This Chinese Game Developer Has Monster Potential
The technology sector is one of the most widely covered – and hyped – segments of the financial world. Over the past year, it has been the axiomatic engine of the economy, returning 7.4 percent while the broader markets have yielded squat. Investors’ first inclination may be to hold a tech ETF to ensure adequate diversification, but there’s a better way to seize the opportunities that lie in this sector. Aside from choosing companies with consistent earnings growth, quality cash flow generation, and attractive multiples, it’s also crucial to determine which demonstrate a clear commitment to research and development.
Just as a fashion designer continually strives to create the next chic style, technology companies too must be models of innovation, for their marketplace is marred with fickle consumers and unpredictable product lifecycles. In almost all cases, the only way to progress is through dollars-driven research. While earnings reports receive most of the noise in the financial press, tech investors must measure: (1) the percentage of sales a company is spending on R&D, and (2) how the markets are valuing that R&D.
By determining which R&D devotees are underappreciated by the herd, it is possible to outperform the broader market indices. If any of these firms are able to translate their research into innovation, you might knock a few out of the park. In fact, multiple scholars – Aboody in 2000, Eberhart in 2002, and Chambers in 2002 – have found a statistically significant positive correlation between R&D spending and abnormal returns, so this isn’t just another market myth.
Changyou.com Ltd (NASDAQ: CYOU) has been singing ‘its all about the R&D baby’, though it has fallen on deaf ears to this point. All investors must do is listen to the music and a fairer valuation may be on the horizon. The online videogame developer is a 2009-era spin-off of Sohu.com (NASDAQ: SOHU), one of the most successful Internet companies in China. In the two years following the split from Sohu, Changyou’s stock boomed, returning over 100 percent (read here to learn more about the historical returns of spin-offs). In the past year, however, shares of CYOU lost most of the value they gained, falling back to their debut price near $20.
Though the company had traditionally developed all of its games internally, it has recently announced that it would begin to dabble in the licensing arena as well. This strategic shift may have stimulated some sell off, though most of the uncertainty about Changyou lies in its ability to release successful games on a consistent basis. Looking at the company’s last 12 months of sales, it has spent 11.2 percent on R&D. This is middle of the road compared to developers like Take-Two Interactive (NASDAQ: TTWO) at 7.7 percent, Activision Blizzard (NASDAQ: ATVI) at 14.0 percent, and Giant Interactive (NYSE: GA) at 13.2 percent.
The kicker, though, is to measure how this R&D is valued. To do this, we simply add R&D per share to earnings per share (a metric called growth flow), and compute what is known as the Price-to-Growth Flow ratio. Similar to P/E analysis, a lower P/GF ratio indicates that a particular stock is undervalued. When looking at the P/GF ratio of CYOU (4.2X), it is below TTWO (8.7X), ATVI (8.5X), and GA (6.1X). Thus, Changyou looks to be trading at a 30 to 50 percent discount in relation to its peers when using this metric. Moreover, we can also compute how quickly each company has expanded its growth flow, which also favors Changyou. To avoid confusion, note that we are calling growth flow ‘GF’ for short. In the past three years, Changyou has averaged a better GF growth rate (26.7%) than TTWO (13.5%) and GA (6.5%), which has been achieved primarily through higher R&D spending. Specifically, the company spent $27 million the year it split from Sohu, and $58 million just three years later.
Looking at CYOU from a more conventional standpoint also tells a similar story. The stock is trading at Price-to-Earnings (4.6X) and Price-to-Cash Flow (4.2X) ratios way below the industry averages of 18.2X and 12.3X respectively. This massive undervaluation seems unwarranted, as the company sports solid 3-year average EPS (26.4%) and operating cash flow (15.8%) growth rates. In fact, in its first two years as a publicly traded company, Changyou’s earnings were trading at a 47 percent discount relative to those of the S&P 500. This year, they are cheaper, trading at a 68 percent discount. Using a year-ahead EPS estimate of $4.68 in conjunction with the stock’s historical P/E, a price target of $35.57 can be set by next spring. The stock currently trades just above $20 a share.
Going forward, Changyou has four new massively multiplayer online games on the horizon, with God Slayer being the most anticipated. Gamers are probably used to MMOs having subpar graphics in comparison to their offline peers, though this could all change with the developer’s new CryENGINE 3 system. The graphics engine is being developed in conjunction with Crytek, the creator of popular North American titles like Far Cry, Crysis, and Crysis 2. It is hoped that God Slayer can be a global success for Changyou and Crytek, much in the way that the World of Warcraft series has been for Activision Blizzard. The game has been made to fit the demands of a multicultural user base, as it puts players in a world that fuses eastern and western mythology into one. God Slayer’s release date has not been made public, though fall or winter of 2013 would make sense. Check out this epic trailer in the mean time.
Whether its CYOU’s strong growth flow numbers, persistent undervaluation, or promising game pipeline, investors may be wise to consider taking a long position in the stock. To learn more about the video gaming industry and how titles like Mass Effect 3 have stung investors everywhere, continue reading here.
Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.