Anticipating the Success of Netease’s Tian Xia 2

I have always been a big fan of Netease (NTES), primarily because of its strong management team. It might be my venture capital background, but I always look at the strength of a company’s management team first when analyzing a company. That to me is more important than some new killer product as a bad team can destroy even the best ideas and even the very best products get stale. Unless a company can be flexible to see shifts in consumer patterns, especially in a marketplace which transforms faster than Paula Abdul’s bouts of clarity on American Idol, the company is dead. Strong and deep management teams are why I have always preferred CTRIP (CTRP) over Elong (LONG) or China Mobile (CHL) over China Unicom (CHU).

In Netease’s case, they have had the good fortune of having a strong team in a booming sector, online games. But many skeptics have argued that Netease’s stock will collapse in the coming months because it’s most popular games, Fantasy Westward Journey and Westward Journey Online II, which account for 80% of their revenues, are showing their age. In addition, a more recent release, Datang, has found limited success with Chinese youth. Many investors worry that the lack of a large pipeline of new games may impact the future success of Netease.

In 2007, the success of Netease hangs largely on the popularity of its long anticipated new game Tian Xia II, which went into Stage 2 of Beta testing earlier this month. My firm works closely with a lot of hedge funds looking to buy Chinese equities. Our Skype (EBAY) lines have been ringing off the hook as investors ask for insights into Tian Xia II’s potential for success.

To determine if Tian Xia II will be successful or not, CMR assembled a team to monitor blog and BBS discussions about the game. The results are interesting. Investors should take note – there are a lot of bugs in Netease’s Tian Xia II, but those bugs can be exterminated. This bodes well for Netease and look for the stock price to go up if Netease can fix the minor bugs that are affecting the game.

Game Play

Based on comments made on blogs and BBS forums during the three weeks after the release of the beta gamers are generally happy with how Tian Xia II is progressing. Gamers are favorably impressed with the graphics engine that Netease used for the game, and they like the game environment. This is key as many skeptics have said that a Chinese game company cannot produce something at an international level, which is why they suggest investing in Shanda (SNDA) or The9 (NCTY) which rely quite a bit on licensing agreements like for World of Warcraft. Moreover, Netease was able to handle the graphics despite losing some of its top people to Kingsoft last year which indicates that they do indeed have a deep management team of talented people.

Chinese Nationalism

One of the most noticeable themes running through blogs and BBS is nationalist pride associated with the game. Gamers like the fact that the game was developed in China, and they like the fact that the game strongly integrates elements of Chinese culture. One BBS poster commented that “Tianxia II is a game full of Chinese culture…it is the pride of Chinese game players”. Another said, “The presence of ancient Chinese culture is something which you cannot get from other games.”

In a country where the consumers are increasingly willing to express nationalistic sentiments (especially anti-Japanese sentiment), Netease is well-positioned to benefit from this.

Cost

One topic that comes up frequently in BBS forums that deal with online gaming is the fee structure that companies assign to their games. When Shanda’s games began to lose their luster, the company decided to offer free game play as a way to lure gamers. To make their money Shanda began selling in game items with the end result that many gamers could play for free but they had to shell out a lot of money if they wanted to do well in the game. This new model was competitive and helped Shanda’s stock price emerge from the doldrums last year.

However, we found that many gamers do not like this pay for free model which puts into question the sustainability of Shanda’s model. Netease has adopted a subscription based plan for their games where gamers have to pay a certain amount of money per hour of play time. Gamers are lobbying strongly on BBS for this to continue with Tian Xia II. Posters frequently write comments such as “I really wish Tian Xia II will be a charged game. I hate free games and will never play free games.” Another blogger said that charging for games creates “a more equal environment,” because the gamers move up based on skill rather than money.

Growing Pains

While the responses have been fairly positive towards Tian Xia II, there are still some bugs for Netease to work out if the game is to really contribute to its bottom line.

Some gamers have complained that it takes a very long time to reach interesting parts of the game. One blogger points out that “Tian Xia II is a slow game, but once you have passed level 30, the game is awesome.” The system for moving up in the games may deter a gaming population that wants instant gratification. Gamers have a lot of choices in massively multiplayer online games so if it takes them too long to build up a character that they can feel proud of then they will jump ship.

Another prevalent complaint that may cause problems for Netease is that Tian Xia II places a huge strain on a computer’s resources. Many gamers, even those running fast machines from Dell (DELL) and HP (HPQ), were concerned with how much the game required of their computers. As one gamer put it “CPU usage is always 100%, this drives me crazy. ”

Conclusion

Netease still has some kinks that they need to work out before the game is ready for prime time. During this phase of beta testing many gamers have complained that it is nearly impossible to log on to play the game because Netease is not dedicating enough servers to Tian Xia II to match interest in the beta. But this shows the real and continued interest gamers have in the game and will be easily solved with some new hardware.

None of the problems that we found gamers have with Tian Xia II are unfixable. They are problems that Netease’s team can solve in the next few months before the final version is ready to go live. On the good side, the key parts – graphics, price, and game play – have so far satisfied the demands of Chinese gamers.

To investors out there, keep a close eye on the success of Tian Xia II to see how well Netease’s stock price will do this year.

NTES 1-yr chart

Note: CMR Analysts Ben Cavender, Anna Li, and Natalie Zhu contributed to this article.