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Deutsche Bank
Markets Research
Industry Date
02 December 2011
China Internet Asia

Insights China

Technology
Software & Services

Alan Hellawell III
Research Analyst
(+852) 2203 6240
alan.hellawell@db.com

Alex Yao Yoshio Ando, CMA
Research Analyst Research Analyst
(+86) 21 3896 2831 (+81) 3 5156-6681
alex.yao@db.com yoshio.ando@db.com

Jeetil Patel
Research Analyst
(+1) 415 617-4223
jeetil.patel@db.com

F.I.T.T. for investors
China social games: New characters,
new plots, new twists
China's social gaming companies are climbing the same steep growth curves plotted by their
counterparts in the US and Japan. The market otherwise has very distinct elements to it, from the
wide range of revenue shares that its competing SNS platforms offer to the delicate partner-
competitor duality that gaming companies and platforms must negotiate. We expect Sina Weibo
to disturb the current order as it builds share, while Tencent grapples with social gaming's
deflationary impact on its high-ARPU online gaming business.

________________________________________________________________________________________________________________
Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced
from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject
companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus,
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. DISCLOSURES AND
ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.

Deutsche Bank
Markets Research
Asia Industry Date
China 02 December 2011
China Internet
Technology FITT Research
Software & Services Insights
Alan Hellawell III
Research Analyst
China social games: New characters, (+852) 2203 6240
alan.hellawell@db.com
new plots, new twists
Alex Yao Yoshio Ando, CMA
Social gaming business model morphs as underlying platforms do battle
Research Analyst Research Analyst
China's social gaming companies are climbing the same steep growth curves (+86) 21 3896 2831 (+81) 3 5156-6681
plotted by their counterparts in the US and Japan. The market otherwise has alex.yao@db.com yoshio.ando@db.com
very distinct elements to it, from the wide range of revenue shares that its
competing SNS platforms offer to the delicate partner-competitor duality that Jeetil Patel
gaming companies and platforms must negotiate. We expect Sina Weibo to
Research Analyst
disturb the current order as it builds share, while Tencent grapples with social
(+1) 415 617-4223
gaming's deflationary impact on its high-ARPU online gaming business.
jeetil.patel@db.com
More than just planting crops; Sina likely to reap the greatest benefits
Chances are that many readers of this report have played social games on their
Top Picks
favorite social networks (SNS). Social games are a critical component of
keeping users on SNS sites. An estimated two-thirds of Facebook users play Sina Corp (SINA.OQ),USD66.08 Buy
games at least once a week, and gaming represents 40-50% of time spent on Companies Featured
the platform. China continues to deepen its embrace of these social games.
Tencent (0700.HK),HKD145.20 Buy
We expect social games’ revenues to double in 2012 to RMB3.5bn compared
2010A 2011E 2012E
to 2011. We believe battles being waged across SNS portals Tencent, Renren
P/E (x) 29.8 20.7 16.7
and Sina Weibo to woo game developers reflect their much broader struggle to EV/EBITDA (x) 22.5 15.2 11.5
become the outright leader in social networking. As a result of our analysis, we Price/book (x) 12.3 7.0 5.1
are changing our outlook for social gaming and the impact it will have on the Renren Inc (RENN.N),USD3.70 Hold
companies we follow. We upgrade Sina to Buy, as it vaults towards a more 2010A 2011E 2012E
dominant role in social gaming, and as broader Weibo usage grows and P/E (x) – – –
monetization kicks in. EV/EBITDA (x) – – –
For social gaming heavyweights Tencent and Renren, next steps are pivotal Price/book (x) 0.0 0.8 1.2
With low barriers to entry, we expect scale, breadth of platform involvement, Sina Corp (SINA.OQ),USD66.08 Buy
geographical diversification and other elements to prove crucial for success in 2010A 2011E 2012E
the inevitable consolidation. As regards platform partners, Tencent is China’s P/E (x) 26.2 70.8 49.6
biggest. However, it may struggle to maintain its dominance, as its games EV/EBITDA (x) 12.6 – 40.7
developers, many failing to make money from operating on Tencent, Price/book (x) 3.4 4.6 4.3
investigate the more generous competing revenue shares from Sina and
Renren. Moreover, with ARPUs of only RMB3-5/month, Tencent could
encounter cannibalization of its hardcore games. Renren, China’s first mover in
third-party social gaming, is seeing its share decline as it continues to diversify
beyond games revenues, while maneuvering for success as the group-buying
industry undergoes painful consolidation.
Revising target prices for Sina, Tencent and Renren; upgrading Sina to Buy
We raise our Sina target price to USD94.8 and upgrade our rating to Buy from
Hold. We reduce our target price on Tencent from HKD230 to HKD195 and on
Renren from USD8.17 to USD4.11. Across most of the Chinese internet sector,
we apply a PEG multiple to a three-year earnings CAGR as our primary
valuation methodology, due to its ability to balance valuation multiples against
growth prospects. Upside risks include acceleration in the monetization of
social advertising, better games performance and broader execution of open
platform strategy. Downside risks include potential regulatory action, SNS
product issues and inability to efficiently monetize SNS products.

________________________________________________________________________________________________________________
Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced
from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject
companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus,
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. DISCLOSURES AND
ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.

Deutsche Bank 02 December 2011 Software & Services China Internet
Insights
Markets Research

Table Of Contents

Executive summary ....................................................................... 5
Our main thesis ............................................................................. 8
Social games introduction........................................................... 10
China’s social games growth prospects...................................... 12
The basic business model ........................................................... 18
The Chinese social gamer ........................................................... 21
Battle of the platforms ................................................................ 26
Competition in China social gaming............................................ 29
Emerging opportunities: Mobile social gaming ........................... 32
Key risks ...................................................................................... 35
Conclusions................................................................................. 36
Other social games company profiles ......................................... 37
Appendix A ................................................................................. 55
Appendix B.................................................................................. 58
Appendix C ................................................................................. 62
Renren Inc ................................................................................... 63
Sina Corp .................................................................................... 63
Tencent ....................................................................................... 63

About the cover page:

1. Top left : "Landlord Lady" from KingNet's Happy Tower game

2. Top right: "Youko" from Rekoo's Sunshine Ranch game

3. Center: "Daisy" from Renren's Renren Party game.

4. Bottom left: "Cao Pi" from Vanchu's Back to the Three Kingdoms game

5. Bottom right: "Xiao Die" from Vanchu's Back to the Three Kingdoms game.

Page 4 Deutsche Bank AG/Hong Kong

Insights
Markets Research

Executive summary
China social games: exciting growth prospects as platforms,
business models in flux
Fame and fortune abroad, exciting challenge and change domestically
China’s social games developers tend to carry dual passports: while several of the
leading players have come to derive appreciable revenues from major overseas
platforms such as Facebook and its counterparts in Japan, Korea and elsewhere, all of
them are in various states of trying, or having tried, to crack the more challenging
business models of the domestic platforms. Although key to keeping China’s competing
SNS platforms vibrant and attractive, the independent social games studios, broadly
speaking, face less generous revenue share terms from some of China’s SNS platforms,
and, moreover, are competing against games internally developed by their social
networking hosts. We expect the all-important revenue share to shift gradually in favor
of the social games developers, as China’s SNS platforms battle for developer
allegiances.

Will Weibo woo? Expecting shift in share; upgrading Sina; cutting Tencent, Renren
target prices
SNS ‘juggernauts’ Tencent and Renren dominate domestically in the provisioning of
social games. With its hit Weibo service, Sina, in its never-ending diversification away
from its strict micro-blog roots to a much broader SNS and social media platform, is
actively challenging the dominance of China’s SNS incumbents, having targeted among
other areas, their basic business models (e.g. social games revenue share). Our upgrade
of Sina is in anticipation of a long-awaited monetization of its Weibo platform, and also
in the belief that it will continuously refine its social games strategy to compete more
effectively with Tencent and Renren. We also lower our target prices on both Tencent
and Renren.

Will China's social games sector go the way of traditional on-line games?
Social games present a growing threat to traditional on-line games, as time spent shifts
from one to the other. Paradoxically, despite the allure of widening social gaming take-
up both domestically and abroad, China’s social games studios run a real risk of
encountering the same painful challenges of their on-line games predecessors. Most of
China’s publically listed gaming players suffer from weak valuations, indicative of
decelerating growth, given low barriers to entry. Adding to these potential challenges
for China’s social gaming companies is the aforementioned concentration of power and
leverage among China’s SNS platforms. In the absence of a “super-game studio”, such
as Zynga, the beneficiaries of China’s inevitable social games consolidation are likely to
require unrivaled delivery capabilities, revenue diversification, both geographically and
platform-based, and other factors to prevail.

Our bold three-year prediction: Alibaba to become a player
When we consider some of the crucial elements required to succeed in social
networking and social games, we regard a deep knowledge of the user as a starting
point. Strength in areas such as CRM and billing are also important. Robust brand
equity, dominance in respective lines of business and longevity of the platform in
serving users should also prove supportive of success in SNS. Of all of the major
internet companies with the optionality of entering SNS, social gaming, etc., we
consider the Alibaba Group. A web site, Taojianghu, with Facebook-style applications
and Twitter-style feeds, was grafted into Taobao.com in April 2009. With more of a
social commerce orientation, Taojianghu ultimately saw an underwhelming take-up.

Deutsche Bank AG/Hong Kong Page 5

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Markets Research

However, we still believe that Alibaba is in the rare position of launching a much higher
profile and successful SNS offering should it so desire. Hiring veteran managers from
the admittedly young SNS space would mark the first major step in that direction, in our
view.

Valuation
Our universe of Chinese internet companies currently trades at 0.8-1.1x PEG and 15-45x
2011E PE. We regard China internet sector valuations as generally attractive at current
levels, compared to their historical trading range.

We upgrade Sina to Buy and raise our target price to USD94.8. In valuing Sina, we
assign a 22x ex-cash 2012E PE to its online ads non-GAAP 2012E net profit of
USD182.2m; and an 8x 2012E ex-cash PE to 2012 non-ad business non-GAAP net profit
of USD8.0m. We value Sina Weibo at USD1.8bn, or USD1.5bn to Sina after options
dilution. Our valuation of Weibo is based on our 2014 Weibo net profit forecast of
USD55m and a 2014E PE of 40x. A valuation of USD1.5bn is equal to USD22 per share.

We maintain our Buy rating on Tencent and cut our target price to HKD195 from
HKD230. Our target price is based on a 2012E non-GAAP EPS of HKD8.61, 2012-14E
EPS CAGR of 23%, and a PEG of 1.0x. We cut our PEG from 1.1x to 1.0x, largely on
recent evidence that the company is no longer consistently outperforming our forecasts.

We maintain Hold on Renren and cut our target price to USD4.11 from USD8.17 on:

a softening earnings growth outlook in the next 24 months due to increasing
investment and weakening outlook for the group-buy business

slower-than-expected adoption of Renren’s self-service ad system mentioned
later in this report, indicating the inability to capture significant long tail ad
budget in the next 24 months

competitive pressure from Sina Weibo, not just in social gaming, but across
other fronts

We adopt a sum-of-the-parts valuation methodology to value 1) Renren ex-Nuomi, 2)
Nuomi and 3) 56.com separately, given that they are in different development stages,
participate in segments with very different market share structures, and, broadly
speaking, exhibit major differences in visibility and competitive landscape. We assign
USD466m to Renren ex-Nuomi, USD44m to Nuomi and USD54m to 56.com.

Our top picks across the China internet space are Baidu and Sina. We believe both
companies offer strong growth potential and trade at attractive valuations. Baidu trades
at 28x 2012E non-GAAP PE against our 2012-14 earnings CAGR of 29%, translating to a
PEG of 0.7x. Sina’s current stock price is 9% below fair value of Sina ex-Weibo (our
estimate: USD72 per share). We expect Sina’s PE to drop quickly after 2012 as Weibo
begins to contribute earnings and the company retreats from aggressive marketing
efforts.


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Markets Research

Figure 1: China internet comp table
Ticker Rating Price Mkt Cap EV CY11E CY12E CY13E CY11E CY12E CY13E
(m) (m) PE PE PE PS PS PS
China internet portals
Baidu BIDU.OQ Buy USD 124.92 43,488 40,408 43.0 x 27.5 x 19.6 x 19.7 x 12.5 x 8.9 x
Sina SINA.OQ Buy USD 62.67 3,871 3,136 67.4 x 47.1 x 20.6 x 8.5 x 6.6 x 4.7 x
Sohu SOHU.OQ Buy USD 48.05 1,829 1,291 9.8 x 8.8 x 8.0 x 2.2 x 1.6 x 1.4 x
Tencent 0700.HK Buy HKD 145.20 266,912 243,402 21.4 x 17.2 x 13.3 x 8.0 x 6.2 x 5.0 x
Alibaba 1688.HK Hold HKD 7.79 38,900 26,738 15.7 x 13.4 x 11.3 x 5.0 x 4.3 x 3.8 x
CRIC CRIC.OQ NR USD 4.61 661 371 15.2 x 11.0 x 9.5 x 2.7 x 2.3 x 2.0 x
SouFun SFUN.N Buy USD 12.18 926 957 9.0 x 7.1 x 6.0 x 2.7 x 2.2 x 1.9 x
Qihoo QIHU.OQ NR USD 16.10 1,888 1,571 45.0 x 21.2 x 11.5 x 11.8 x 6.8 x 4.1 x
Bitauto BITA.OQ NR USD 4.67 193 446 24.1 x 18.4 x 23.4 x 1.9 x 1.4 x 1.1 x
Renren RENN.N Hold USD 3.77 1,987 1,594 -125.7 x -125.7 x 37.7 x 12.8 x 8.6 x 5.5 x
Phoenix New Media FENG.N Buy USD 5.21 394 318 19.2 x 12.9 x 8.3 x 2.9 x 1.9 x 1.2 x
Taomee TAOM.N Buy USD 4.78 173 52 9.2 x 8.8 x 5.2 x 3.7 x 2.9 x 2.1 x
Mean 27.8 x 19.1 x 13.7 x 6.8 x 4.8 x 3.5 x
China online games
Giant Interactive GA.N NR USD 3.78 892 592 5.9 x 5.0 x 4.7 x 3.2 x 2.7 x 2.4 x
Netdragon 0777.HK NR HKD 4.74 2,439 847 12.8 x 9.3 x 6.4 x 3.4 x 2.7 x 2.2 x
Perfect World PWRD.OQ NR USD 9.93 499 1,766 3.3 x 3.1 x 2.7 x 1.1 x 1.0 x 0.9 x
Kingsoft 3888.HK NR HKD 3.01 3,515 1,915 7.3 x 6.0 x 5.4 x 3.3 x 2.9 x 2.5 x
Changyou CYOU.OQ NR USD 21.63 1,126 700 5.4 x 4.7 x 4.2 x 2.5 x 2.1 x 1.9 x
Shanda Interactive SNDA.OQ Hold USD 39.88 2,254 238 21.3 x 13.8 x 11.7 x 2.1 x 1.9 x 1.8 x
Shanda Games GAME.OQ Buy USD 4.35 1,253 862 5.3 x 4.7 x 4.3 x 1.6 x 1.4 x 1.3 x
NetEase NTES.OQ Buy USD 42.95 5,588 564 11.2 x 9.8 x 8.5 x 5.0 x 4.2 x 3.8 x
The9 NCTY.OQ NR USD 5.50 138 -467 -3.1 x -7.1 x N/A 6.2 x 1.2 x N/A
Mean 9.1 x 7.0 x 6.0 x 2.8 x 2.4 x 2.1 x
China travel
eLong LONG.OQ NR USD 14.23 479 1,265 38.5 x 29.6 x 24.5 x 5.3 x 4.2 x 3.6 x
Ctrip CTRP.OQ Hold USD 26.16 3,756 477 18.9 x 15.8 x 12.9 x 7.0 x 5.5 x 4.5 x
Mean 28.7 x 22.7 x 12.9 x 6.2 x 4.8 x 4.1 x
China e-commerce
Dangdang DANG.OQ NR USD 4.45 352 121 -12.5 x -6.9 x -6.9 x 0.6 x 0.4 x 0.3 x
Mecox Lane MCOX.OQ NR USD 1.54 88 6 -3.3 x -3.9 x -4.5 x 0.4 x 0.4 x 0.4 x
Mean -7.9 x -5.4 x -4.5 x 0.5 x 0.4 x 0.3 x
China Video
Youku YOKU.OQ NR USD 17.56 2,000 2,551 -106.4 x -175.6 x 84.0 x 14.3 x 7.8 x 4.7 x
Ku6 Media HRAY.OQ NR USD 1.17 59 19 N/A N/A N/A N/A N/A N/A
LeTV 300104.SZ NR CNY 30.93 6,805 6,974 54.7 x 35.8 x 25.4 x 14.2 x 9.2 x 6.4 x
Tudou TUDO.OQ Buy USD 11.82 335 174 -3.7 x -17.1 x 16.0 x 4.7 x 2.3 x 1.4 x
Mean -25.8 x -69.9 x 25.4 x 14.2 x 9.2 x 6.4 x
Source: Deutsche Bank, Bloomberg Finance LP, closing date 29 November 2011

Risks
We believe investors need to be aware of the following key risks when investing in
Chinese online social names:

Regulation risk
Change of revenue share term between operator and developer
Cannibalization on operators core business from social games
Monetization of social apps, in particular non-gaming apps


Insights
Markets Research

Our main thesis
Of high growth and major transformation
While China’s social gaming industry significantly resembles that of any other market –
with third-party games developers porting their games into the large social networking
platforms – there also exist some very profound differences. The two prime components
of successful social gaming – the social networking platforms and the games developer
segment – have far less industry concentration than the widely profiled symbiosis
between giants Facebook and Zynga in other markets. China’s social gaming business
model is similarly variegated. While the country’s dominant SNS platform, Tencent,
takes the lion’s share of gaming revenue and the game author a minority slice, the
dominant player in real-name SNS (by which the user discloses his/her real identity in
using the platform), Renren, offers a more favorable share, while challenger Sina,
through its Weibo platform, passes through nearly all of its revenues to its gaming
partner. We believe both the business model and competitive landscape are set to
change throughout 2012. The dramatic shift of time away from traditional SNS to
micro-blog is likely to give rise to new power brokers in the industry, particularly as
Sina’s Weibo platform continues to refine its games strategy. Assuming revenue share
is a tactical weapon in this battle of the platforms, industry wealth may well be poured
back into the coffers of China’s social games developers. Listed companies with
significant exposure to these trends are:

Platforms Tencent, Renren, Sina

Traditional gaming companies such as Shanda Game, Netease, etc.

In Figure 2, we show a summary, highlighting some of the conclusions of this report.

Figure 2: Exposure to China social games
Company Ticker 2013E social 2013E social 2013E social 2013E social Net impact from Notes
games rev games rev as % of games operating games OP as % of social games
(USDm) total rev profit (USDm) total OP thesis
Renren RENN 13.8 5% 7.6 41% Usage share declining
●
Sina SINA 23.1 3% 12.7 8% Major gainer
Tencent 0700.HK 369.2 5% 203.1 7% ◐ Risk to existing games

NetEase NTES NM <5% NM <5% ◐ Exposed to social
games cannibalization
Shanda Games GAME NM <5% NM <5% ◐ Exposed to social
Sohu (Changyou) SOHU NM <5% NM <5% ◐ Exposed to social
Source: Deutsche Bank estimates

Note: Empty circle : positive, Black circle ●: negative

Source: Deutsche Bank


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Markets Research

Key focus questions
Our broad aim in this report is to offer a thorough overview of China’s social games
market. However, more specifically, we hope to add value in attempting to answer what
we believe to be the three most important questions relating to the future of social
gaming through the highlighted “Focus” sections throughout the report. These
questions are:

How will the basic social games business model evolve, and who is likely to
benefit? (Discussion begins on page 12.)

Will new platform players emerge to challenge the current order? (Discussion
from page 18.)

Can China social gaming remain attractive long term? (Section begins on page
21.)


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Markets Research

Social games introduction
What is a social game?
A social game is, in short, a browser-based game that is intimately tied to one’s social
networking presence, allowing a gamer to play with friends, update them on their
accomplishments, and build a community in ways that discreet online games do not.
Social games tend to have the attribute of being easy to pick up and leave, if need be,
while allowing the player to resume again after logging back into the underlying social
networking site. Social games are, in this regard, considered “light core” or “middle
core” games. Massively multi-player on-line role playing games (MMORPGs) and
advanced casual games (ACGs), in contrast, tend to range from middle core to hard
core. These terms are used to characterize the intensity and complexity of the game-
play, the system requirements for computers used to play the game, and often the
sheer size of the “client” that a player must download (sometimes multiple gigabits in
size.)

Gaming website gamesbrief.com recently compiled a list of the characteristics of the
social gaming genre from industry experts. We have extracted several useful attempts
at defining the category below:

"My definition of a social game is a game that has a very gentle learning curve,
easy-to-understand user interface ("UI"), and lives on a social network, taking
advantage of your friendships in meaningful ways within the game...these
games are predominantly free-to-play and employ microtransactions as a
business model..." - John Romero, game designer

"A social game is a game played on and using the infrastructure of a social
networking website...a social game is a game played with, against or alongside
social-network friends, often asynchronously...games are open-ended and lack
win-states or fail-states: the only way to win or lose is not to play." - James
Wallis, game designer

"Social games take advantage of the social graph to include your real life
friends into the game experience. They are easy to get into, challenging over a
long period of time and they create a highly competitive atmosphere among
our real live friends." - Jens Begemann, CEO, wooga

"...the most important mechanisms of reward and pleasure come attached to
explicitly social aims. And these aims will tend to involve sharing, competing
and cooperating with other players, as well as harnessing existing social bonds
and networks as part of the game’s fundamental mechanisms of progress and
achievement." Tom Chatfield, author

The global social games market
Total social games market including Facebook to hit USD8.6bn in revenue by 2014
The social games market has seen strong growth in many parts of the world, driven by
both the rapid expansion of adoption of its underlying SNS host platforms (such as
Facebook, Renren, Tencent) and on its own unique merits. We profile the rise of social
networking as a growth driver in Appendix A of this report. Gaming has become one of
the most popular activities on the internet across most markets. Having once accounted
for nearly 25% of all time spent on the Chinese internet as of 2006, pure-play gaming
remains some 10-15%, according to iResearch. Indeed, on-line gaming could still
represent nearly 20% of the average Chinese netizen’s time on-line if we include its
latest incarnation, namely, as a part of the social networking experience


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App platform Viximo and market research firm SuperData Research recently conducted
a study together on the worldwide social games market. The report predicts that the
global social games market, including both Facebook and its peers globally, will
generate USD8.6bn revenue by the end of 2014 (not including ad revenue). Asia is the
largest social games market, with revenues of about USD2bn in 2011. South America,
Western and Eastern Europe are growing at very fast rates. In terms of social game
users, Russia has 35m, while Brazil has reached 32.6m. China is estimated to have
202m social gamers (42% of China’s internet population). Among all European
countries, Germany is generating the most social games revenues, with expected
revenue of more than USD173m in 2011. Meanwhile, the country is expected to
generate more than USD250m by 2014. iResearch expects China to generate social
games revenues of RMB1.8bn in 2011. Please note that the estimated revenue statistics
for China and Asia are from two different sources, one from Viximo and the other one
from iResearch.

While Facebook is the world’s largest social network, other large regional social game
networks include Renren and Tencent in China, Hyves in the Netherlands, Tuenti in
Spain, SudiVZ in Germany, and Badoo in the United Kingdom. Google+ is also emerging
as both an SNS of scale and a growing social games platform in North America, and is
now considered to be the most serious competitor to Facebook since the demise of
MySpace.

Non-Facebook social games to hit USD5.6bn in revenue by 2014
The report by Viximo and SuperData Research also highlighted that revenues from
social games played outside of the Facebook social platform will grow to USD5.6bn by
2014 (or 65% of the aforementioned total of USD8.6bn), from a current level of
USD3.2bn. This estimate is grounded by hard data, which include the surveying of
some 774,158 unique transactions by 152,159 individuals playing social games for the
six months ending June 2011. As such, Facebook is clearly not the only platform where
social games are booming. Despite Facebook being the largest social games platform in
the US and globally, it represents only one-third of total traffic. The study expects that
non-Facebook platforms in western markets will account for nearly one quarter of the
worldwide social games market within the next three years.
Viximo expects key social game markets such as China, Brazil, Germany, Russia and
Turkey to see strong growth in non-Facebook traffic. As Asia is currently the largest
social games market, we indeed expect the Chinese market to be one of the major
growth catalysts due to its large population and the rapidly rising popularity of social
networks.

Recent insight into growth: the Information Solutions Group study
Leading casual games company PopCap in mid-November released the results of an
exhaustive study that it commissioned led by the Information Solutions Group. The
study notes that, as of September, significantly more Internet users in both the US and
the UK were playing social games than in January, 2010. Some 41% of Internet users in
the US and UK had played a social game in the past three months, and moreover play
more than 15 minutes per week compared to only 24% in January 2010. The number of
what the study terms “Avid social game players” (those who play at least six hours a
week) had more than doubled over the same period. We refer readers to the underlying
76-page study at the following link:

http://www.infosolutionsgroup.com/pdfs/2011_PopCap_Social_Gaming_Research_Resul
ts.pdf


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Markets Research

China’s social games growth
prospects
Outlook
Chinese “netizens” are well-known for their fondness for online gaming relative to their
counterparts in almost any other country. Below, we present the past and forecast
growth of the broader on-line games market.

Figure 3: 2007–2013E China online games market
80
62.8% 67.4%

70 33.8%
25.2% 18.1% 14.2% 8.2%
60
51.2
50 47.3
RMB billion

41.4
40 35.1
28.0
30
20.9
20
12.5
10

0
2007A 2008A 2009A 2010A 2011E 2012E 2013E

transaction value (RMBb) % YoY growth
Source: Deutsche Bank with input from iResearch

Not only has China gamers’ appetite for traditional massively multi-player on-line role
playing games (MMORPGs) and casual games created a large sub-segment of the
internet economy, but their adoption of social games, available to those who socialize
on SNS platforms, is also growing rapidly. Revenue in social gaming is almost
exclusively derived from the purchase of in-game virtual items, from fertilizer for a farm
game, to weapons for a war strategy game.

Market research firm iResearch estimates that the transaction value of the China social
games market totaled RMB491m in 2010, up 338% YoY. iResearch meanwhile forecasts
that the China social games market will continue this strong growth in the next two
years, reaching a transaction value of RMB5bn by 2013, representing a CAGR of 117%
from 2010-2013. iResearch also forecasts that the share of social games as a
percentage of total online games revenue will continue to increase from 1.4% in 2010 to
9.8% in 2013. We present iResearch’s predictions of the rise of social games revenues
below.


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Figure 4: 2007–2013E China online games market breakdown
100% 1.1% 3.1% 1.4%
6.2% 4.3% 7.4%
7.9% 6.1% 9.5% 9.8%
90% 5.9% 11.6%
6.0% 11.7%
11.8%
80% 6.6%
7.7%
8.6%
70%

60%

50%
91.0% 90.8% 87.5%
40% 83.1%
77.4% 73.2% 69.9%
30%

20%

10%

0%
2007A 2008A 2009A 2010A 2011E 2012E 2013E

MMORPG Platform games Web games Social games

In growing to nearly 10% of total China on-line gaming revenues by 2013, social games
growth will likely nearly double in 2012 alone, as illustrated below.

Figure 5: 2009–2013E China social games market
6,000 338%
263%
5,015
5,000
96%
43%
4,000
3,500
RMB million

3,000

2,000 1,781

1,000
491
112
0
2009A 2010A 2011E 2012E 2013E
Transaction value (RMBm) 112 491 1,781 3,500 5,015
% YoY growth 338% 263% 96% 43%

Stage I of growth for China social gaming companies largely overseas
Many Chinese social games developers have benefited greatly from opportunities in the
international markets, as these markets often have relatively higher ARPU than their
Chinese counterparts, and revenue share can be more generous. We believe China
social games companies going overseas are regarded as a value-add to the domestic
market, as they can earn a higher revenue from the international market and gain more
experience in terms of content development, marketing, customer services, etc., which
will ultimately give them more resources and experience to expand the domestic market
at an appropriate time. For instance, Beijing-based social game company Rekoo is
famous for its social games in Japan. The company has 90% of its 400 staff in China,
but it is one of the leading social games developers in Japan’s leading social network,


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Mixi. Company CEO Liu Yong announced in February 2011 that, while he expected
steady growth in the Japanese market, the more substantial growth would be in China.
Liu expected revenues in China to grow from the current RMB1m per month to USD1-
2m per month by the end of 2011. The company now has more resources to expand the
domestic market and recently just signed a deal with Tencent.

Social games follow social networks’ growth; forecasting 340m social game users by
2013E
China’s leading social networks have, over the years, increasingly integrated online
games as a prominent offering for their users. Social games have thus rapidly gained
popularity alongside the evolution of social networks, as they provide entertainment
services and serve to increase communication among users. Social games include
social network identity, and they exist as a plug-in that allows convenient access within
a social network. While a majority of these games can be played on a “free” basis, the
introduction of virtual items (e.g. special fertilizers to grow one’s crop more quickly in a
farming game) has become the major form of monetization for this game genre. At
present, we believe the number of social gamers in China is about 202m (or some 75%
of total 2011E China SNS users of 269m), with active paying users of about 1.8m.
Meanwhile, we expect the number of social gamers to reach 340m by 2013
(representing 80% of 2013E China SNS users of 425m), with active paying users of
about 3.7m.

Leading indicators for growth: Renren, Facebook already deriving significant revenues
from games
In looking at two leading SNS platforms, it is clear that on-line gaming has become a
prominent source of revenues for both Renren and Facebook. We expect games-related
revenues to represent roughly 38% of Renren’s 2011E revenues of USD115m
(moreover, this number captures only two-thirds of the company’s third-party social
games revenues – the balance is shared with the games developer). eMarketer
meanwhile forecasts that Facebook will realize roughly USD4.3bn in revenues in 2011.
It also forecasts that the dominant SNS platform will derive $3.8bn from advertising this
year (+104% YoY, from USD1.86bn in 2010), and USD470m from Facebook Credits, a
virtual currency program that lets users buy items in games (accounting for more than
3x the USD140m it made in 2010). Bearing witness to the sheer amount of social games
traffic on more advanced platforms such as Facebook, it seems quite clear that China’s
SNSA platforms should see strong secular growth in this space for years to come. We
estimate there to be more than 50 games and other apps on Facebook with multi-
million daily active users (DAU.) We believe there will be only a handful of such apps on
Tencent. We believe online games will remain an important revenue source for the
social networking industry in the short term. We profile an even more basic driver for
the social games industry, the social networking industry itself, in our Appendix A
section.

Major drivers
Proliferation of open platforms in China
We regard the proliferation of open platforms in China, and growth in SNS user
accounts, to represent the most basic driver of social games growth. While we discuss
in detail the three main SNS presences in China, namely Tencent, Renren and Sina
Weibo, other platforms to which games are being ported include Baidu box computing,
Qihoo, Shanda, and others. As such, social game users will continue to ride on the
growth of the open platform in China.


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Abundant supply of domestic social game developers
China is regarded as one of the world’s most prolific social games development hubs. In
August 2011, Tencent’s VP announced that the company’s open platform had almost
80,000 registered developers. We estimate that the whole China gaming market may
have close to 100,000 developers. Even though some Chinese social games companies
choose to go overseas, the abundant supply of Chinese social games developers still
suffices for domestic market expansion. In addition, the large number of domestic
developers who have gained strong operational experience from overseas social
platforms can help the development and expansion of the domestic market.

Rapidly increasing internet penetration rates and SNS user growth
Chinese internet users reached 485m in June 2011, and the internet penetration rate
reached 36.2%, increasing by 1.9% YoY compared with 2010. This number is still falling
behind the 70% penetration rate in developed countries such as the United States and
Japan. The strong growth of internet access and broadband connections in China
provides a solid foundation for the continued growth of the online gaming industry in
China. Meanwhile, we estimate China internet users to reach 800m by 2015,
representing a CAGR of 13% (2011–15E). China SNS growth will also be another major
growth driver for social games. iResearch forecasts that China will have 269m SNS
users by the end of 2011, and will reach 425m SNS users by 2013, representing a CAGR
of 26% (2011-2013).

We also note that the number of mobile internet users totaled 318m in June 2011,
which means that around 65.5% of Chinese netizens are using mobile devices to access
the internet. China’s expanding 3G mobile network allows users to surf the internet
more conveniently and at a faster rate, which should pave the way for mobile social
gaming growth in the next few years.

China’s massive network convergence plan should benefit social gaming
The Chinese government has begun a massive nationwide network convergence
initiative by which it seeks to be able to deliver multiple services to a user through one
connection. Currently, fixed telephony, television, internet, mobile communications and
other forms of media are delivered over disparate, costly and largely redundant
pathways. The government is encouraging China’s cable operators and telecoms
providers to deliver most/all of these services over one connection, and to create tight
connections across them so that media can be shared across TV, the internet, on a
handheld, etc. This ambitious convergence initiative should open a window of
opportunity for cross-platform implementation of online games, including social games.
Under this ambitious planned framework, it will be possible to play a game interactively
across TV, computers, mobile phones, and other devices. We believe that such
convergence, while likely only to emerge over the next five years, should provide
greater access to social games for interested users, while creating valuable
opportunities for new participants, such as broadcasting and television companies, to
expand into the online gaming market.

“Viral channels” – China’s platforms, Facebook going in opposite directions?
One key to the rapid growth in popularity of games on the social networking platforms
related to the broad, and nearly costless “viral channels” that the SNS platform allowed
between the game and the platform’s large user base. A viral channel is best described
as any means that leads to the rapid spread of a piece of media, be it a funny video
virally spread on Youtube, to a joke virally spread to millions of Twitter users in a matter
of minutes through re-tweets, or a social game attracting massive new registrations, as
SNS users respond to their friends’ accomplishments in the game on their SNS walls by
themselves signing up for the game.


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Game developers, for instance, were permitted by Facebook to send invites to the SNS
“friends” of a gamer’s Facebook contacts. Frequent status updates from a player’s
achievements in a game were often pushed to a gamer’s wall. These updates, requests
for assistance, or outright invitations to play the game, would show up in the
“Notifications” or news flow of his/her friends, serving to pique the interest of other
users, thus expanding the player base very rapidly, and with little cost or effort. Sample
postings might include:

Alan Hellawell sent you a request in Happy City

Alan has attained Level 8 in Happy City! Alan reached Level 8 in Happy City and
received a new title of Senior City Planner. Join him and build your own city of
happiness!

Facebook, from late-2010 onwards, began closing off some of these pathways,
consolidating frequent updates into groups of notifications, and limiting the
opportunities for games to communicate so widely throughout the SNS platform.
Facebook claimed that its users were, as Josh Williams, president of Kontagent puts it,
“tiring of the high-volume, low-quality, spam that many apps were sending out. This
fatigue was reflected in dramatically reduced viral message response rates in many
apps over just a year ago.” Mr. Williams claims that, since Facebook’s changes to user
communication channels, viral response rates are now trending higher (probably
specifically because fewer messages are being sent out to each user per week).

China social games should clearly benefit should SNS platforms open viral channels
further
From discussions with both China’s social gaming companies and its leading SNS
platforms, it seems that China’s platforms are experimenting with more liberal viral
channels of communications between games played on the platforms and the large
SNS user bases. In the case of Tencent, social games players can send invites to SNS
buddies. Other promotional channels include free in-game items for buddies and status
updates on SNS user walls.

“Requests” and “Invitations” are indeed among the more common forms of viral
marketing on Tencent. A request, often sent to dozens of a player’s friends, might be

“Alan Hellawell is trying to complete a task in the game Farmhand and needs
your help. Can you send him a mini-saw?”

An invitation, meanwhile, could appear in the following form:

“Enjoy the exhilaration of racing the countryside and come play Country Road
Race with me!”

Opening up APIs to improve gamer experience further, and better empower games
companies
These viral channels are significantly enabled by the APIs that platform owners such as
Tencent and Facebook extend to their social games partners. Generally speaking, the
more APIs that are opened to the games developers, the more interactive and relevant
the game can become. We estimate that there are fewer than 10 APIs available to social
games developers on Tencent, including: “Request invitation”, “Send present to
friends ” , “ Share information ” (must be confirmed by user) ， “ Acquire user
information”, “Get friend’s information,” “Inner game blog”, etc. Not surprisingly,
Facebook offers a wider range of APIs, including “ Feed ” (automatically shares
information, does not need the user to approve and confirm); “Request invitation“
(the third-party developer can track where the user comes from.) While these links can
be abused and result in spam to the users involved, if applied intelligently, they can


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serve to improve the gaming experience, while improving the social games vendor’s
access to valuable information in order to consistently improve game play,
monetization, etc. We expect China’s major SNS platforms to continue testing the
release of more APIs to the social games developer community.

Open API merely the first step: how the platform "surfaces" games news flow is
important
While the basic APIs enable the basic analysis, composition and sharing of player
information, the ultimate success in viral sharing relies upon how the underlying SNS
platform "surfaces" and shares this information with other users. Facebook has spent
three to four years attempting to distill and refine the massive flow of data into
intelligible, actionable news flow. In September, 2011, Facebook decided to insert
games updates into a "top news" stream into the right-center column of a user's page.
We believe that Tencent remains far behind Facebook in learning how to curate or
surface these news flows for maximal effect, and we expect progress in this area to
benefit social games.


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The basic business model
Revenue sharing with social networking platforms: China
compared and contrasted
Social games developers derive a majority of their revenues from virtual goods
transactions. Social networking platforms, in general, share part of their revenues with
social games developers from virtual goods transactions (for instance, Facebook takes a
30% share of all transactions that use Facebook Credits to purchase virtual goods, and
Zynga and other developers take the remaining 70%). In-game advertising is also
another, much smaller, revenue source for social games developers and SNS platforms.

Getting to net revenue: channel fees and platform sharing
China’s leading SNS platforms offer a wide range of social games revenue sharing. We
estimate that Renren takes 36-52% of gaming revenue, while competitor Tencent takes
70-80% of its social games partners’ revenue. This ratio tends to improve with the
popularity of a specific social game (with more revenue share being given to
developers). Sina Weibo, however, passes through 100% of its games partner’s revenue
in year 1. As we discuss later in this report, we believe that revenue share will
increasingly be used as a weapon among the dominant SNS platforms to win allegiance
from the social games makers, and thus traffic from SNS users. Below, we profile the
broad social gaming revenue share arrangements of China’s major SNS platforms, and
also compare them with arrangements outside of China. An SNS platform such as
Tencent will charge its game partner a “channel fee” to cover costs, such as back-end
billing operations, elements of customer relationship management (CRM), etc.

Figure 6: Social gaming revenue share arrangements of major SNS platforms
Platform Channel fee Post-channel fee revenue Effective split for platform
claim
Tencent 40% 50-67% 70-80%
Renren 20% 20-40% 36-52%
Sina Weibo 0% 0% 0%
Facebook, USA Combined channel+ rev share 30% 30%
Mixi, Japan 20% for desktop, 30% for mobile 2030%
Source: Company data, Deutsche Bank estimates

Note: Revenue share at three levels: more popular games enjoy better cut for games developers. Tencent offers
revenue sharing on a progressive basis and uses it as an incentive scheme for outperforming apps developers. The
values above are approximate. In the case of Tencent, for instance, channel fees can vary depending on the
services that the company provides to apps developers (e.g. cloud-based services).

Among the Japanese platforms, we estimate that Mixi takes a 20-30% revenue cut, as
the table above shows; while both Gree and DeNa take 39%.

Additional costs – advertising, bandwidth, other
Figure 6 fails to capture other potentially significant costs beyond revenue share, such
as advertising spend. A social games partner on Facebook, for instance, can spend
more than 100% of the gross revenues of a new game on advertising in the first several
weeks after it launches. Tencent, meanwhile, while staking by far the highest revenue
claim on games revenues, does offer a range of marketing and promotional assistance,
although those supporting services seem somewhat opaque as to exactly when (e.g. at
what scale) a social game qualifies for enhanced marketing support.


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High profit margins on net revenues
From our discussions with industry professionals, the profit margin on net revenue for
social games (after deducting revenue share and channel fees), can be relatively high
(with a gross margin of about 90%), particularly overseas, as there are few significant
costs associated with the sale of virtual items. If we then include major costs, such as
server and bandwidth costs, we believe the average net profit margin in social gaming
can be as high as 50-60%.

Focus question: How will the social games business model
evolve?
"No one makes any money on Tencent"
The past several months of research into this report involved numerous claims from
various parts of the social games eco-system that, between the revenue share structure
that Tencent maintains, and other costs associated with operating a game on the
platform, very few social games companies make any money operating on Tencent.

We indeed expect the very basic elements of revenue share to evolve in China.
Generally speaking, we expect social games developers to enjoy a gradual improvement
in revenue realization, if only due to the mounting attempts from the ambitious Sina
Weibo platform to gain market share in gaming platform revenues by passing the
entirety of its gaming partner’s revenue back to the partner in year 1, and continuing to
share a majority of this revenue in subsequent years. While revenue share per se should
decline, other costs are likely to rise, such as advertising costs, as gaming companies
seek to draw attention to their games by placing targeted ads on their host SNS
platforms.

More generous revenue share beneficial for social gaming companies; Sina likely to win
among platforms
Broadly speaking, better revenue share is likely to mean good things for China’s social
gaming segment. The impact on China’s three aspiring SNS platforms is less clear.
Social gaming revenues per se are likely to remain a small minority of each of the three
listed companies’ revenues. However, we believe the broader structural changes that
accompany this one element (including improvements in monetization, time spent, etc.)
will eventually benefit Sina over Tencent and Renren.

New monetization opportunities: In-game advertising for social
games, the US precedent
According to a study from PricewaterhouseCoopers, around USD1bn will be spent in
2011 on in-game ads in the United States. PricewaterhouseCoopers expects this
number to increase at a 33% CAGR from 2011 to 2015. A majority of this spend will be
targeted towards casual and social games, such as simple farming or fishing games
that can be played in a short period of time on a smartphone or on the Web. The study
has found that advertisers feel there is a benefit in advertising through casual games, as
they are easy to play and are generally enjoyed by a wide audience. An analyst from
eMarketer commented that gaming is evolving from a young gamer pursuit to much
more of a mainstream activity.

eMarketer estimates that there are now about 90m casual gamers in the United States,
more than double the number of gamers who regularly play on consoles. We expect the
growing popularity of smartphones and tablets to continue to drive the growth of
casual/social games. Interestingly, other than the typical web-style banner ad formats,
some advertisers are innovatively trying to incorporate characteristics about their
companies’ attributes into games in order to raise the brand awareness among users;
for instance, inserting branded food items into restaurant menus appearing in a game.
This type of advertising is known as Product Placement advertising.


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According to technologyreview.com, Google’s AdSense for Games allows companies to
place a message before, during, or after a casual game. Apple also distributes in-game
ads through mobile devices. As reported in technologyreview.com, Apple gives
developers 60% of the ad revenue. We regard in-game ads for social gaming as being
still in a nascent stage, with many companies doing beta testing.

While mobile ads show promise, virtual goods likely to remain revenue source
In China, we have seen social games developers increasingly adopt in-game
advertising, often in order to promote other games in their own portfolios, those of their
partners, and various FMCG and other products and services. We would however note
that a report from eMarketer reveals that virtual goods ARPU for mobile games was
USD7.80 as of September, 2011 (up from USD0.30 as of September, 2009), while
advertising ARPU was only USD1.20 (actually down from USD1.50.)


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The Chinese social gamer
Proportion of social networking users playing social games
According to the statistics of AppLeap and Great Wall Club, about 34% of Chinese SNS
users log into social networking sites every day; while 40-50% of Chinese SNS users log
into social networking sites due to social games. In addition, Chinese online users are
eager to play online social games. About 34.69% of SNS users have played more than
10 social games on SNS platforms, and this category represents the largest number of
online users over the number of social games played. Only about 15.65% of SNS users
have never played social games before. Recent research from insidesocialgames.com
has shown that male gamers between the ages of 18 and 34 tend to monetize in
freemium games at higher rates than most other demographics.

According to IDC, Tencent’s Qzone SNS destination was the most frequently visited
social networking platform by social gamers in 2010 (90.8%), followed by
Kaixin001.com and Renren.com. We believe that the data shown in the figure below
may understate Renren’s market share, given the sheer number of games on the
platform, and the basic traffic numbers as shown by Alexa.com and other third-party
traffic tracking services. The survey, released in April of this year, also fails to capture
the recent rise of Sina Weibo’s games center.

Figure 7: Selection of social networking platforms by China social gamers as at year-end
2010

Qzone 90.8

Kaixin001.com 4.3

renren.com 3.2

51.com 0.8

bai.sohu.com 0.3

dream.163.com 0.3

Others 0.1

0.0 20.0 40.0 60.0 80.0 100.0

% of respondents
Source: IDC and GPC

Note: “Qzone” is a Tencent social networking property

In addition, more than two-thirds of social game users regard the “fun to play” aspects
and convenience of use to be their main determinants in choosing the type of social
game to play. Referral from friends is also another important element in the selection
process.


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A similar study from iResearch revealed that about 25.3% of Chinese SNS users play
social games every day, while 33.2% of users reported that they play social games
“sometimes.” Another 22.9% of users mentioned that they have played social games
before. We attribute the relatively high rate of occasional players of social games to the
shorter gaming cycle of social games, and the lack of depth that the average MMORPG
offers, which tends to lower user stickiness and retention ratios.

Figure 8: Proportion of social networking users playing social games in 2011

Played sometimes 33.2%

Played daily 25.3%

Have once played 22.9%

Never played before 17.2%

Don't know what social game is 1.4%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%

% of respondents
Source: iResearch

Types of social games played by users by year-end 2010
Among the major types of social games, character education games were the most
popular as at year-end 2010.

Figure 9: Types of social games played by users as at year-end 2010

Character TCG (e.g., Fashion Life) 90.1

Simulation Game (e.g., Glory Hospital, Renren Dining
4.7
room, Crazy Football, etc.)
Farm TCG (e.g., The Farm, The Ranch, The Sea Island,
2.6
Fish Raising, etc.)
Interactive social games (e.g., Friends for Sale,
2.2
Parking Dispute, etc.)

Chess Game (e.g., Texas Hold'em Poker) 0.3

Puzzle Game (e.g., Papaya Diamond, LLK) 0.1

Others 0.0

0 10 20 30 40 50 60 70 80 90 100

% of respondents
Source: IDC and GPC

Reasons people stop playing social games
Regarding the reasons why people choose not to continue playing a social game, 48%
of people mentioned lack of fun, while 41% of users mentioned that they had not had a
good gaming experience. About 31% of users attributed the reason to instability of the
gaming environment. As such, we believe companies that have consistently high-
quality content generation ability and strong operational ability will become more
competitive in China’s social games market.


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Social games versus traditional on-line games
Shorter development time, life cycle for social games
The development period for social games is usually shorter than MMORPG games.
From our discussions with several social games developers, the development time for a
social game is around three to four months. Some can go beyond 6 months, depending
on the complexity of the game. There is usually an additional one to two months
needed to fine-tune a game before it is launched on the market. In contrast, the
development period for MMORPG games is one to three years, again largely depending
on the complexity of the game. Although social games have relatively short
development periods, the games tend to have shorter life spans than MMORPGs.

In general, gamers tend to refer to stronger psychological satisfaction in playing
MMORPGs than in social games, as the former offer more sophisticated gaming
interfaces, story lines and content.

Low ARPU for social games
In China, monetization remains a challenge for social game developers, despite the high
popularity of social games. From our discussions with several social game industry
players, the ARPU for domestic social games is around RMB3 to RMB5 per month,
while that of MMORPG is around RMB66.7 per month (RMB200 per quarter).
Discussions with several industry professionals also revealed that ARPU for US social
games is around USD0.9 per month (RMB6 per month), which is slightly higher than
that of China.

Many Chinese developers are looking for opportunities in the international markets, as
they have relatively higher ARPUs than their Chinese counterparts. According to an
estimate by the CEO of Rock you, ARPU in Japan is up to 12x greater than in China.

Upside opportunity for active user payment rate
Social games, in general, have a shorter gaming cycle. We believe the willingness of
users to pay much for virtual items, etc., remains relatively low compared with
MMORPG games. Discussions with industry professionals suggest that the active user
payment rate of social games in China is believed to be in the range of 0.5% to 1.5%,
depending on the various aspects of each game. In comparison, Facebook’s active user
payment rate of social games is believed to be about 1%. Broadly speaking, the active
user payment rate of social games in China is thus similar to that in the US. We believe
Chinese game users, in general, are used to pay for virtual items online.

Distribution of work differs dramatically between traditional on-line games and social
games
While the development timeline of a social game can be as little as two to three months
(and that of an MMORPG two to three years), management at one social games house
suggested that 70% of the work around a social game occurs after a platform launch,
with developers working around the clock to add refinements and other updates as
frequently as weekly. “Expansion packs”, as they are referred to in the MMORPG world,
may happen only once or twice a year, or even less frequently.

Social games are more likely to convert non-gamers into gamers
Social games are usually free to play and are easy to learn; as a result, it is more likely
to convert non-gamers into gamers. We believe social games appeal to a wider
audience range when compared with MMORPGs’ target audience. Social networks
leverage their large user base in promoting their games. We believe having an active
social network is vital for the growth and development of social games. Many non-
gamers on SNSs have picked up playing social games, following friends introducing the
games to them. Gamers enjoy chatting with friends, posting updates to their walls, etc.,
thus contributing to a totally different gaming experience.


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Degree of cannibalization of traditional games
Social games are easy to learn, and are enjoyed by a wider audience range, when
compared with the MMORPGs’ target audience. Industry statistics from market
research firm IDC have shown that gamers are able to chat in a social game, while
actively playing the game, due to the relative ease of control compared with MMORPG
games. In addition, according to the 2011 China web-based game survey report, 53.1%
of web-based game users received information regarding social games through
recommendations from friends or other people. The content on gaming websites is also
an effective way to promote social games. About 48.3% of users have shown interest in
a particular game by reading the description of games on gaming websites. We believe
the usage shift to social games from MMORPGs is likely to be detrimental to overall
online gaming growth, due to the low paying ratio and ARPU of social games.
Furthermore, social games tend to have less monetization ability than MMORPGs. In
our view, China’s MMORPG market has been largely over-monetized in the past several
years.

Social games are taking up possible MMORPG airtime
In a recent China TMT Daily dated Oct 17 with title “East meets west: student SNS
users”, Online PHD, a resource provider for potential, current and former PHD students,
recently conducted a study about students’ activities on Facebook. The study shows
that students, both graduates and undergraduates, spend roughly 100 minutes on
Facebook, with six visits, on average, each day. In terms of activities, “less engaged”
students (per number of friends and posts) mostly spend their time on Facebook for
playing social games, while more engaged students normally comment on posts and
browse photos.

Renren recently analyzed college students’ usage of SNS in China. According to its
survey, based on 800 college students’ visits on Renren, around 96% visited the
platform, averaging 1.8 visits and 1.1 hours on the platform per day. Those visitors, on
average, generated 0.7 posts, shared 3.7 pieces of user-generated content (UGC),
browsed 8.4 posts and played social games on a daily basis. The study also suggests
that Renren, Tencent’s Pengyou and Douban are the three most visited social network
platforms among students. More than 80% of the 90s generation use IM and SNS to
keep in touch with classmates and friends, as well as relatives, and accounted for
nearly 47% of students’ regular contacts. Similar to the US, Chinese universities have
started to use SNS to market to, and interact with, students.

Based on the above statistics, social network sites, such as Facebook, Renren and
Tencent’s Pengyou, have become part of must-visit web sites every day and these users
tend to play social games on a daily basis. We believe this has taken up possible
MMORPG airtime. Online users now have the option of spending their time on SNSs
rather than on their MMORPG portal. Below is a chart showing the rapid decline in time
spent on online games and the increase in time spent on social platforms from an
iResearch study.

Ultimate characterization of the Chinese social gamer hard to predict
The Chinese social gamer is, in many ways, a new creature. Not only are the game
dynamics quite different from traditional Chinese on-line gaming, but much of the
Chinese social gamer demographic has never played on-line games before. It is thus not
clear how much time and money these players will spend playing social games, or
when, if ever, they will tire of them, etc.


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Figure 10: User time spent on Internet applications
40%

35% IM

30%

25% Online gaming

20%
Online video

15%
SNS

10%
Search
News
5%

E-commerce

0%
4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11

Source: iResearch


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Battle of the platforms
Analysis of extremes: Tencent vs. Sina
Tencent takes a more aggressive cut of social games revenues
As we have mentioned in previous sections of this report, social game developers derive
a majority of their revenues from virtual goods transactions. Social networking
platforms in general share part of the revenue with the social game developers from the
sale of virtual goods transactions. Current social game dominant player Tencent takes a
more aggressive cut of social games revenues (an estimated 70% to 80% of its
partners’ revenue). We believe that the effective revenue share can go beyond 80% due
to the additional services Tencent provides its game partners, including advertising
services. Leading real-name player Renren takes an apparently more modest 36-52% of
gross revenue, a level which similarly rises should a social gaming partner seek, for
instance, to advertise on the Renren site.

Drivers behind Tencent’s revenue share arrangements
Tencent management indicated that in 3Q11, the number of gaming apps on both
platforms exceeded 10,000. Some of the gaming apps are also accessible on Tencent
Microblog and Q+ platforms. Tencent currently has more than 500 social games on its
Qzone platform alone. However, from the discussions with several industry
professionals, the number of Tencent’s in house developed social games available on
the Qzone platform does not exceed more than ten games, which represents only a
mere 2% of the total number of Qzone social games. However, significant revenues
(“significant double digits” of total Tencent social game revenues) are believed to be
generated from these in-house developed games. We believe Tencent is likely to have
given priority to its in-house developed social games, including more advertising space
for the games on the Qzone platform, more aggressive advertisements, shorter game
review periods, other free resources, etc. In-house developed games obviously
contribute 100% of their revenue to the Tencent platform.

Sina 100% revenue share likely to drive market gains
Sina Weibo is, in our mind, the major emerging platform in the SNS market, and
possibly stands to gain the greatest incremental traction in social gaming. Scale,
however, could be a challenge. Sina Weibo currently has less than 50 social games
available on its platform, far below the 500 social games available in Tencent’s Qzone.
In order to gain market share, Sina is now offering 100% revenue sharing with its social
games partners in the first year. The number of active users on Qzone alone was 539m
in 3Q11. While Sina does not disclose the number of active users on its Sina Weibo
platform, we estimate the number of monthly active users is around 20% of its total
registered users (about 250m), reaching 50m. In order to determine which company will
offer a higher revenue to social game partners, our rationale is to use this formula:
(number of active users * rate of paying active users * ARPU * revenue share portion).
As neither company discloses the ARPU for social games and Sina does not disclose its
rate of paying active users, it is hard to estimate which company will offer a higher
revenue to social game partners.


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Focus question: Will the SNS platform order change?
Our upgrade of, and preference for, Sina to some extent driven by social games gains
Given these very disparate revenue share terms, we have begun to see nearly all of the
game developers interviewed for this report begin to develop games for the Sina Weibo
platform, creating a good opportunity for Sina to build market share. In the next one or
two years, we view Sina as gradually taking market share away from Renren and
Tencent owing largely to the 100% revenue share Weibo is offering. We do not expect
Sina to scrap its 100% first-year revenue share strategy in the short term until it has
gained a significant market share in the social game industry.

Much of the social games community seems to welcome the disruptive presence of the
Sina Weibo platform. Developers like that the Sina Weibo user tends to be of a
wealthier, white collar pedigree, compared to the prevailing profile of the Tencent user
as being younger and less wealthy. Indeed, some of the more successful games on Sina
Weibo, such as Boyaa Texas Hold’em, boast amongst the highest ARPUs in the sector.

Challenges in Sina Weibo’s attempts at social gaming
However, Sina Weibo faces a wide range of challenges. First and most immediately
apparent is the still-inadequate offerings and forms of support that it offers to games
developers relative to the likes of more seasoned operators such as Renren and
Tencent. Tencent for instance has:

1. A well-established online payment system (users can pay by Q coin or Tenpay to
purchase items of the apps). Much of the platform’s massive user base has a long-
term billing relationship with Tencent, and online payment behaviors are well
established.

2. Extensive marketing and promotional resources including cross-selling across other
Tencent platforms, the bundling of apps privileges into monthly subscriptions, and
self-help advertising delivery.

3. Relatively strong technical support (e.g. cloud-based services), and data analysis
(user demographic, online behavior, traffic, etc.)

Sina seems to lack these strengths, although we believe it is racing to come up to par
with Tencent on these and other fronts.

The Weibo user: although wealthier than the Tencent QQ user, interest in games not as
clear
We would also note that the same qualities of the Weibo user (being largely white
collar, coastal urbanites) may well preclude much traction for the platform on the social
gaming front. Such a profile of user may not have the same level of time or interest to
play games on-line. From another perspective, the Sina Weibo platform at its heart is
more media-oriented (users trawling tweets for newsflow, celebrity updates, etc.). Sina
Weibo since its launch has been accepted above all as an effective information center
and powerful media channel by users. It is unclear whether the average user will find
cause to expand his/her Weibo usage beyond following movie stars and newsflow, to
begin playing games.

On the other hand, most of Tencent’s properties are at their core more oriented toward
recreating, socializing and communicating. Gaming is in this light a natural extension of
these areas. And with Tencent deriving some 55% of current revenues from traditional
on-line gaming, it would make natural sense that China’s largest SNS platform would
also dominate in social gaming.


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Despite disparate demographic, forecasting 20%+ of SNS gaming usage market share
for Sina by 2013
Extrapolating from the amount of development China’s leading social gaming houses
have diverted to the Sina Weibo platform, assuming that both overall SNS time spent
will continue to shift to Sina Weibo and a more generous revenue share regime
continues, we would expect Sina Weibo to capture at least 20% of China’s SNS gaming
usage by 2013. We view the number of daily active users (DAU) as a useful proxy for
market share. We estimate that Sina Weibo’s games portal already boasts 10%-15% of
the DAU AND MAU of Tencent. This level may have already exceeded Renren, which by
some accounts is about 10% of the DAU/MAU of Tencent.

Domestic social games active user payment rate is similar to that in the US
From discussions with industry professionals, we believe the domestic social games’
active user payment rate to be 0.5-1.5%, depending on the various aspects of each
game. We meanwhile estimate the active user payment rate on Facebook to be about
1%. Broadly speaking, the active user payment rate of social games in China is thus
similar to that in the US. We expect this rate to gradually increase as the market
develops further and monetization mechanisms improve.


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Competition in China social
gaming
Peeling away the layers of competition
Are China’s traditional online gaming companies viable competition?
We do not regard the leading lights of traditional Chinese on-line gaming, such as
Netease, Shanda and others, as constituting significant competition to China’s pure-
play social gaming segment going forward. The former category of companies, with
years of refining business models built around delivering massive MMORPG projects
over as much as a few years supported by multi-million dollar budgets, seem to find the
more compact development timelines, lighter focus on content and story line, and
frequent, real-time database-driven updates somewhat anathema to their core value
proposition. The sticker shock of such low ARPU’s may also have dissuaded these
companies from developing much social gaming competence. We also believe that the
need to interact relatively deeply with the underlying SNS platforms, and specifically
competitor Tencent, does not appeal to these largely client-based development houses
and distributors.

How will the partner-competitor relationship with Tencent, Renren evolve?
Outside of fellow third-party social games developers, the companies we profile toward
the end of this report actually find their most direct competition embedded in the SNS
platforms in China from which they operate. For instance, on numerous occasions,
Tencent Chairman Pony Ma has emphasized the company’s growing commitment to
both its open API initiative, and the third-party games and other applications it is
designed to encourage, we believe, that Tencent continues to derive a vast majority of
its games revenues on platforms such as Qzone from its own web games and social
games. Judging from statements from leadership from both companies, we predict that
Tencent and Renren will gradually shift emphasis from internally developed games
toward a greater collaboration with, and dependence upon, third-party social games.

Profile of a successful Chinese social game: Hoolai Three Kingdoms
One of China’s more successful social games companies is Hoolai. With a heavy
emphasis on the local market, the company recently reported peak DAU of more than
10m and peak MAU of more than 40m on the Tencent platform. Tencent’s top third-
party social game is Hoolai Three Kingdoms. As we profile later in this report, Three
Kingdoms was launched in December 2010, and is a flash-based game. The game is
based on the Chinese Three Kingdoms tale from ancient Chinese history. It is a
combination of strategy and city-building simulation. Management estimates average
DAU of 5-6m, and MAU of 30-40m. Local media sources suggest that monthly revenue
stands at RMB35-45m.

Hoolai Three Kingdoms DAU and MAU not too far off Facebook leader CityVille
According to AppData, Zynga’s game CityVille currently tops the Facebook charts with
10.6m DAU, and MAU of 50.3m. Hoolai Three Kingdom’s user numbers are thus not too
far off those of the world’s most popular social game. While it is impossible to define an
average social game, we would compare the numbers above to more commonplace
DAU levels on the Chinese SNS platforms of 100,000-200,000, MAU of 300,000-
500,000, and monthly revenue of RMB300,000.


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