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Changyou.com: Profitability and Growth Analysis in the Complex Gaming Industry

February 14, 2014 | About:

The online game developer Changyou.com Ltd. ADR (CYOU) operates massive multiplayer online role-playing games through in-house development and licensing. Revenue is generated mainly from selling virtual items in the games, as well as web-based games and online advertising. Competing in the fierce Chinese online gaming industry, the company has had its fair share of issues, mainly due to the lack of success of its new games.

On another note, the company is majority owned by the portal Sohu, which holds a 68% stake. CEO Tao Wang’s recently 13% control of the gaming firm showed a promising horizon for investors, given Wang’s interest alignment. And although some success was attained by diversifying the gaming portfolio and creating more independence from blockbuster game TLBB, complications remain at hand. The Chinese industry regulations, which forbid foreign companies from owning and operating Internet companies in that territory, obligates Changyou to turn to complex contractual arrangements. This situation could be tiresome in the long run. Furthermore, looking at profitability is a very important step in understanding a company. Profitability is — essentially — the reason behind a company’s existence, and a key component in deciding whether to invest in or maintain an investment in a company. So, in this article I will look at Changyou.com’s earnings and growth, profit margins, profitability ratios and cash flow. In addition, I will evaluate which institutional investors bought the stock in the recent quarters.

EPS Growth

For many stock investors, the most important thing is growth and, specifically, growth in earnings. This is what fuels aggressive growth stocks. Therefore, it is of utmost importance that investors have an idea of how long a company can sustain a certain level of earnings expansion. The company's valuation, and thus the stock price, is almost completely dependent on this fact.

The first question to ask is how much has the stock grown, compared to the same quarter last year. In this case, the company showed quarterly earnings at negative 42% compared to the same quarter in the previous year. Quarterly growth rates above 15% mark profitability. Therefore, I’m not encouraged by Changyou.com’s results. Past market winners (Apple Inc. (AAPL), Baidu Inc. (ADR) (BIDU), etc.) generated consistent quarterly EPS growth above 15% and I am certainly looking for that level before investing. What’s interesting is that consensus analysts recently upgraded their estimates for the current year, increasing their EPS projections by 16%. This shows that sell-side analysts are confident in the company.

I also looked at the three-year annual average EPS growth rate to get a perspective on how the company grew in the recent years, and the result was 13% annualized average EPS growth for the company in that time frame. I do not like that Changyou.com grew less than 15% per year in the past three years, because 15% is the minimum annual growth level I am looking for when investing in growth stocks. However, while this fact does not prevent me from potentially investing in the firm, it is certainly a warning sign that cannot be ignored.

Revenue Growth and Sales

Let's take a look at the company’s revenue growth. This is a key metric that needs to be analyzed before investing in a company, as it is one of the scarce figures that cannot be modified through accounting tricks and similar dodges.

The company reported a 12% quarterly revenue growth year over year. Personally, I require a minimum 15% quarterly year-over-year growth metric when investing in stocks and Changyou.com underperformed in this area. When quarterly revenues grow at a faster rate than EPS, I usually interpret it as a good signal. This is exactly the case at Changyou.com, which generated revenue growth levels above its own EPS growth levels. In general, the opposite happens. Managements mask earnings growth and show very different revenues and earnings growth levels (revenues are more difficult to trick using accounting tactics).

It is important to watch beyond quarterly earnings, which are more short-term oriented. It is also crucial to pay attention to how annual sales grew in the past three years. In this segment, the firm reported an average annual sales growth of 29%. Considering my minimum requirement of 15% in three-year annual sales growth, Changyou.com meets that criterion.

Gross Margin

The gross profit margin is a measure of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor what percentage of revenue/sales is left, after subtracting the cost of the goods or services sold. A company that operates on a higher profit margin than its competitors is more efficient. Therefore, investors tend to pay more for businesses with higher efficiency ratings, as these should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

In reviewing Changyou.com's gross margin over the past five years, it becomes evident that the company's gross margin has been decreasing. In fact, the five-year low for this metric was reported at 83.2%. The five-year high for this ratio was achieved over the past 12 months, when the margin reached 93.5%. However, the TTM gross profit margin of 83.3% is below the five-year average of 89.3%, implying a lack of efficiency on behalf of management.

Operating Margin = Operating Income / Total Sales

The operating margin is a measure of the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for fixed costs like interest on debt. If a company's margin is increasing, it is earning more per each dollar of sales.

Over the past five years, Changyou.com’s operating margin has been decreasing. For example, in 2009, the company reported an operating margin of 57.2%, but the company's TTM operating margin stands at 51.7%, below the five-year average of 58.68%. This implies that there has been a reduction in the percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the five-year average. I always stress that it is essential to find companies with improving profit margins. While a declining margin does not prevent me from investing in the company, I hope to see this trend reverted sometime soon.

Net Profit Margin = Net Income / Total Sales

Looking at profit margins is very useful when comparing companies in the same –or similar- industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. A 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Over the past five years, Changyou.com's net profit margin shrank, compared to the five-year average. The TTM net profit margin of 41.98% is below the five-year average of 51.39%, which implies that there’s been a decline in the percentage of earnings that the company is able to keep compared to the company's five-year average.

ROA - Return on Assets = Net Income / Total Assets

The ROA ratio gives us an idea as to how efficient management is using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage and sometimes referred to as "return on investment". The company’s ROA in 2012 of 24.85% was slightly above the five-year average of 56.01%, implying that management has ameliorated its ability to use the company's assets to generate earnings over the past five years.

Free Cash Flow

Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. This metric is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. Changyou.com generated a solid ratio of cash flow from operations/total sales of 42.70.

Institutional Investors and Analyst Outlook

It’s important to know that both Jim Simons (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) recently sold out their position in this stock at an average price of $23.60.
Currently, analysts at MSN money are predicting that Changyou.com will retrieve EPS of $4.26 for fiscal year 2013 and an EPS of $4.84 for fiscal year 2014. Analysts at Bloomberg, on the other hand, estimate revenue to reach $816.97M million for fiscal year 2013 and $913.14 million for fiscal year 2014. The company’s current $35.34 price target also signifies significant upside potential from this point.

Conclusion

Changyou faces several complications in the Chinese gaming market, due in large part to a lack of innovation when it comes to gaming product launches. Although the changes in management have been welcomed on behalf of investors, this company still remains a tricky business in terms of uncertainty ratings. The stock’s current trading price discount of 83% relative to the industry average’s P/E of 24.10x, is in my view quite fitting considering the inherent risks in this investment. Therefore, I would recommend staying away from this online gaming firm, at least for the time being.

About the author:

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

Visit Damian Illia's Website


Rating: 3.5/5 (6 votes)

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