Asia’s Top Gaming Stocks

01/04/2012 7:30 am EST

Focus: GLOBAL

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Gaming has been a major force in the US marketplace, and now Asia is going through its own gaming revolution, writes Benjamin Shepherd of Investing Daily.

Online gaming is one of the fastest-growing segments of the global technology sector, and the pastime’s popularity has grown beyond the geek squad. In the US, 67% of households have at least one gamer who devotes an average of eight hours per week to playing video games.

With 49% of gamers between the ages of 18 and 49, gaming is no longer exclusively the domain of youth. In fact, the average gamer is now 34 years old. Although the majority of gamers are male, women comprise 40% of the market, and their share is growing every year.

The global picture is much the same. In 2010, an estimated 20 million people devoted 17 billion man-hours to playing games on Xbox Live, Microsoft’s (MSFT) online multiplayer gaming platform.

But Chinese gamers are among the most dedicated gamers in the world, and their share of the market is growing rapidly. Last year, 120 million Chinese played online games and spent more than $5 billion on them.

As the Internet becomes more widely available throughout China, both the number of players and the revenue they generate for the online gaming industry is expected to grow, between 13% and 15% annually over the next several years.

Changyou.com (CYOU)—which was spun off in 2009 from Internet search powerhouse Sohu.com (SOHU)—has emerged as one of China’s most popular gaming franchises. Although Changyou trails competitors NetEase.com (NTES) and Shanda Games (GAME) in terms of market share, Changyou’s martial arts-themed Tian Long Ba Bu (TLBB) is one of the hottest games in China, with about 1.2 million peak concurrent users—a measure of the number of people logged in at any one time.

The company built upon the success of TLBB with the launch of Duke of Mount Deer (DMD) in mid-2011. Duke of Mount Deer is also a martial arts-themed game, but its more advanced gameplay appeals to hardcore gamers. That shift in focus has allowed DMD to grow rapidly without cannibalizing Changyou’s TLBB user base.

Changyou is also further expanding its product line by offering Web-based games that enable the company to reach gamers in other countries. For example, DDTank is a first-person shooter game that can be played via social media platforms such as Facebook. It has become increasingly popular in Vietnam and Indonesia.

The company’s success in capturing market share has translated into ballooning revenues, which grew 38.4% during the third quarter from the year-ago period. Changyou’s fully diluted earnings per share increased 16.5% over that same period. The firm has no outstanding debt and threw off $197 million in free cash flow in 2010.

Additionally, Changyou boasts some of the most attractive margins in the industry, with a 57.9% operating margin for the trailing 12 months, compared to an industry average of 10.6%.

Despite its competitive position in the gaming industry, Changyou’s stock sold off recently after the firm announced that its operating margin fell 16.1% during the third quarter from the year-ago period. Management attributed this decline to costs incurred during the launch of DMD, but the news spooked investors who were already worried about a slowing Chinese economy.

However, the company’s margins should recover now that the launch of DMD—and the related expenses—is behind it. Changyou has established an enduring franchise among gamers, and this short-term decline in its share price offers investors growth at an attractive value.

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