JAGUAR MEDIA AUG 3RD, 2020

UPDATED AUG 6TH, 2020 (see end of research note)

“CHINESE TECH DEMYSTIFIED” SERIES – EPISODE 2

DouYu (DOYU) & Huya (HUYA): Winner Takes All

Often referred to as China’s Twitch equivalents, DouYu and Huya are the providers of China’s biggest game livestreaming platforms. In Chinese, DouYu means “fighting fish”, while Huya is a nonsensical phrase where “Hu” means “tiger” and “ya” means “tooth”. Hence why the latter’s logo is a tiger with teeth.

As a company, Huya was a late-2014 spinoff from JOYY (previously known as YY), with the latter as the new entity’s biggest shareholder. However, in 2018, Tencent acquired a 35% stake in Huya with an option to boost its control to 50.1% within the period March 8th, 2020 and March 8th, 2021. Then in April 2020, Tencent proceeded to exercise that option, effectively becoming Huya’s biggest controlling shareholder as JOYY's stake was reduced to 43% from 56%.

Meanwhile, DouYu began as a livestreaming sub-segment of AcFun, a video hosting platform geared towards animation and games. But due to constant ownership issues and former employees leaving to start up their own competing businesses, a lot of spinoffs resulted from AcFun (including Bilibili, which we’ll cover another time). And not liking the direction AcFun was headed, DouYu founder Chen Shaojie decided in 2014 to sever ties with the parent company and run DouYu as its own entity. Then in 2018, Tencent invested ¥4B in DouYu in exchange for a controlling stake, on the very same day it acquired its 35% stake in Huya (see above).

Today, Huya boasts ~150M MAUs while DouYu has ~165M (Twitch has ~140M in comparison), and China’s game livestreaming market has essentially become a duopoly between the two (we’ll briefly explore how this duopoly came to be).

Summarizing the current state of China’s gaming industry

Boasting over 650M gamers and $36.5B in annual gaming revenue at the end of 2019, China comes second only to the US in terms of gaming market size. As shown by the chart below, China used to be the largest market globally (from 2015 to 2018), but 2019 was a difficult year due to the well-documented 9-month license freeze on new games, plus other regulatory hurdles implemented by the State Administration of Press and Publication (which took control over digital games regulations in 2018).

Out of all the regulations currently in place, the three that stand out the most are ISBN license requirements (every mobile game must have its own ISBN number as proof of government approval), enforced ID registrations where every player is registered with their real identification and monitored to ensure they adhere to playtime restrictions, and age-based purchase restrictions:

Despite all these barriers, game approvals in China are slowly recapturing levels seen before the aforementioned license freeze, as the regulatory body works through its massive backlog. Additionally, COVID-19 has no doubt played a part in total game app downloads in China increasing 27% YoY during Q1. And according to Sensor Tower, the nation then saw 2.06B downloads in 2Q20, up from 2.02B in 2Q19. Separately, Niko Partners predicts 20 to 30 foreign games will get approval each month, on average, for a total of 240 to 360 new licenses expected this year. This will be a major improvement from only 185 foreign games approved in all of 2019. As a result, the Chinese gaming market as of June is being forecast to recover and grow at above 20% CAGR through 2025, which would imply overtaking the US to regain top spot this year or next.

A brief history of game livestreaming in China, plus how Huya and DouYu became the runaway leaders.

Although a subsection of Chinese gamers had already begun filming themselves while gaming in the early 2010’s, it wasn’t until around late 2013 that the trend gradually began to catch on. And even then, the growth in adoption was rather uneven due to the overreliance on the same handful of popular streamers to generate an audience. Prior to 2015, no exact statistical records were kept on game livestreaming. But TechNode estimates (don’t ask me how) there were only between 25M to 30M Chinese livestreaming gamers in 2013, followed by 45M to 50M in 2014. Assuming those numbers are accurate, that’s an almost negligible adoption considering China had a total of roughly 490M gamers during the time, per Statista.

Then, in mid-2016, China’s game livestreaming culture suddenly experienced a boom due to the emergence of e-sports and competitive gaming. Such events helped to draw massive live audiences, who tuned in to watch professional gamers compete against each other for up to six-figures worth (USD) of prize money. And eventually, China’s National Development & Reform Commission saw its potential in unifying the younger crowd and began publicly backing the development of these tournaments, rolling out plans to host dozens of physical domestic and international e-sports events.

These initiatives sparked a series of high-profile investments and publicity campaigns within the sector, led by JD, Alibaba, and Suning (retailer giant). And within the space of a year, game livestreaming went from being just 14% of total streaming in China to 23% in 2017. Tens of millions of new viewers began signing up to these platforms not just to watch e-sports, but also regular people live sharing their experiences and reactions while playing games in their own homes. The growing culture also resulted in many new sub- trends, like streamers using the platforms to hold regular live talking sessions, singing/dancing/jamming sessions, live travel vlogging, even educational tutoring sessions, rather than actually playing video games. And just like in North America, many career streamers have become celebrities, garnering millions of subscribers and receiving large sums of donations and gift contributions from their fans.

It was during this period of acceleration when Huya and DouYu began to face growing competition, as over a hundred (not an exaggeration!) other different game livestreaming platforms began emerging to take advantage of this new craze. It quickly became a difficult environment as most of these new companies were burning large sums of cash to recruit top professional e-sports gamers/teams and famous streamers into using their platforms exclusively, in the hopes that they would drive more traffic to their sites. Essentially, the industry morphed into a rat race of who could outspend the rest. Although many of these younger platforms would quickly go bust or get acquired for various reasons (ran out of cash, inability to retain popular streamers, overpriced contracts with celebrity gamers, market saturation, etc.), barely a week would pass before the void they left was replaced by more newcomers. This overexuberance persisted into 2018, but came to an abrupt end when the State Administration of Press and Publication was given regulatory authority over digital gaming (as detailed on pages 1 and 2). The rise in regulations and sudden lack of new game approvals, combined with the best streamers and e- sports professionals slowly but collectively gravitating towards the bigger, more reputable platforms, was what spelt the end for most of Huya’s and DouYu’s smaller rivals.

That said, the bigger competition remained — like Panda.TV (3rd-largest platform with 80M MAUs at the time, behind only DouYu and Huya), Longzhu, and Huomao, among others — at a time when growth of the entire gaming market pie had slowed to a snail’s pace. Thus, the cash burn intensified for the remaining survivors even as the industry consolidated significantly.

But the “game-changing” moment soon arrived. Tencent at the time was facing challenges from its core gaming business mainly due to growing competition from NetEase, a company many of our Jag subscribers will be familiar with. So, they needed something fresh added to the ecosystem. Something that could help them win back younger users who were reducing usage of their flagship app WeChat in favor of “cooler” platforms like TikTok and Bilibili. Having sponsored many e-sports tournaments as part of its social network/gaming/streaming operations, Tencent’s next logical step was to invest in game livestreaming platforms. And as mentioned at the beginning, they eventually settled on DouYu and Huya.

With their newfound capitalization plus subsequent capital raises from their IPOs, and under the guidance of Tencent, DouYu and Huya smartly set about investing in their in-house agencies which recruited, trained, and managed raw talent. Basically, their strategy was to put more emphasis on nurturing and building their own roster of livestreaming stars and professional gamers, rather than continuing to throw large sums of money to attract the biggest talents on the market.

Meanwhile, largest competitor Panda.TV opted to continue down the path of spending big bucks to build their roster of established stars, a decision which eventually proved fatal. On March 2019, the streaming giant was forced to shut down after it was declared insolvent. The skyrocketing cash burn was the main factor, but the company was also experiencing decreased backing from VCs and investors who did not fancy their chances against Tencent. After all, the Chinese tech graveyard is known to be littered with corpses of former enterprises that had the misfortune of being in the way of Tencent-backed companies. Separately, major competitor Longzhu took a reputation hit following public backlash for repeatedly hosting illegal content on their site (a recurring problem they’ve struggled with since 2017).

With reduced competition, Huya and DouYu began enjoying a strong pair of tailwinds:

• Their own recruitment efforts were paying off, as their in-house developed talents were found to be more “loyal” and less costly compared to externally recruited bigshot streamers who typically don’t see themselves as beholden to any particular platform. Retention is crucial because when stars migrate, so do their audiences (a common issue for all livestreaming platforms).

• They benefitted from a sudden influx of superstar talent from the now defunct Panda.TV, likely at a very low cost. As a result, Huya saw its revenue jump 80% to ¥8.37B ($1.2B) and its MAUs rise 29% to 150M in 2019, while DouYu’s revenue increased 99% to ¥7.28B ($1.0B) with MAUs up 8% to 166M. Those were impressive numbers considering all the newly introduced regulations and the sharp drop in game approvals during the year. According to latest statistics, the number of livestreaming gamers in China reached 350M at the start of the year, and is forecast to surpass 450M by the end of 2021, or at least 35% of the entire livestreaming market (see chart below). Huya and DouYu now enjoy the lion’s share of that, representing over 70% of total game-centric streaming hours, while the rest of the competition fights for scraps.

Looking at HUYA’s and DOYU’s growth/profitability, plus how they generate revenue.

First off, let’s take a look at the source of Huya’s and DouYu’s revenue. Unlike Twitch and other Western platforms that make money mostly through advertising and subscription fees, Chinese platforms derive the vast majority of their revenue (typically ~85%) from two avenues:

• Selling virtual items to users. These items can then be sent as gifts to popular streamers. It’s not unusual for the most highly followed streamers to receive millions of dollars’ worth of such gifts in a given month.

• Taking a cut of audience “perk purchases”. Many popular streamers offer custom tiered benefits to their audiences, which are tied to the amount of cash tips/donations and gifts received. A very simplistic example would be a streamer creating a 2-tier supporter system. Let’s say they offer a “Rank-A supporter badge” in return for monthly donations worth ¥100 and above, and a “Rank-B supporter badge” for ¥50. Audiences who “unlock” Rank-B may get benefits such as getting an occasional mention from the streamer or being able to use a wider range of emoticons in the comment section. Meanwhile, Rank-A offers all of the Rank-B benefits, plus being able to directly message the streamer, or perhaps receive digital autographs. In reality, things are more convoluted than this example, as many streamers are known to offer over half a dozen tiers.

On the cost side, the largest expense and contributor to cash burn for these companies comes from revenue sharing with the streamers and content creators. Size matters, as smaller platforms tend to have less bargaining power with streamers, and are thus forced to offer higher pay-outs (often >70% of revenue) to retain their best roster. After revenue sharing, the second largest cost comes from offering lucrative signing and recurring fees to contract the very best streamers to their platform. Again, smaller competitors often found themselves giving out ridiculously high offers during bidding wars and getting locked into overpriced contracts, with their signings often fading into obscurity shortly after.

Between the two giants, Huya has enjoyed the better cost control over the years, consistently paying out just under 50% of revenue to their roster, vs between 50% to 60% for DouYu. In contrast, the now bankrupt Panda.TV was rumoured to be have been paying out close to 100% at times.

With the explanation of the business model out of the way, now let’s take a look at the top and bottom- line metrics for both companies.

Both revenues and average revenue per paying user (ARPPU) reflect tremendous growth. No surprises here, as it’s clear a reflection of how Huya and DouYu have become the clear runaway leaders. However, it’s worth noting how the former has been able to generate higher sales despite routinely having slightly less MAUs than DouYu:

Similarly, with the exception of the difficult year that was 2018, Huya has tended to enjoy superior margins and higher net income vs DouYu. But both companies are now beginning to turn profitable following those Tencent stake purchases and the death of Panda.TV (plus smaller competition). Notably, the most recent 1Q20 numbers show that DouYu is starting to get the upper hand, though a single quarter does not make a trend:

Going forward, iResearch estimates total game-centric livestreaming revenue will increase 25% to ¥24B in 2020, and will carry on growing at roughly the same pace through 2023:

And separately, NewZoo is forecasting 14.0% CAGR in global e-sports audiences from 2017 to 2022, after coming in at 454M for 2019, +15.0% YoY. Notably, the Asia-Pacific region accounts for 57% of audiences. See the research firm’s latest report here, which now includes 2023 projections. Another key source of streaming growth is expansion into Southeast Asia, which is projected to experience 24.0% CAGR in e- sports through 2023. The region has high potential due to fast improving standards of living, high internet penetration, and a well-established gaming culture.

WARNING: It’s not all clear skies, as regulatory challenges remain.

Essentially, this is a risk that isn’t going away. Most recently, on June 23rd, the Cyberspace Administration of China (CAC) began a crackdown on 10 major streaming platforms (including DouYu, Bilibili, Huya, NetEase’s CC Live, and Baidu’s Quanmin), due to “vulgar and other problematic content”. Punishments carried out ranged from halting new user sign-ups to suspending content updates. While it remains unclear what exactly the update suspensions will affect, Huya and DouYu both made announcements that they “suspended updates” shortly after the CAC notice. And both companies have since remained silent on when the suspensions will be lifted and to what degree the disruption affects revenues. Not an ideal situation to say the least.

Separately, in February, Huya and DouYu both launched free live-streaming services for online classes, with the latter even gaining backing from the Wuhan Ministry of Education. However, it did not take long for CCTV (China’s biggest state media conglomerate) to call out the two companies for inserting gaming ads into their channels offering free online lessons/courses for students. In response to the backlash, Huya had to shut down its online course offerings entirely, while offering refunds to minors who clicked on those ads and spent their parents’ money on the advertised games/gadgets. Meanwhile, DouYu got off lightly as the company only had to remove the ads in question from its online learning platform.

And going back a little further, in November last year, China imposed an enforced curfew to limit the time spent by children playing games online. The regulations, which are still in effect today, state those under 18 cannot play games online between 10PM and 8AM, and can only play for 90 minutes per session during the day. The guidelines also reduced the amount of money minors can spend online playing games to ¥200 per month, and to ¥400 for 16 to 18-year-olds (as shown on Page 2).

These incidents are just the latest examples in what has been an ongoing campaign by authorities since 2018 to tighten their grip on the industry. The State Administration of Press and Publication’s newfound oversight over the digital industry seems to have gotten political leaders aware of just how quickly online content and livestreaming can explode, and they are making the space increasingly a priority for governance. Thus, anyone considering getting long DOYU or HUYA will simply have to factor into their risk assessment that government interventions and scrutiny are going to be regular occurrences.

The biggest reason to be long either of these two stocks.

Put simply, if anyone’s currently placing bullish bets on HUYA or DOYU, it is likely they are doing so for one reason and one reason only: the growing possibility that Tencent will merge the two companies. Recall, Tencent invested in Huya and DouYu on the same day during March 2018, and proceeded to gain the biggest controlling stake in Huya in April this year.

The two streaming platforms have seemingly eased up in their attempts to outspend and compete against each other ever since Tencent’s stake acquisitions. This has been good for both stocks, as further cash burn and margin deterioration would have resulted from all the continued fighting. But what would be even better is an integration of the two companies, as such a move would unlock substantial value and result in tremendous upside for both stocks.

This is neither a mere dream nor conjecture. Because on March 27th, not long before Tencent exercised its option to gain a 50.1% share of Huya, the company appointed new directors to serve on the boards of DouYu and Huya. Then on June 11th, Beijing News published a remarkable article, separately citing insiders from Huya and Tencent who all confirmed that plans for a merger of DouYu and Huya are “on the way”, and that a proposal to promote the merger has been submitted by Tencent. Further, the state- owned newspaper was told by one of the sources to expect a merger around early 2021: “The transaction will possibly be completed later than the end of this year, the beginning of next year.” Meanwhile, members of DouYu declined to comment on the matter.

If the merger does indeed happen, the resulting behemoth would have over 70% of the China market share, substantial pricing power, and a near-impenetrable moat with price war worries forever put to bed. Additionally, the sharing of analytics and user data between Huya and DouYu will likely result in new ways to monetize the platforms. What immediately comes to mind is using the combined data to generate large-scale revenue from targeted advertising. Additionally, Tencent could also make use of analytics in its own game development projects, while Huya and DouYu can work together to further refine their talent recruitment strategy. Expansions into other regions outside of China will be more coordinated. E-sports tournaments could increase in size and length. Heck, Tencent could even start releasing its most highly anticipated content exclusively through both platforms if it so chooses.

When I titled this note “Winner Takes All”, I wasn’t talking about Huya or DouYu. I meant Tencent.

As a $660B market cap juggernaut in Chinese interactive entertainment, Tencent has always controlled every phase of the game development and game deployment lifecycles. But the one area where the conglomerate hasn’t been as influential in is transmission and content delivery. Thus, a Huya-DouYu merger would help put Tencent well on its way to completing the “Triple-D trifecta” (development- deployment-delivery), granting them considerable influence over every stage of the gaming macrocosm.

Right now, a bet on Huya or DouYu is essentially a bet on Tencent.

Update, August 6th, 2020:

Bloomberg was out with an article today (August 6th) before the market open, reaffirming what Beijing News wrote on June 11th. The article notes:

“Tencent Holdings Ltd. is driving discussions to merge China’s biggest game-streaming platforms Huya Inc. and DouYu International Holdings Ltd., people familiar with the matter said, in a deal that would allow it to dominate the $3.4 billion arena.”

Shares of both Huya and DouYu popped on the news, but have since gotten faded on profit-taking. As the merger catalyst is still in play (and all the synergy benefits mentioned in Page 9 still apply), I believe any pullbacks remain buying opportunities. Between the two, HUYA is more mispriced and has more upside vs DOYU in the event of a takeout by Tencent.

Over the past several weeks, the market has favored DouYu relative to Huya because their margins and profitability have improved sharply from very easy comparisons (see Page 6). But in reality, Huya has had the better cost control, higher revenues, and slightly faster growth the whole time.

What would be a fair takeout price for HUYA? Roughly $38 would be my estimate if we’re assuming an equal merger of the two companies. However, Tencent is a habitual scrooge when it comes to M&A, and they tend to seek the lowest price possible when buying up companies. Knowing them, I wouldn’t be surprised if the final offer for Huya ends up somewhere in the low $30s, which would still represent between 12% to 30% upside from today’s levels.

Chronicle Yu Research Analyst, Jaguar Analytics Email: [email protected] Twitter: @JaguarAnalytics