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Gaming industry's future amid new regulations?

05-16

The gaming industry took a major hit last week, causing widespread investor doubt. Is the future of the gaming sector truly in jeopardy?

"On December 22, the National Press and Publication Administration released a draft of the 'Management Measures for the Online Gaming Industry,' making adjustments to game issuance, operation, and spending limits. On the issuance side, it prohibits game companies from hoarding licenses, requiring expiration after a year, and disallowing early testing. On the gameplay side, it restricts inducement rewards like daily logins, first-time and consecutive recharge rewards, and introduces spending limits.

After the 1100-word draft was published, NetEase's stock on the Hong Kong Stock Exchange dropped by 25%, Tencent's by over 10%, collectively losing over HKD 400 billion. In the A-share market, gaming companies experienced widespread declines, and gaming ETFs hit their limit down.

Following the market uproar, the National Press and Publication Administration responded, stating it would 'listen to various opinions, further refine the details.' It also issued the third batch of game licenses for the year, approving over 40 imported games and 105 domestic games, partially offsetting the negative impact.

The gaming industry has faced regulatory scrutiny before; in 2021, the administration issued a notice focusing on strict management to prevent minors from becoming addicted to online games. However, this draft targets all players and gaming companies, extending its impact.

I. Profits in the Gaming Industry:

The gaming industry is one of the high-profit segments within the internet industry. A mature game can generate consistent cash flow for companies. Even during economic downturns, an increase in the number of players results in better performance.

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Taking 37 Interactive Entertainment as an example, their gross profit margin in 2022 was 81.4%, surpassing other A-share companies, including Wuliangye at 74%, and approaching Moutai's 93%. Despite the high natural gross profit margin in the internet industry, 37 Interactive Entertainment maintains a significant lead over comparable companies like 360 with a gross profit margin of 58.8% and People's Daily Online with a margin of 52%.

In terms of profitability, despite the strict regulations in 2021 to prevent minors from getting addicted to games, 37 Interactive Entertainment maintained a compound annual growth rate of 7.5% in operating income over the past three years, with a compound annual growth rate of 12% in net profit. The average net profit margin over the last three years has ranged between 17% and 20%.

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This profitability is not unique to 37 Interactive Entertainment. In the Hong Kong stock market, 80% of NetEase's revenue comes from games, achieving a net profit of HKD 20.3 billion last year, a growth of over 20%. Tencent's gaming business segment accounts for nearly one-third of its revenue, with significantly higher profitability than other business segments.

This high profitability and sustained growth are evident in the third quarter of this year, with NetEase's gaming segment revenue reaching HKD 21.8 billion, a year-on-year growth of 16.5%. Despite a 16.3% decrease in revenue from Cloud Music, NetEase continues to demonstrate growth. This growth and sustained profitability in the gaming industry stand out, especially in the current economic downturn.

II. AI Reducing Costs and Increasing Efficiency:

The gaming industry is labor-intensive, requiring many dedicated personnel for several years to develop a large-scale client game. For example, the development of 'Red Dead Redemption 2,' with sales exceeding 46 million copies, involved over 1200 dedicated developers over eight years, with a cost of nearly USD 300 million.

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While not all domestic mobile game projects require such extensive resources and development cycles, the cost of a 10-20 person team for one year is still substantial. The maturation of AI technology earlier this year offers the potential for significant cost reduction in the gaming industry. Generative AI can enhance productivity across various aspects of game development, including planning, audio, art, and programming, leading to a substantial reduction in game production costs.

Several companies, both domestically and internationally, have invested in generative AI for the gaming sector. In June of last year, Activision Blizzard subsidiary King announced the acquisition of the Swedish AI software company Peltarion.

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In the first half of this year, the gaming industry experienced a surge in capital, with companies like Kunlun Wanwei witnessing a five-fold increase in share prices. Logic suggests that the gaming industry's logic of reducing costs and increasing efficiency played a role in this surge.

III. Gaming Expansion Overseas:

Following the stock price decline, many gaming companies announced buybacks or increased holdings. On December 22, Tencent spent HKD 1 billion repurchasing 3.59 million shares. On December 25, 37 Interactive Entertainment, Perfect World, and Giant Network proposed company buybacks totaling CNY 100-200 million, with other gaming companies following suit. As of Tuesday, A-share gaming companies have stabilized, with uncertainties remaining in the Hong Kong stock market due to the Christmas holiday.

In 2022, Tencent Games launched its international gaming business brand, receiving positive market feedback and revenue performance. Established games like 'Honor of Kings' also maintained steady growth overseas. In the third quarter of this year, overseas game revenue accounted for nearly one-third. NetEase's games, such as 'Onmyoji' and 'Rules of Survival,' continue to deepen their presence in the Japanese market. During the 2022 Q1 performance report, the company stated that overseas revenue accounted for over 10%, with hopes for further improvement. Last year's annual report and this year's latest financial report did not disclose overseas revenue data.

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Conclusion on the Outlook:

Currently, the detailed regulations of the draft are unclear, and it's challenging to determine the extent of their impact on gaming companies. In the long term, with positive factors such as AI cost reduction and gaming expansion overseas, the industry's outlook does not seem pessimistic. Globally, 40% of people engage in gaming, contributing to a gaming industry worth $240 billion, surpassing the combined revenue of the film and music industries.

While the gaming industry may not face a severe setback or be uprooted entirely, as its size increases, standardized management becomes an inevitable trend. After a period of regulatory constraints, the industry, accustomed to market and regulatory norms, can continue its normal development without excessive pessimism.

Finally, it is crucial to remind investors that every investment involves risks. Please carefully consider your risk tolerance and make rational investment decisions."

Risk Warning and Disclaimer

The market carries risks, and investment should be cautious. This article does not constitute personal investment advice and has not taken into account individual users' specific investment goals, financial situations, or needs. Users should consider whether any opinions, viewpoints, or conclusions in this article are suitable for their particular circumstances. Investing based on this is at one's own responsibility.

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