For U.S. gaming companies, China is a tantalizing opportunity that comes at a very high cost.
As trade talks plod along, some game publishers have been opening up on how they're approaching the valuable market. China is the largest market in the world for games -- 1 billion people will play games in China by 2022, according to one projection by Niko Partners -- and naturally, that's an irresistible draw for game makers like Activision Blizzard (ATVI - Get Report) , Electronic Arts (EA - Get Report) , and Take-Two Interactive (TTWO - Get Report)
"China, I think, as everyone would acknowledge, China is a very particular marketplace," EA CEO Andrew Wilson told investors on a Feb. 5 earnings call. "And as that market continues to evolve and mature, we're seeing that brands like FIFA, brands like Need for Speed, Plants vs. Zombies, Command & Conquer, and potentially The Sims may have tremendous appeal there. And are working towards plans on how we execute against that over time."
Selling games in China comes with heavy burdens. Under Chinese law, foreign game makers must license their games to local partners, and must also ensure the approval of Chinese regulators tasked with screening games and other content. The regulators have approved games in fits and starts over the past two years, a process that can affect Chinese game makers as well as foreign firms.
Indeed, shares of Electronic Arts and Take Two both took a hit in February when Chinese regulators announced they would be halting the approval of new games as they worked through a backlog. Overall, major game makers posted mixed results last quarter, with EA, Take-Two and Activision Blizzard reporting lackluster guidance. Year to date, Activision Blizzard's stock is down 9% and Take-Two's stock is down 16%, while EA's is up 17% on optimism about its new Fortnite-like game, Apex Legends.
The Chinese government's mandate that foreign game makers work with Chinese licensors is a boon to tech firms like Tencent (TCEHY) , which is the world's largest games distributor in addition to its other holdings across social media, AI and ecommerce. Major Chinese licensors of U.S. games include Tencent, NetEase (NTES - Get Report) and Perfect World (PWRD) , and licensing agreements with U.S. game makers are a reliable revenue pipeline for those tech firms.
Activision Blizzard, for example, has a 10-year relationship with NetEase, which co-develops popular titles like World of Warcraft and Overwatch for Chinese distribution. NetEase takes a cut of 65% in the partnership, Wedbush's Michael Pachter told TheStreet in an email. That licensing partnership appears to be going the distance, with Activision-Blizzard recently extending the licensing agreement with NetEase into 2023.
The burdens that U.S. gaming companies face in China have the attention of U.S. trade specialists, who note the lopsided barriers to entry for American distributors of content -- in addition to the legal "whack-a-mole" of stamping out pirated versions that appear in the Chinese market. In the ongoing trade negotiations, the U.S. is demanding that China enact changes to its laws and procedures to better guard against intellectual property theft, among other objectives, or face an escalation of tariffs.
"China's digital game market has become the largest in the world, accounting for 26 percent of global digital game revenue, but due to China's market restrictions, U.S. games account for only 5 percent of China's market," wrote Matt Snyder, a trade analyst with the U.S.-China Economic and Security Review Commission, in a 2018 report. "It is likely U.S. games would enjoy greater success in the absence of such discriminatory regulations."
Relative to the size of its economy, mainland China makes up a very modest slice of overall revenue for major U.S. game makers, with Activision Blizzard earning 5.2% of its total revenue in the country and EA earning 2.8%, according to FactSet.
Easing the Chinese government's mandate that American companies work with Chinese intermediaries is one priority of U.S. negotiators working on a trade deal, Bloomberg reported this week. And gaming executives have expressed some cautious optimism about the market opening up slightly for the U.S. gaming industry.
"There's a wonderful opportunity for us in China right now. And if regulation is softened there'd be an even greater opportunity. But we understand we have to work within the environment that we find ourselves in there," said Strauss Zelnick, chairman of Take-Two, on a Feb. 6 earnings call.
But there are other barriers to success in China, namely its bureaucracy. China's General Administration of Press and Publications, which regulates gaming content, is also working through a backlog of approvals. In late February, the agency put a hold on new game applications while it clears the backlog -- the second time it's frozen new applications in the past two years.
In its recent 10-K filing, Activision Blizzard noted the uncertain regulatory environment in China, as well as the costs of meeting regulatory burdens, as a risk factor to its business.
"The Chinese game approval procedure was suspended from March 2018 until January 2019 and, due to the large number of pending applications, it remains uncertain as to if and when our new products will be approved for release in China. Further, the enforcement of regulations relating to mobile and other games with an online element in China remains uncertain, and further changes, either in the regulations or their enforcement, could have a negative impact on our business in China," the company wrote.
That's one of the reasons why for investors, it might be premature to get excited about a level -- or more level -- playing field in the world's biggest market for digital games.
"I think it's probably too soon to say and timing is really uncertain," said Stephens analyst Jeff Cohen, asked about recent developments in China and their impact on Take-Two. "It was a setback when a few weeks ago they froze the application process again while the regulators work through the current backlog."