpler terms, Changyou is failing to convert free users into premium users. Even more, its paying online customer base average revenue per user rose by a paltry 2% in the latest quarter. Not only is it converting customers at an extremely low rate, but it isn't getting much more out of existing customers.

The real concern for gaming developers remains costs. Electronic Arts' vice president of corporate communications, Jeff Brown, predicts game development costs will rise 200% by the time the next generation of consoles hits the market. If that prediction proves true, margins for online gamers could really take a hit.

One thing we can't deny, however, is that if growth rates slow down, China-based online game providers Perfect World (NAS: PWRD) , NetEase (NAS: NTES) , and Changyou are very inexpensive relative to their U.S.-based peers.

How it stacks up
Let's see how stacks up next to its peers:

CYOU Chart
CYOU Chart

CYOU data by YCharts

Aside from NetEase, most China-based online gamers have struggled recently.



Price/Cash Flow

Forward P/E

5-Year Revenue CAGR










Perfect World










Source: Morningstar; author's calculations; CAGR = compound annual growth rate.

First things first... relax! Before you go calling up your buddy and telling him or her you've found the next greatest investment since sliced bread, understand that these five-year growth rates don't account for the fact that many companies were brand-spanking new in 2006. Perfect World and Changyou literally had only a few million in revenue in 2006 as their operations had just kicked off.

Another factor to consider is the declining margins across the board in this sector. SINA and both saw earnings weaken in their latest quarters, while I noted last week that my reason for avoiding NetEase was its moderate deterioration in margin over the past five years. Although still healthy, Changyou's margins have been slowly dipping since 2009 while its spending has been creeping steadily higher.

What really can't be overlooked here is how hit-and-miss online games can be, what little growth online gaming companies are seeing with regards to converting free customers to paying customers, and how rapidly development costs are rising. Considering how freely the Chinese consumer is spending, I would expect better results from these developers.

What's next
Now for the $64,000 question: What's next for That really comes down to whether or not it can convert non-paying customers into premium subscribers and whether it can keep development expenses down.

Our very own CAPS community gives the company a two-star rating (out of five), with 86.8% of members who've rated it expecting it to outperform. Personally, I've yet to make a CAPScall on the company in either direction, and I'm still not ready for that sort of commitment.

The reason I'm leaving Changyou hanging at the altar has to do with its failure to really pack on paying members or increase ARPU enough to satisfy my own personal expectations for an online gaming company based in high-growth China. If I hadn't made it clear, gaming development costs and Changyou's spike in spending has me concerned too. On the other hand, Changyou is dirt cheap and could be a great value even if its growth slows to the high single digits. For now I'll take a wait-and-see approach on the stock and revisit it in a few months.

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At the time thisarticle was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.Motley Fool newsletter services have recommended buying shares of, SINA, and NetEase. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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