China Stock Research

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Several years experience as an analyst in the hedge fund world. Investment knowledge includes long/short equities, credit, macro, arbitrage, distressed debt, and special situations. Previous research publication experience includes Japanese small cap research distributed to institutional investors. Education credentials include BS in Computer Science, MBA in Finance, and CFA Charter. Follow on Twitter @ChinaStockRsrch Follow on StockTwits @ChinaStockResearch Tanks After Q4, Buy The Dip?

After reporting Q4 FY2014 results, Changyou (NASDAQ:CYOU), promptly sold lower on heavy volume, shedding over -17% by the close of trade. One of the reasons for the tumble was performance during the quarter, but management’s revenue outlook was also beneath the consensus, suggesting further challenges ahead.

Challenges, of any kind, are exactly what the company does not need right now.

FY2014 has been a difficult one for Changyou, which saw its efforts to reinvent itself as a platform company largely fall flat. Earlier acquisitions to help this transition, namely the $50 million additional investment in RaidCall for a majority stake, haven’t produced the desired results, and seem to be the reason for the recent shuffling in the management suite. Tao Wang, the previous CEO who helped found the company that later became Changyou, stepped down in Q3, an unambiguous signal that the current strategy wasn’t working. The previous acting CFO, who was appointed in mid-July 2014, was also recently replaced.

Full year financial results reflected operational challenges facing the company. Quarterly revenue slid lower during the first half of the year, and the company accumulated operating losses following gross margin compression in the core Online Game and Advertising businesses. Gross margin pressure came from, not only, higher expenses for game operations, but also due to gross losses associated with the new RaidCall business, dragging down IVAS results. The RaidCall experiment effectively ended in Q4 when management recorded an impairment charge of over $50 million USD.

Looking ahead into FY2015, the company’s hopes appear pinned on its core competence, game operations in both PC and mobile games. On the Q4 call, management emphasized its commitment to the business, focusing on the continued strength of its core title Tian Long Ba Bu (TLBB) and the successful launch of its mobile title TLBB 3D. Seeing solid performance in TLBB 3D is a notable win for the company; gross billings were over 65 million USD in the game’s first two months of operation, a strong start. There is a degree of uncertainty, however, regarding TLBB 3D’s prospects – mobile games typically have shorter lifespans than PC games, but a dedicated TLBB fan base combined with the hard-core nature of the title could buck that industry trend.

In addition to TLBB 3D, the company had more in the queue for mobile games. Management mentioned that it had about 15 titles in its development pipeline in early FY2015, so there could be more releases later in the year if development and test proceed smoothly.

In terms of PC games, TLBB did reach a noteworthy milestone, its eighth year of operations, but there were some signs that it was progressing further along the maturity spectrum. Management adjusted its promotional strategy in Q3 to boost game revenues, which did produce some near-term results (+25% QoQ), but the need to do so raises questions about gamer fatigue with the title. To counteract this effect, the company planned to introduce more social and interactive events to the game, ostensibly targeting player retention. Although these moves may extend the game lifespan somewhat, the potential impact is an area of uncertainty in both magnitude and time span.

For the Advertising business, management sounded cautiously optimistic about continued revenue growth in FY2015 following improvements in the sales function. Further progress here would be positive for the company, but considering the relatively small contribution to revenues (8% of FY2014 total revenues), upside here is likely to have only an incremental impact.

Has turned the corner?

Rebounding fourth quarter revenues were a strong start for, and are cause for optimism. There are, however, several factors, which necessarily remain uncertain due to their ongoing development (new mobile games, TLBB, further monetizing mobile). Although it is tempting to see the large write down in Q4 as some house cleaning before starting fresh in FY2015, waiting for more clarity to develop seems like a less risky strategy.

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