Will China Legalize Gaming Consoles? Changyou.Com Ltd (CYOU), NetEase, Inc (NTES)

Is that Mario bounding over the Great Wall?  China is reportedly considering opening its borders to gaming consoles, and that could have significant implications for investors.

The Chinese government has clamped down on video gaming consoles since 2000 over concerns that video games would corrupt China’s youth.  The entire Chinese video game market is PC-based because of this ban on video game consoles.  Now, reports have emerged that China’s government is mulling lifting the ban on consoles.

Changyou.Com LtdAlthough the growth potential for China’s gaming sector is promising, I still hold to a belief of cautious optimism.  China is a very complex market, and the government’s whims dictate whether or not gaming consoles will be allowed in the first place.  Piracy is also a massive problem which can eat away chunks of profit margins.   I believe that industry leaders like Changyou.Com Ltd (NASDAQ:CYOU) and NetEase, Inc (NTES) will continue to maintain growth and profitability, while companies such as Sony Corporation (NYSE:SNE), Microsoft Corporation (NASDAQ:MSFT) , and Nintendo Co., Ltd (PINK:NTDOY) will be able to reap benefits if China does indeed open itself up to traditional gaming consoles.

The Current State of Chinese Gaming

Fellow Motley Fool blogger Leo Sun, in an article entitled “Is Changyou Right for You?,” provides some scintillating numbers and insight on the state of China’s gaming sector:

According to Chinese site Techweb, the Chinese gaming industry grew 35.1% to $9.1 billion last year…estimates from various firms forecast the Chinese video game market to grow annually at 12.4%, potentially reaching $21.7 billion by 2017.

To put this into perspective, the market was only worth $200 million a decade ago.

Changyou’s online games also cost far less to produce than “Triple A” games, which cost up to $30 million to produce.  Changyou’s profit margin is currently 47%, compared to Western video game giant Activision Blizzard’s 20%.

In the fall of 2012, China approved Sony’s Playstation 3 to be sold in the country despite their ongoing console ban.  This led to speculation that China’s ban might be lifted soon.  According to a recent statement from an anonymous Chinese government source:

We are reviewing the policy and have conducted some surveys and held discussions with other ministries on the possibility of opening up the game console market. However, since the ban was issued by seven ministries more than a decade ago, we will need approval from all parties to lift it.

Shares of both Sony and Nintendo have gradually increased since these recent events.  These companies are buoyed by optimism surrounding China.  However, another Chinese government official has categorically denied the allegations.  As of now, the conflicting reports are, at most, speculative and sensational until more information “officially” comes out.

Potential Pitfalls

Assume for a moment that China does lift the ban.  What are some potential problems for companies who wish to jump in to this hot China market?

Reuters points out that although game consoles are banned in China, online gaming and playing games on mobile devices are both extremely common.  These entrenched competitors pose a potential barrier for Sony and rival game makers.  Since Chinese gamers have been used to these forms of gaming for over a decade, traditional gaming devices might not be as popular.  Changyou and Netease already have a stable presence in the country, which gives them an upper hand against market newcomers Sony, Microsoft, and Nintendo.

But, perhaps a larger looming issue is the black market and piracy.  Although China is the world’s biggest manufacturing base for Microsoft’s Xbox, Xbox and similar systems suffer from both market inaccessibility and piracy problems.  The launch of Sony’s Playstation 2 in China in 2004 resulted in rampant game piracy and of the hardware itself.  Sadly, as a result, there are a variety of counterfeit devices and boot-legged games almost everywhere you look in China.  If China lifts the ban on consoles, then companies who jump in, unfortunately, might have their profits cut into by fake games and devices.

The situation with China’s government is also cause for concern.  If China continues to become more open and free politically, then many more competitors will rush in to fill the void.  But, if China’s government becomes stricter and clamps down, then internet access will most likely be restricted and so will outside influences.  Companies won’t be able to get their products in or out of the country without paying high tariffs, and a restricted market would be anemic at best (while the illicit black market would thrive).  Thus any returns for initial investments in marketing, distribution, and production capabilities would quickly evaporate.

The Upside of Legalization

As previously noted, there is a black market for game consoles in China.  It would be a wise move for the Chinese government to legalize traditional gaming consoles if it wishes to truly take control of the industry.  By legalizing the game trade, China would open up a lucrative new source for tax and revenue.  Therefore, giving permission for such consoles to be sold legally may be the only option.

Nintendo, Sony and Microsoft could also benefit from the Chinese market being opened by teaming with local online companies like Changyou to push their own franchises.  Nintendo, Sony, and Microsoft could significantly boost sales of their consoles and their games by offering limited capability games online while providing the full version in the console.

The Bottom Line

China is a rapidly expanding and relatively new frontier for gaming companies.  If China does lift the ban on gaming consoles, then Sony, Microsoft, and Nintendo will gain much from establishing a presence in China.  But, if pirating is not kept under control, these companies will fall victim to what many other foreign companies have already felt by doing business in China.  Also, Sony, Microsoft, and Nintendo will have to compete with well-established online and mobile gaming companies like Changyou.com and NetEase.  Overall, I believe it is likely that China will legalize gaming consoles, which presents a great opportunity for gaming companies like Sony and Nintendo, as well as investors of those companies.  Mario will “supersize” in popularity!

The article Will China Legalize Gaming Consoles? originally appeared on Fool.com and is written by Evan Buck.

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