A Real-World Mortal Kombat

Byline: Brian Bremner

They’re both self-made Chinese billionaires and run Nasdaq-listed companies in the world’s fastest-growing Internet market. Tiangiao Chen, chairman of Shanda Interactive Entertainment (SNDA), and William Ding, CEO of Netease.com (NTES), are also locked in a real-world Mortal Kombat for supremacy of China’s rapidly expanding online gaming space with two radically different business models.

Young Chinese are among the most avid gamers on the planet. At Internet caf s in Shanghai and Beijing it’s not uncommon to find Chinese twentysomethings spending hours on end immersed in online fantasy and combat games such as The Legend of Mir II or World of Warcraft. In short, there is serious money to be made [see BusinessWeek.com, 7/24/06, “China’s Online Gaming Craze”].

The Chinese market for fantasy and adventure multiple role-playing games shot up 54%, to $460 million, in 2005, and is on track to reach $2.1 billion by the end of the decade, figures research firm IDC. China is even expected to surpass tech-happy South Korea next year as Asia’s biggest gaming market. China’s overall Internet user base is enormous — about 120 million this year and growing fast.

Stock Slide

Yet it’s a business in flux, and there is a huge debate among companies in this arena about whether to stick to a subscription fee model or go with a free-to-play one to build up a huge online consumer base. The lost revenues would be more than made up by sale of virtual goods [such as ammo for avatars, and so on] and also music and online movies to the legions of gaming fans attracted to its site — or so the theory goes.

Shares of both Shada and Netease, once darlings among U.S. investors hungry for China Internet plays, have fallen on hard times. Shanda shares traded on Nasdaq have slid about 26%, to $16.48, from its recent 52-week high back in November, 2005. Meanwhile, Netease shares on the U.S. tech-laden exchange are off nearly 40% since the end of March, to $15.25.

Shanda’s shift away from a primarily subscription fee-based model has been fitful. On Nov. 10, Shanda posted a 43% decline in third-quarter net profits year-on-year, to $18.1 million. However, Shanda and investors did take some solace in the fact that online game revenues increased 9.4% quarter-over-quarter, to $51.7 million.

Lifetime Customers

Shanda’s Chen firmly contends his shift in strategy is the way to go. “We believe this new model has now justified itself as an effective way to most efficiently discover and satisfy user demands, extend the life cycle of our games, and build a sustainable community experience from our interactive entertainment offerings,” Chen said when the company’s earnings were released.

The basic idea is that users will stay with a game longer if the experience is more diverse, strategic, and fun. Shanda thinks it can rake in even more revenues by eliminating a base subscription fee to enter a game and instead charge for things like weapons and ammo and other virtual goods needed to advance within various games. Companies “are switching to a model with revenues generated by the sale of virtual items,” says Jun-Fwu Chin, a senior analyst and online gaming specialist with IDC Malaysia.

Shanda is also aggressively pursuing tie-ups to keep its online game offerings fresh. In May, Walt Disney’s (DIS) Internet unit struck a deal with Shanda to distribute and operate games based on Disney’s hottest animated characters. And later this year, it plans to launch Dungeons & Dragons Online as well as three other games, including a martial arts number called Kong-Fu Masters that contains well-known Chinese folklore characters such as Mulan and Monkey King.

Millions at Play

Still, Shanda, Netease, and others are also trying to beef up the quality and diversity of in-house-developed games. Right now, South Korean developers rule with about a 45% share of the online games in operation in China.

Nexon, a Korean company, offers games through operators in China, and one called Crazy Arcade BnB [for Bomb and Bubble] which goes under the name Paopaotang in Chinese, has an incredible following of 130 million registered users. Chinese online game sites, however, must pay royalty and licensing fees to the South Koreans.

Netease.com, which has developed some smash games of its own, has stuck mostly to a subscription model and has overtaken Shanda as the No.1 online game operator in China. The company scored big with its Westward Journey Online II, which is based on the famous Chinese novel Journey to the West and a film adaptation of that classic tale by Hong Kong actor and film director Stephen Chow Sing Chi.

Big Enough For Both

Its visual style draws heavily from traditional Chinese paintings, and it’s one of the most popular games among those developed inside China. This game has attracted more than 83 million registered users. Early next year, Netease will launch a new version of Westward Journey Online and has other games coming on stream. Company Chairman Ding has vowed to spend $400 million-plus to develop new games in the coming years.

While Netease’s third-quarter profits rose 21%, to about $40 million year-on-year, in the third quarter, the company warned of an earnings decline in the final quarter due to competition from Shanda and others offering free games.

When pressed on a recent earnings call with analysts about whether Netease should shift strategy, Chief Operating Officer Michael Tong suggested the market was big enough to support consumers interested in both subscription and virtual item games. The market will continue to support “a lot of fee-based games, like the ones we have,” especially among Chinese gamers in search of a higher quality visual and game-playing experience.

It’s too early to say which company has the smarter strategy in place. But count on plenty of World of Warcraft moments from the Shanda and Netease rivalry in the months ahead.

http://www.businessweek.com/globalbiz/content/nov2006/gb20061110_444614.htm