Company______

  • Changyou.com (CYOU) is atop 10 Chinese online game co with 131.9mm users, generating ARPU of $32 via virtual goods. Co focuses on MMORPGs, with 7 current titles and a strong pipeline.
  • CYOU’s top game, TLBB, is #2 MMORPG in China winning game of the year 2008 to 2010. ~90% revs.
  • CYOU started as a subsidiary of Sohu.com in 2003,spunout in 2007 and IPO in 2009. Today, CYOU is 67% owned by Sohu.com. It also entered into a Marketing Services Agreement and Non-Compete due to transaction.

Investment Thesis______

  • Strong position in growing market:The Chinese online game market, largest in world ($2.5bn), has been growing fast (42% CAGR since ’06). Chinese Internet penetration is 36% vs. U.S. penetration at 78%, leaving room for market growth. Given its technology, user base and marketing advantage, CYOU is poised to capture market growth.
  • Financially attractive:CYOU is highly profitable (60% EBITDA margin),with a debt-free balance sheet and solid cash flows (~$200mm adj. cash flows in CY 2010). Moreover, the company’s valuation is low. Growth is not priced into stock, and multiples have compressed significantly since CYOU’s IPO (EV/Sales of 1.9x vs. peak of over 10x).
  • Sohu.com relationship provides unfair advantage: CYOU’s current (and growing) game portfolio benefits materially from its Marketing Services Agreement with Sohu.com. Marketing across portal, search and mobile allows CYOU to compete aggressively for users. Ease of use, via Sohu’s ID system, makes barriers to play lower than other sites.

Potential Catalysts______

  • Release of DMD:CYOU employs over 3,000 people, including 1,000 engineers focused on developing new games, most notably Duke of Mount Deer (DMD). DMD, in development for 4 years, was the most anticipated game launch in China. The DMD launch in 2Q11 was well received (user base up 20%), and is expected to generate 20% of revenues in 2012. The game is #7 in China today, and aggressive marketing via movie should help further.
  • TLBB3 expansion pack:The TLBB3 expansion pack, the largest expansion pack ever, is set to be released in 2H11. For reference, TLBB2 increased 3Q10 revenues 10% QoQ.
  • Entry into web-based games: Acquired 7Road Technology, a web-based game company that develops free-to-play multiplayer web games, in 2Q11. The acquisition gives CYOU a strong team (300 engineers) to develop casual games for the web games market (96% CAGR over last 2 years, 6% of 2010 market, expected forward 3-year CAGR of 37%).

Risks______

  • Fierce competition:Competition in the Chinese online game market is intense, with competition from both well-funded start-ups and public companies. CYOU is in a strong financial position to invest heavily, if needed.
  • TLBB Fatigue: TLBB was launched in 2007 and represents a large percentage of CYOU’s user base. If enhancement packs cannot keep users engaged, CYOU could see large decline in revenue. TLBB3 expansion pack launched in 2H11 should mitigate risk.
  • Deterioration in margins: As competition increases, and especially if TLBB experiences fatigue, CYOU will have to spend more on marketing to acquire users. Its relationship with Sohu.com helps mitigate this risk.

Valuation______

  • Multiples:This stock works without multiple expansion: At its current LTM P/E multiple of 7.2x, one year from now, with an expected LTM EPS of $5.12 it would be worth $37 (36% upside). If CYOU’sP/E multiple expands to its pre-Sino Forest level of 12.5x, the stock could trade as high as $64 (135% upside). I believe $40 is a reasonable price target.
  • DCF: The price target of $40 was cross-checked with a discounted cash flow analysis using a 20% discount rate (for conservatism), 3% terminal growth rate, and consensus revenue estimates and margins. This resulted in a $51 share price and an implied 2015 implied EBITDA exit multiple of 5.6x (vs. 4.4x current EBITDA multiple).