ChinaJoy, China’s equivalent of the Electronic Entertainment Expo (E3), is famous for its thousands of show girls, new title releases, and the flashy sports cars of the top executives behind it all. This glitz not only attracts droves of young men—potential gamers—like moths to a light, but also reflects the rich fortunes of hardcore online games in China.

Gaming is the largest market by revenue in China’s internet industry: $3.57 billion in 2009 and $9.2 billion by 2014, according to a forecast by Niko Partners. China’s casual games generate some revenues and there’s a nascent social games sector, but about 80% of the riches come from massive multiplayer online games.

Of the Chinese internet companies listed on the NASDAQ and NYSE, 7 of 15 are either completely or heavily dependent upon massive multiplayer online games: Shanda, The 9, Netease, Kongzhong, Changyou, Perfect World, and Giant Interactive.

Tempering Sky-High Expectations for Massive Multiplayer Online Games

Despite the carnival atmosphere at the ChinaJoy expo, there were sober concerns on the business conference side that growth is slowing. Stocks for all virtually of the major Chinese gaming companies are down for the year-to-date.

SIG analyst Zhao Chunming cites five challenges facing massive multiplayer online games:

  1. User growth is slowing down as new Internet users are mainly coming from older age groups, rural areas, and mobile users.
  2. Competition is appearing on multiple fronts, most notably social network games.
  3. Competition is intensifying among game companies as the market matures. Major game companies have seen talent losses to rivals or VC-invested start-ups, resulting in an across-the-board increase in engineer and designer costs.
  4. The market is filled with homogeneous content, lack of innovations. We believe the stickiness of games has come down, due to games “learning” from each other in-game play and money-making features. It is increasingly difficult to produce blockbusters in this market.
  5. Average revenue per user growth is significantly slower, raising questions about the virtual item-based model. In our opinion, the money-making incentives behind the item-based games have caused deviation of game usage, i.e., chasing virtual items rather than the core entertainment purpose.

Bill Bishop, formerly chief executive of a Beijing-based developer and operator of online games and a blogger at Digicha, states: “The cost of user acquisition (getting new users) has gone up significantly. In the last couple of months, Perfect World, Giant, and NetEase have all enacted big cuts in their field marketing teams for internet cafes, laying off hundreds or maybe even thousands of sales agents, because they’re trying to protect margins.”

Still, “Most companies around the world would kill to have the ‘problems’ of Chinese game firms,” says Bishop. Though decelerating, growth is still strong. It may just be a matter of investors tempering sky-high expectations for the domestic Chinese market.

Moreover, by examining only the speed bumps facing by China’s publicly listed companies, many analysts are missing the growth of small to medium-sized developers generating $0.5 to $4 million per month, says Calvin Ng, a CEO and advisor to several massive multiplayer online gaming companies. “The Chinese mentality is that everybody wants to get rich. Today all of the small game developers think they can become the next Shanda,” a reference to one of the biggest public game companies.

There are fewer barriers to entry for newcomers today, prompting more developers to strike out on their own. Ng says, “It’s become easy to share your game with 20 to 30 portals. I have personally met 6 or 7 startup studios that came out of Kingsoft alone.”

Recognizing this shift, the top firms have started publishing games and making acquisitions. “It’s very hard for the big boys to retain talent, so they’ve become venture capital firms themselves,” states Ng. Shanda has launched Fund 18, which will invest in, publish, and distribute games. In the case of overseas publishing, Shanda retains 60 percent of revenues. Giant Interactive has set up a similar fund, called Win with Giant. In addition, there have been a number of acquisitions of smaller developers at a price to earnings ratio of five to six, according to Ng.

Chinese Firms Go Abroad, But Foreign Firms Face Prohibitive Regulations in China

With government encouragement, Chinese companies are also headed overseas in search of new markets. Calvin Ng says, “NetDragon was the first one and the father of [Chinese gaming companies] going abroad. From there spin-offs include IGG (I Got Game), Ray Flame (actually all of their games are from China), and Enjoy MMO. They’re already doing pretty well in the West.” Perfect World expects its overseas revenues to reach $100 million in 2010. Chinese gaming firms are also starting to purchase abroad: Shanda acquired Mochi Media, Tencent invested in Riot Games, and The9 invested in Aurora Feint.

At the same time, severe regulatory issues cripple foreign firms attempting to enter China. Bill Bishop writes, “From a US policy perspective, assuming the U.S. game industry lobby cares about this issue, it seems like an easy argument to make to USTR and the Congress that while China is blocking American firms from a $4 billion+ market (and growing 30%+ per year), the Chinese are piling unrestricted into the wide open US market and have a very good chance of gaining real share.” Even the sale of Xbox, Playstation, and Wii consoles is technically illegal in China, though there is a gray market.

Blizzard Entertainment, one of the few major foreign exhibitors at ChinaJoy (sharing a booth with its partner NetEase), exemplifies the travails facing foreign firms in China. The company had difficulties getting its content approved for World of Warcraft when it changed operators in China from The9 to NetEase. When a sector is “sensitive”, even a strong and experienced Chinese partner cannot guarantee smooth sailing.

Kai Lukoff is an analyst at BloggerInsight and an editor on China Social Games. Follow Kai on Twitter @klukoff.

Jens Hilgers is the CEO at China Venture Labs, a privately held early stage investment company focused on internet and gaming startups based out of Beijing, China. Jens has built several successful gaming companies in Europe amongst them Turtle Entertainment GmbH, a global leading online platform for competitive computer gamers which he still oversees as chairman of the board today.

Photo by Michele Travierso