By Gregroy Spear
The Spear Report

        During the third quarter of 2007, 78 Chinese companies went public in markets around the world. A number of multi-$billion IPOs are likely to launch over the next two weeks. China is hot, but Asian stocks present an ambiguous investing terrain. Emerging market growth is likely to far outpace that of our domestic economy in 2008 and beyond. That said, concerns over market bubbles, governmental manipulation and corporate corruption are valid issues when investing in the wild wild East. One needs to do due diligence to sort through the hype and identify value-on the-move.
        After the U.S., China sports the world's next largest group of Internet users - more than 160 million. This amounts to only 1/8th of the population, so the room for growth is tremendous. Early in 2007, the Chinese government began a crackdown on the 100,000 Internet cafes where young people 18-30 congregate to play computer games. Not just any computer game, but the MMORPGS, i.e. massive, multiplayer online role playing games in which large groups of individuals can connect and interact, forming a virtual, and addictive, social network. These networks serve an important affiliative purpose for a culture that has sharply limited childbirth. With little in the way of other media competition, these games are the #1 Internet application in China based on time measures. Most games are now free, with revenue generated by add-on enhancement packages.
        Shares of Netease (NTES) and other online gaming companies were hurt by the crackdown, plunging to multi-year lows this past summer. In fact, Netease, a momentum leader in years past, has been trading more or less sideways since October 2003. The stock made minor new highs in 2005 ($24) and 2006 ($25) but it closed yesterday (11/1) at $22.41.
        Over the last year, however, the company has been raising cash and improving its balance sheet, while adjusting quickly to shifts in government regulations and changing consumer tastes. Netease, which provides online gaming entertainment in multiple Chinese dialects, has beaten analysts expectations in all but one quarter over the past three years. In the most recent quarter, however, sales and earnings were lackluster. NTES posted 31 cents in profits on flatish revenues. The company has over $400 million in cash and a robust $200 million in cash flow.
        The online gaming sector in China is forecast to grow at a 25% annual rate over the next four years. The catalyst for NTES shares going forward is the pipeline of new products in development and the buzz around the Beijing Olympics. This past summer, Netease joined forces with MSN China, Yahoo China and dozens of other Chinese Internet players to provide extensive coverage and product marketing for the summer Olympics.
        Shares of other Chinese Internet companies are on the move and the investment climate is positive. We expect NTES to follow the trend and make new all-time highs before next summer.
        Back in 1999, The9 (NCTY) was a small distribution company for Korean-made games in China. The company struck it big about three years ago, however, with one blockbuster game and put itself on the map. Over the last few years, NCTY has made almost 99% of its revenue from World of Warcraft. The game, a global hit that on any one day may have over 500,000 simultaneous users, has enabled NCTY to grow its subscriber base to 7.5 million paid accounts and over 22 million registered users.
        The Chinese video game market grew 68% last year, with more than 37 million players logging in, but the most recent quarter, NCTY's revenue decreased 8% and net income was down 23%. Those disappointing figures were anticipated, however, pressuring the share price this summer from a high of $52 in July down to a low of $28 at the end of October. But things are changing for NCTY. In May, Electronic Arts (EA) announced it was taking a 15% stake in the company and The9 will be distributing product for EA in China. At the end of the company's second quarter, cash on hand amounted to $274 million, half of which was from EA's equity investment.
        A new upgrade to World of Warcraft appears to be a big success. More than 800,000 people logged into the latest version, the largest concurrency since the game was launched in 2005. The company knows it needs to diversify and is doing so aggressively. It has obtained rights to ten more games and is developing its first two proprietary offerings.
        Internet cafes may come and go, but Internet connectivity in China is only going to increase as broadband spreads. 2008 will represent a watershed year for the country. We recommend shares of the gamers like NCTY ahead of the Olympics and as long-term holds. It is rare that investors get a chance to buy a Chinese company so well positioned for a price that is half off. We would take advantage of the sale.
       Editor's Note: Gregory Spear is editor of The Spear Report, 45 Wintonbury Ave., Ste 301, Bloomfield CT 06002, 1 year, 50 issues, $297.