Virtual worlds, real profits

Spending your free time in a non-existent land pretending to be an elf may not be to everyone's taste, yet online role-play games are seriously big business. We seek out some of the best opportunities in the sector.

In the film The Matrix, the world we live in was revealed to be a computer-generated reality, developed to soak up the energies of its inhabitants. Now, with the advent of online games, the internet has spawned a series of Matrix-like alternative realities of its own.

The majority of these cumbersomely named massively multiplayer online role-playing games (MMORPGs), including the most popular World of Warcraft tend to involve taking on the guise of a character straight out of the pages of The Lord of the Rings, and then roaming around fantasy worlds, collecting treasure and killing monsters. While spending your spare hours wandering a non-existent land pretending to be a virtual elf might not be to everyone's taste, MMORPGs are big business World of Warcraft has more than 7.5 million subscribers worldwide. With each subscriber paying about $15 a month, that's a yearly cash take of $1.35bn. To put that into perspective, says The Weekly Standard, "in 2006, all of the movies released by Universal grossed about $800m at the box office".

Another of these virtual universes, Second Life, has attracted a great deal of attention in the press, and even has its own Reuters newswire. Residents', as players call themselves, buy in-game currency Linden dollars with real dollars, which they then use to buy land, property and clothes for their in-game personas. Interest in Second Life has soared after it produced its first millionaire, Anshe Chung, a virtual property tycoon whose virtual assets and cash pile added up to more than $1m by the end of 2006. A number of companies, including IBM, have set up shop inside the game, using virtual offices to hold conference calls and meetings; some even claim that the three-dimensional world of Second Life represents the future of the internet. Others argue that it's all a big pyramid scheme, resting largely on virtual sex and gambling.

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But in any case, for those of us who don't dream of packing in the day job to become a virtual clothes designer, the best way to make money from the gaming boom is to invest in the companies that stand to benefit. And as is so often the case these days, the biggest growth market lies to the East. In China, online gaming has become spectacularly popular among the emerging middle classes. About 70% of China's 132 million internet users are under the age of 30, according to Morgan Stanley, and a third of them played games online last year, says the China Internet Network Information Centre. More importantly for investors, spending on online games jumped 75% to $830m in 2006, and is set to reach $2.1bn by the end of the decade, "underscoring the opportunity facing gaming companies", says Smart Money.

You could be forgiven for being sceptical about such explosive growth projections. After all, internet users are fickle, as previously hot young companies such as Napster have found to their cost. But the way that players of online games can continually develop their characters and abilities encourages its own special kind of fanaticism "players like going out and finding iron ore, smelting it into iron, hammering it into a sword, selling it for some gold pieces, so they can buy new clothes. Each of those steps is emotionally satisfying," says John Kirriemuir in D-Lib Magazine. Below, we have a look at some firms profiting from the way these virtual worlds are spilling into the real one.

Top online gaming stocks

As mentioned above, the biggest online game is World of Warcraft (WoW). The game's creator, Blizzard Entertainment, is owned by French media conglomerate Vivendi (VIV) hardly a pure play on the online gaming sector. However, the good news is that WoW is licensed in China, where five million of its 7.5 million subscribers are based. The company that owns the licence, The9 (Nasdaq: NCTY) gets 98% of its revenues from WoW, with net profit up 54% year on year in the fourth quarter of last year, thanks to its success. The company trades on a p/e for 2007 of around 21, but earnings are expected to jump by 47% this year as it imports more games into China, and its PEG is around 0.72.

Other stocks include rivals Netease (Nasdaq: NTES) and Shanda (Nasdaq: SNDA). Netease has 24% of the Chinese gaming market, and generates 81.8% of its revenue from online games, with almost 50% deriving from its flagship title, Fantasy Westward Journey. The company has maintained a solid revenue growth with third-quarter revenues up 23.7% to $68.6m last year. Meanwhile, Shanda took a serious knock last year as it shifted to a free subscription model (with players paying for in-game items).

But the move is paying off, says Deutsche Bank analyst William Bao; last year, the group raked in $67.8m on $211m in revenues, up from $21.3m the year before.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.