Why aren't online gaming values higher?

Asia is significantly ahead of the US in the development of the free to play MMOG market. If China’s market is an indication, the future certainly looks bright. Says GamesIndustry.biz:

China’s online games market will exceed USD 5.5 billion by 2012, according to Pearl Research, which estimated that the market grew more than 63 per cent to USD 2.8 billion in 2008.

The study, entitled “Games Market in China”, reported that six online game operators, including Tencent, Changyou, The9, Netease, Shanda and Giant each brought in more than USD 200 million in revenue last year.

Peak concurrent user rates are phenomenal, especially when you consider that free to play MMO publishers in the west consider a game successful if they get more than 50k PCUs:

China’s most popular online games were named, with Netease’s Fantasy Westward Journey leading the pack at 1.8 million peak concurrent users, followed by Giant’s Zhengtu Online at 1.5 million.

Tencent’s Dungeon and Fighter hit 1.2 million concurrent users, while Blizzard’s World of Warcraft, operated in the region by The9, came in at 1 million users.

But a rising tide does not raise all boats. 70% of Chinese Gaming companies are operating at a loss, according to iResearch Consulting Group:

There are about 200 online games in the Chinese market presently, said insiders. But only several developers can make a profit on their games, such as NetEase.com, Inc. (NASDAQ: NTES), Shanda Interactive Entertainment Ltd. (NASDAQ: SNDA) and The9 Ltd. (NASDAQ: NCTY).

Such estimates may stun those people who believe that the business generates huge profits. But from analysts’ points of view, the huge profits, if existing, have been killed by costs on human resources, hardware, promotion and after-services firstly.

T2 Entertainment Co., Ltd., a Chinese online game operator, invested about CNY 30 million in the South Korean game Freestyle before the open beta testing in China, including over USD 1 million on the operating rights and CNY 20 million on promotion.

Besides, the R&D of an ordinary three-dimension online game often costs CNY 10 million, insiders said, adding that of ten online games, only one is profitable.

Because of the hit-driven nature of gaming, if the cost of a “shot on goal” is high (as the examples above suggest) then most launched games will not be profitable. Also each game is a “project” with an end-of-life, rather than having ongoing enterprise value. Some hits have the ability to build sequels, but in many cases a company that created a hit game in the past doesn’t have a guarantee that their next game will be a hit.

As a result, some of the nominally successful online games companies are not that highly valued. Shanda, NetEase, Changyou and Giant are all valued at over a billion dollars. However The9, noted above, currently has negative enterprise value. (See Avista Partner’s video game industry April Briefing – page 6 for online games.) This means that The9 is valued by the market at less than the amount of net cash that they have. (The9 recently lost it’s World of Warcraft license in China to NetEase. WoW represents 75% of The9’s revenue and they have not had a true hit of their own outside of WoW.)

The9 is an extreme case, but in general the median multiple for the online gaming category is just 7.0x 2008 EBITDA. Even for the four online gaming companies with more than a billion dollars in market cap noted above, 2008 EBITDA multiples average just 10x. Given the high growth rate of this industry, that is a surprisingly low multiple. As an online MMOG typically has a 4-6 year life, there isn’t much credit being given for companies being able to launch new hit games.

These relatively low multiple are being driven by three factors:

1) High cost to launch a new game
2) Low number of new games launched each year
3) Low probability of each game being a “hit”

In order to unlock the much higher multiples that a market growing as fast as online gaming should allow, companies will need to figure out a way to address one or more of these factors. I think a few of the free to play “social gaming” companies that are starting to figure out how to do this.

(For more from Jeremy, visit his blog)
(Image source: https://cache.daylife.com)