02 November 2012 Asia Pacific/Japan Equity Research Social Network Gaming Connections Series Impact of higher-spec social network games? ■ Issues and overview: With the implementation of self-regulation and current rollouts of games in existing genres now over, top-line growth in the domestic social network gaming market has slackened. Despite strong potential, it will likely be some time before overseas operations begin to make genuine profit contributions (the role of platforms remains unknown), so overseas markets do not offer much relief either, in our view. As the market shifts to native smartphone applications, the balance between increased costs and growth in user numbers in the domestic market will likely become a critical earnings variable for social network game developers. In this report, we look at earnings under different scenarios, as well as the The Credit Suisse Connections Series potential for business diversification to help stabilize earnings. leverages our exceptional breadth of ■ Conclusions: Game development costs are set to increase in response to: macro and micro research to deliver (1) higher royalty payments and (2) the ongoing shift to higher-spec games. incisive cross-sector and cross-border thematic insights for our clients. With no increase in the number of users, we estimate operating margins would fall to around 30% (from a peak of nearly 50% in Jan–Mar 2012), Research Analysts equating to about 15–20% downside for share prices. We believe P/Es Yuki Nakayasu remaining around 10x at current share prices would require: (1) migration of 81 3 4550 9966 console game users, and (2) gaining new users to boost the number of [email protected] paying users by 1mn (from a little over 7mn currently). We would expect 20– Shunsuke Tsuchiya 30% upside for share prices if paying users grew by 2mn and overseas 81 3 4550 9740 operations moved to profitability earlier than anticipated. [email protected] ■ Our picks: In social network games, we look at the two main scenarios of an expansion of the higher-spec games market or continued growth in the current low-spec games market. Growth in the higher-spec market would likely come at the expense of the console game market, so our ranking of firms by level of expected impact is: third-party > Gree (3632) and DeNA (2432) > Nintendo (7974). Among third-party developers, we favor Konami (9766) due to its strength in higher-spec games, a likely recovery in earnings momentum from 2H 2012, and low valuations. Figure 1: Case simulations/stock picks according to social network gaming market changes High-spec market High-spec market Low-spec market No expansion Probable expansion Probable expansion Positive 3rd Party 3rd Party GREE / DeNA・SAP Neutral Nintendo・SAP GREE / DeNA Nintendo Negative GREE / DeNA Nintendo・SAP 3rd Party Note: Third parties include Konami, Square Enix, Capcom, and Namco Bandai Holdings. SAP include Klab, Drecom, and Crooz Source: Credit Suisse. DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION™ Client-Driven Solutions, Insights, and Access 02 November 2012 Table of contents Key charts 3 Earnings situation at dedicated social network game makers 4 Costs: Shift to native smartphone apps resulting in two factors that are raising costs 5 Revenue: Potential for market growth driven by shift to higher-spec games 10 OP estimates: What levels of (1) migration of console users a (2) new users needed to keep current profit? 15 Shedding reliance on games through diversification: Comparison with console games17 Overseas social network gaming: More time needed for earnings contributions 20 Appendix 22 Social Network Gaming 2 02 November 2012 Key charts Figure 2: Social network gaming shifting to higher-spec Figure 3: Can an increase in user numbers cover higher games as smartphone capabilities improve costs associated with the shift to higher specs OP per Paying User Decreasing margin due to the increases Network type Package type in loyalties and R&D. Freemium type One-time charge type Monthly OP per paying user: Y 1,700 Konami Attracting new users and users from home Square Enix video games. High spec Paying Users ? Namco Bandai HD Monthly OP per paying user: Y 1,400 ARPU ? CAPCOM Sega Sammy Many paying users / Low ARPPU GREE DeNA CyberAgent Low spec Klab Drecom Crooz Paying Users: +1M?, +2M?, +3M? Mobc as t Few paying users / High ARPPU Paying Users: 7.2M # of Paying Users Source: Credit Suisse Source: Credit Suisse Figure 4: Social network game OP estimates by scenario: Share price falls once higher costs priced in; current price seems to reflect increase of 1mn paying users, but not yet 2mn increase or overseas profit 50 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep- 13 Oct-13 Nov-13 Dec-13 1,200 (Y bn) (Y bn) OP Market Value (RHS) PER PER PER PER 45 x12 x10 x8.2 x7.5 1,000 40 35 +30% 800 CS想定 +20% 30 -15-20% 25 600 43 20 40 37 36 37 400 32 15 31 26 24 25 10 Share price once higher costs, no market growth 200 factored in. 5 - - Mkt increase Mkt increase Mkt increase Mkt increase 1Q 2Q 3Q 4Q 1Q 2Q Japan 0 1 mn people 2 mn people 2 mn people 2011 2012 CY13 2H CY13 2H CY13 2H CY13 1H Overseas +ve profit +ve profit +ve profit +ve profit Source: Company data, Thomson Reuters, Credit Suisse estimates Social Network Gaming 3 02 November 2012 Earnings situation at dedicated social network game makers In the final phase of the era of phones with unique-to-Japan specs, DeNA and Gree drove rapid expansion of the Japanese social network gaming market. The market hit quarterly sales of ¥100bn, generating OP of nearly ¥50bn in Jan–Mar 2012 at the major companies. Sluggish top line growth: End of current game genre launches, implementation of self-regulation measures In early 2012, the industry underwent changes, implementing self-regulations in response Struggling at the top line to opposition to: (1) games that encourage gambling and (2) unfair practices of targeting certain heavy fee-based users. The popularity of “card battle” games also began to decline, culminating in the peaking out of the domestic market we are seeing now. Higher development costs: Efforts to expand range of game genres With the aim of accelerating their social network gaming development programs, all New initiatives driving rise in companies are aggressively hiring engineers. With hiring currently running at a QoQ pace employee headcount of over 500 people, the supply of talent in the industry remains tight. Per-employee sales and OP are both falling rapidly. We believe margins, which used to be Per-employee revenue double those at console game developers, fell to about the 30% level in Jul–Sep and that falling the gap will continue to shrink over the next quarter or two. With top-line growth having leveled off as a result of self-regulation measures and the end of gains from hit titles, we estimate OP at the six major industry firms is down about 25% from peak levels and expect a second consecutive quarter of declines in Jul–Sep. Figure 5: Sales at six social network game companies / Figure 6: Comparison of sales per employee: social OP / No. of employees: Growth in no. of employees network gaming is experiencing a rapid decrease, outpacing sales narrowing the gap with console games 140 7,000 30.0 (Y bn) (Y mn) Sales per head (Social Game) Sales (Gree/DeNA/CA/Klab/Drecom/Crooz) Sales per head (Video Game) OP (Gree/DeNA/CA/Klab/Drecom/Crooz) 6,632 # of employee (RHS) 118.9 120 116.5116.1 6,000 25.4 5,956 25.0 24.2 23.4 23.3 22.7 23.1 99.6 22.3 100 5,000 21.7 21.7 4,817 84.9 19.5 20.0 80 4,270 4,000 72.4 17.9 3,913 64.0 58.7 60 3,339 3,000 53.5 15.0 49.8 46.5 2,740 41.8 41.2 39.7 2,316 2,313 36.6 36.9 40 2,086 2,000 27.2 28.9 1,744 24.5 22.1 10.0 18.3 20 16.5 1,000 - - 5.0 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3QE 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3QE CY10 CY11 CY12 CY10 CY11 CY12 Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates Social Network Gaming 4 02 November 2012 Costs: Shift to native smartphone apps resulting in two factors that are raising costs The shift in the social network gaming market from web browser-type games used on Two factors driving up costs traditional feature phones to native applications for smartphones will raise costs, in our (feature phones→smartphones) view. We see the two main factors as: (1) an increase in royalty fees and (2) a jump in development costs as the focus of development efforts shifts to higher-spec games.