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Top News

#1: Huya and DouYu Struggles to Continue Post Regulatory Upheaval

Huya (NYSE: HUYA) and DouYu (NASDAQ: DOYU), the two largest video game livestreaming platforms in China, both reported fourth quarter and FY 2022 earnings last week. The companies both reported declines in their active user bases, one of the most important metrics for a streaming company, in turn causing shares to slide. Huya and DouYu have fallen significantly since February 2021, a period which marked the recent peak of tech stocks globally. 

For context, Huya was spun out of YY.com in 2014 to target the Chinese video game streaming market. This was not too dissimilar from how Twitch started as Justin.tv and eventually grew into its own entity, although unlike the now shuttered Justin.tv, YY continues to thrive. In addition to video game content, Huya has also expanded into other areas of streaming, including music and entertainment. 

DouYu was founded in 2013, growing from the game livestreaming unit of video sharing website AcFun. In 2018, DouYu was the most funded Chinese gaming startup, raising a total of $1.13 billion from backers such as Tencent and Phoenix Capital. Like its peer Huya, DouYu signs exclusivity contracts with streamers to get more viewers on the platform. The company was listed on the Nasdaq in 2019, becoming the largest IPO of any Chinese company that year. 

As evidenced from their front page UI, these two services are exceedingly similar. Huya and DouYu both make money via advertisements and virtual gifts that users can purchase to support their favorite streamers. Esports tournaments and events feature prominently on both websites, and they have become the most popular destinations in China to watch matches. Both also deliver content via PC and mobile apps, with mobile growing more popular in recent years. Historically, the companies have had nearly the same valuation, but Huya has eclipsed DouYu in recent years.

Tencent, which holds about a 37% stake in Huya and more than 33% in DouYu, wanted to merge these two platforms in 2020 to create a streaming giant. This stock-for-stock merger would have given Tencent 67.5% voting power in the combined company on a fully-diluted basis. The combined value of the company at the time would have been around $10 billion. DouYu had 158 million monthly active users (MAUs) and HuYa claimed 151 million MAUs around the time of this proposal. 

Tencent had made deals of this size before, such as when it purchased a majority stake in Finnish mobile gaming company Supercell in 2016 for $8.6 billion. But there have rarely been domestic mergers of this size. While China has few qualms about its own technology giants purchasing properties abroad, the Huya-DouYu merger appears to have sparked an intense reaction within the PRC government. In 2021, the State Administration for Market Regulation (SAMR) imposed steep fines on Alibaba and Meituan for alleged anticompetitive activities, and the regulator released the Anti-Monopoly Guidelines for the Platform Economy Sector in February 2021 to show domestic tech companies they couldn’t grow indefinitely. 

This scrutiny resulted in many penalties, but few mergers were actually blocked. In fact, the Huya-DouYu merger, which was officially prohibited by SAMR in July 2021, was just the third one blocked since the agency was given authority in 2008. In their findings, SAMR noted that Tencent could use its gaming licenses to prohibit streaming competitors from broadcasting certain titles. This is similar to the reasoning the FTC has given in its attempts to block Microsoft from buying Activision Blizzard. SAMR found that the new entity would have significant market share, with 70% of the revenue, 80% of the active users, and 60% of the live streamers within the video game live streaming market.

This was not the end of the companies’ troubles, though. That same year, China began an intense campaign against video games, labeling them as “spiritual opium.” These efforts resulted in children and teenagers being limited to playing video games for just one hour a day, on weekends and holidays. This soon extended to limits on watching gaming livestreams as well. The regulator also froze licenses for new game approvals, which particularly targeted large domestic publishers like Tencent and NetEase. 

While much of China’s M&A fixation has ended and licenses are again being approved, the play time and watch time limits have persisted. In fact, last November the regulator-affiliated China Game Industry Group Committee issued a report applauding the limits, though it praised rather than derided the games industry. 

Huya and DouYu’s latest earnings reaffirm the same trends that have persisted for the last two years. For one, both stopped reporting platform-wide MAUs in early 2021, instead focusing only on “average MAUs on mobile apps” and “total paying users.” This obfuscates the trend of declining users on the web-based platform, though mobile MAUs have also suffered. 

Fourth quarter mobile MAUs for DouYu fell by 8% to 57.4 million from 62.4 million in Q4 2021. For Huya, growth over this same period was flat, as MAUs went from 85.4 million to 85.5 million. Given the similarities between the platforms, competition remains intense as content costs and marketing spending remains high, an issue that might otherwise have been solved by the merger if it were approved. This led to layoffs last April, where DouYu and Huya reportedly let go of 10% and 30% of their workforce, respectively. 

Regulatory headwinds have been the biggest contributor to Huya and DouYu’s woes, to the point where their valuations only make sense in the context of their status as ADRs. Shareholders began to grow weary in 2021 as China turned a handful of education technology companies into non-profits. Companies like TAL Education and Gaotu Techedu traded below their liquidation value, meaning that their net cash was higher than their market capitalization. The ADRs of Chinese tech companies do not have to trade rationally, as their status as going concerns is entirely in the hands of the CCP. 

These same worries permeated the streaming sector. DouYu currently has $1.03 billion in current assets while Huya has $1.52 billion. This is primarily in cash, short-term bank deposits, and — to a smaller extent — accounts receivable and prepayments. This also does not include non-current assets like property and market investments, which would have a realizable value in a liquidation. Total liabilities in comparison were $230 million for DouYu and $334 million for Huya. This means DouYu has a net liquidation value of $800 million against a market cap of $355 million, while Huya has a liquidation value of $1.2 billion against a market cap of $818 million.

If regulatory scrutiny were to subside, and U.S. relations with China improved significantly, we would see these companies trading 2-3x where they are now. But a new front has opened up, which is bipartisan U.S. opposition against Chinese tech. ADRs could be forced to delist from U.S. exchanges in a draconian scenario, and without a local listing, could potentially wipe out shareholders. For more context here, this article from the Paul Weiss law firm breaks down the VIE structure, which is the mechanism Chinese companies use to list in the U.S. via ADR. Investors “have no direct investment in the Chinese operating company,” because China would never allow foreign investors to have voting rights in domestic companies. 

In conclusion, the investment thesis in Huya and DouYu should not purely be based on fundamentals. ADRs such as these are like a binary call option – either the liquidation value plus some nominal premium is realized, or these investments go to zero. Many investors increasingly believe this latter option to be the most likely, as the trade war intensifies and the situation within China regarding tech and gaming companies can change at any time. 

#2: GameStop Catches Second Wind as Fundamentals Remain Questionable

On March 21st, the GameStop meme stock frenzy was reignited after the company posted its first profitable quarter in two years. EPS for 4Q 2023 was $0.16, much better than consensus expectations of a decline of $0.13, marking the first profitable quarter since 4Q 2021. This led to GameStop’s (NYSE: GME) best trading day since the height of the 2021 meme craze and its best reaction to earnings in at least a decade. Shares surged by over 50% in after-hours trading, but pared some of this advance to trade up 35.2% by the close of the following day.

Retail investors — particularly those on Reddit’s Superstonk, a community with 871,000 subscribers all devoted to discussing GME — cheered the profitable quarter. The stock was roughly flat year-to-date before these earnings, after getting hammered in 2021 with a decline of 50.2% drawdown along with its meme-stock and “hypergrowth” peers. On a post-split basis (GameStop split 4-for-1 on July 22nd, 2022), the stock peaked at $86.88 on January 27th, 2021, more than 80x higher than its pre-COVID price in February 2020.

GameStop’s fundamentals are disconnected from the performance of its shares for a number of reasons, all of which have been covered extensively online. High inflation and high interest rates have brought GameStop much lower, but it would still be an overstatement to say shares have “returned to Earth.” In fact, its closing price after 4Q earnings is still about 50% higher than at any point in the video game retailer’s 21 years as a public company. 

High volume, high short interest, and significant volatility all are elements of meme stocks. This was on full display on March 22nd, when shorts were squeezed out of their positions and 66 million shares traded hands, the highest since March 2022. But during January 2021, this type of trading activity on GME was normal, reflecting the animal spirits of an era that seems like an eternity ago.

For starters, GameStop was only profitable this quarter due to a technicality. Notwithstanding the fact that the fourth quarter is highly seasonal and has been the best on an EPS basis eight of the last nine years, the results were entirely driven by an inventory drawdown. The earnings report states that “inventory was $682.9 million at the close of the period, compared to $915.0 million at the close of the prior year's fourth quarter.” In fact, revenue compared to Q4 2021 actually decreased by 1.2%, from $2.25 billion to $2.23 billion. Since inventory is an asset, the boon of any further inventory reductions will lessen going forward. 

GameStop also reduced SG&A expenses substantially, from $538.9 million in Q4 2021 to $453.4 million in Q4 2022. Cash equivalents on the balance sheet ended the year at $1.14 billion, down slightly from $1.27 billion last year but still much too high for a company in need of a turnaround. This cash pile should have been used to invest in areas like e-commerce, potentially acquiring a seasoned player in the space in an all cash-deal. Valuations for tech troughed in Q4 last year, so the more time passes, the likelihood of such a deal decreases.

If these cost-cutting efforts continue, GameStop may be able to eke out a slight profit in future quarters. But even if the current quarter’s EPS is annualized, GameStop would be a stock with a P/E ratio near 40x. For a company with flat to declining revenues, earnings multiples should be in the single digits to low double digits at best. 

GameStop’s biggest challenge remains declining sales of physical games amid the rapid transition to an entirely digital gaming marketplace. CEO Matt Furlong unveiled plans for a turnaround last year by growing market share “in areas such as PC gaming, personal electronics, and virtual reality.” But it’s hard to imagine tech enthusiasts walking into a GameStop to buy a new Quest headset or a consumer electronics device like a smartphone or digital camera. E-commerce has displaced these categories, and specialty retailers like Apple and Samsung operate stores that double as experiential technology hubs, a niche that GameStop cannot fill. 

In terms of actual sales figures, this strategy does not appear to be working. The share of hardware as a percentage of total sales actually grew year-over-year, from 52.8% to 53%. The company did manage to grow the share of collectibles sales slightly, but software shrunk by 280 basis points. 

GameStop has been focused on the collectibles market since its 2015 acquisition of ThinkGeek, as it attempts to diversify revenue into other areas. These include action figures, statues, replicas, and apparel from popular franchises such as Marvel, Star Wars, and Super Mario, to name a few. These offerings are integrated with Power Up Rewards Pro, a $15 per year subscription with various benefits such as discounted merchandise. 

Collectibles are one area that may benefit from a physical retailing presence, as consumers like to see the craftsmanship and scale of the product before purchasing it. Still, they only make up about 16% of GameStop’s revenue, and it’s difficult to imagine the company growing into its valuation off just this category alone. Dedicated collectible retailers like Entertainment Earth also offer a much better consumer experience.

Investors should exercise caution investing in GameStop for fundamental reasons, as sentiment is still the main driver of stock price performance. The shift toward digital downloads and online streaming has led to a decrease in foot traffic in GameStop's brick-and-mortar stores, which still rely on physical game sales (and subsequent used games re-sales) for revenue. These challenges were exacerbated after the lockdowns, as many retailers closed their stores and e-commerce companies gained market share. While this decline is not necessarily terminal, management’s focus on cost-cutting and the “strong” balance sheet is the opposite of what needs to be done to turn around a company in a dying industry. 

Going forward it seems like the clock is ticking on GameStop, as it spirals towards the meme stock graveyard. Bed Bath and Beyond’s equity offering in February barely staved off bankruptcy, but was a wake-up call for those hoping these sorts of companies could have a miraculous turnaround. GameStop has cashed in with similar offerings in the past, such as when it sold 3.5 million shares of stock for an average price of $39 (split-adjusted) in April 2021. But continuous dilution like this is not feasible, as it is equivalent to life support rather than fundamental change. 

It’s unclear how the company can successfully shift to e-commerce when Amazon and Best Buy  have been doing the same, albeit much better, for years now. There is also little chance GameStop can displace pure digital distribution storefronts like Valve’s Steam, the Epic Games Store, and GOG. 

In terms of collectibles and other items that might benefit from foot traffic, GameStop may see some success here, but not enough to stave off its revenue decline from physical game sales. Every time people think demise is around the corner though, the fervent GME diehards prop the stock up en masse. So while the company is on an unsustainable and terminal path, its ultimate conclusion will be dictated by the retail community rather than fundamentals. 

Top Movers

• For the week ending March 24th, 2023: the average return for gaming companies tracked by Naavik with a market capitalization exceeding $500 million was +1.8%. The S&P 500 returned +1.4% and the Nasdaq-100 returned +2.0%.
• The Nasdaq continued its run as long-end interest rates fell even further, despite the Fed’s 25 basis point hike to 4.75% - 5.00%. The index closed just shy of its highs for the year which were set in the first week of February. Lipper recorded equity fund inflows of $11.9 billion between March 15th and March 22nd, the highest sum since last November, as investors poured money into equities and withdrew money from regional banks amid the ongoing crisis. 
• GameStop surged 44.5% on the week, its best performance since March 2022, as the company reported its first profitable quarter in two years. This quarter’s profit was primarily due to seasonality as well as a drawdown in inventories, and is covered in more detail in the Top News section above.
• Perfect World and Tencent rose as Chinese technology stocks continued their rebound last week after steep declines earlier in March. Perfect World began its latest run on March 17th, after the company announced the next installment in the Persona franchise, Persona 5: The Phantom X. The game will be free-to-play on iOS and Android platforms with in-app purchases. Tencent reported total revenue of $20.8 billion in Q4 2022, a 0.5% increase from Q4 2021, and earnings that rose 12% over the period. This bottom-line beat driven by cost-cutting measures and the sale of its Meituan stake was enough to fuel a strong rally.
• CD Projekt was the week’s biggest loser, falling 15.6% as the company reset development on Project Sirius. This project was the Witcher spin-off title announced last October when the studio revealed its ambitious game pipeline for the decade. CD Projekt will be writing off $7.6 million in expenses incurred in 2022 and $2.2 million, which will “accordingly burden… financial results.”

Most Notable Strategic Investments

• Arctic7, a game development studio created by EA veterans last February, acquired two new studios. The first is Narwhal Studios, which specializes in digital media creation for film, television, and video games. The company is based out of Los Angeles and currently has 14 employees, according to LinkedIn. The second is Star Fort Games, an outsourced development and consultant studio located in Ottawa. The company’s website shows 13 employees. With these acquisitions, Arctic7’s headcount grows to over 100, and the deals will allow the studio to expand into new entertainment experiences. (Link)
• Take-Two Interactive acquired GameClub, a mobile gaming company that offers a subscription service to access its titles. For $5 per month, users can play games across the GameClub library, which are also accessible offline. Take-Two has not issued a press release regarding its acquisition but Pocket Gamer spotted that the company’s listing on PitchBook describes Take-Two as its parent company. Given the acquisition of Zynga last year, PitchBook’s platform may be a launching ground for a new subscription service for Take-Two’s vast new mobile portfolio. (Link)
• Atari entered into an agreement to purchase Nightdive Studios for $10 million in cash and stock, with an additional $10 million in performance incentives over the next three years. Nightdive is an American video game developer that specializes in remastering classic video games for modern platforms. The acquisition is expected to provide Atari with access to Nightdive's extensive library of game titles and technology, including remastered versions of classic Atari games. Concurrent with this announcement, Atari also issued €30 million in convertible bonds, causing shares to plunge 13% last week. (Link)

Most Notable Venture Financings

• Eve Online developer CCP Games raised $40 million in funding to finance its next project. The studio was acquired by Black Desert Online creator for $425 million in 2018, but it’s operating independently. The round was led by a16z with additional participation from BITKRAFT, Nexon, and Makers Fund, among others. CCP intends to create a blockchain-based game within the Eve universe, as the developer pledged last year that EVE Online itself would not see NFT integration. Given that VR game Eve: Valkyrie saw development cease just one year after its launch, some fans remain skeptical that CCP will see this project through to fruition. (Link)
• Hadean raised $5 million in funding to continue building out infrastructure for the metaverse. This round comes six months after its $30 million Series A round, which saw high-profile investment by companies like Epic Games and Tencent.  In a statement to VentureBeat, Hadean CEO Craig Beddis said this latest funding would be used to “expedite the advancement of [their] cloud-based solutions for the metaverse.” According to the website, the company has over 90 employees, and is headquartered in London. (Link)
• Turkish mobile games startup Passion Punch raised $4 million in seed investment at a $39 million valuation. The investment will be used to shift the studio’s focus to web3 games with a play-to-earn model. Passion Punch claims to have reached over 200 million downloads with its hybrid-casual mobile games, including Call of Colors which was featured in Unity’s 2022 Gaming Report. The deal does not appear to have been disclosed, but at some point after the report’s publication, Passion Punch sold its back catalog to UK publisher Matchingham Games. (Link)

Other News

• Rovio confirmed it will not pursue an acquisition deal with Playtika, after talks that were initiated in January ultimately fell through. Rovio said it will continue to explore options, however, including “preliminary non-binding discussions with certain other parties.” Playtika’s public offer to Rovio earlier this year valued the Angry Birds maker at $738 million, which was about 60% higher than its closing price before the offer. Rovio would have added to Playtika’s growing casual games portfolio, which the company kickstarted after its acquisition of Jelly Button in 2017. (Link)
• Microsoft is reportedly planning to launch a new mobile store for Xbox games in 2024. The store will allow players to purchase and play Xbox games on their smartphones, and it’s expected to be similar to the Xbox app currently available on Android and iOS devices. The move is part of Microsoft's efforts to expand its gaming offerings beyond traditional consoles and PCs. However, these efforts are contingent on Apple allowing alternative app stores on iOS, which are currently prohibited but under regulatory attack in the EU. (Link)
• Valve announced the successor to CS:GO, simply called Counter-Strike 2, which will be based on the Source 2 Engine. The game was revealed via a demo of “responsive smokes,” new smoke grenades which volumetrically fill an area and respond to the environment. Counter-Strike 2 will also have UI updates, map overhauls, and “sub-tick” servers, which no longer rely on tick rate. All items players have in CS:GO will transfer over to the new game when it launches this summer. (Link)
• Roblox has announced the launch of new coding tools and generative AI materials at GDC 2023. The new tools will allow developers to create more complex and dynamic environments in their games, including terrain that can change over time, weather patterns, and realistic lighting effects. The new AI materials will also allow for more realistic and varied textures, such as rust, dirt, and wear and tear on objects. The launch is part of Roblox's ongoing efforts to improve the quality and depth of its games by giving developers more tools to enhance the platform’s experiences. (Link)

A big thanks to Mario Stefanidis, CFA for writing this update! If Naavik can be of help as you build or fund games, please reach out.