Despite benefiting from a gaming surge during Covid lockdowns, the company’s finances still contain some red flags as it eyes a Hong Kong listing

Key Takeaways:

  • ZX Inc.’s revenue and profit both grew significantly in the first half of the year as frequent lockdowns sparked an online gaming craze
  • The company had just 290 million yuan in cash and 2 billion yuan in net current liabilities at the end of June

By Fai Pui

In 2017, Hong Kong movie star Nick Cheung challenged Chinese gamers to “cross me if you dare,” using a thickly-accented but catchy phrase playing on a popular line from one of his movies. That ignited a craze for “Legend of Lanyue,” the game he was endorsing. Five years later, the game’s operator ZX Inc. is once again throwing out a new challenge, this time to Hong Kong investors, with plans to float shares in the city.

ZX Inc.’s preliminary prospectus, filed at the end of last month, shows not only why the company is listing now, but also contains financial data that might give some investors cause for concern over the company’s future development.

China’s online game industry was once a goldmine that was quickly embraced by investors, fueling the meteoric rise of names like Tencent (0700.HK). But all of that has changed in the last two years. In addition to being labeled as “spiritual opium” by official media, the industry has taken a series of regulatory hits, including strict limits on playing time for minors, hitting many companies on both their top and bottom lines.

Amid that gloom, the Covid-19 pandemic brought a breath of fresh air as millions of people turned to games to pass time during lockdowns that left them housebound for weeks or even months. ZX Inc. noted that particular benefit in its preliminary prospectus.

Since its inception in 2015, ZX has provided and operated 259 web and mobile interactive entertainment products with an average of 9.4 million monthly active users (MAUs) as of the end of June this year. Its revenue has also had a very good run. After falling by 4.5% to 2.87 billion yuan ($411 million) in 2020 due to changes in product development schedules for certain games marketed and operated by its customers, its revenue nearly doubled last year and in the first half of 2022 to 5.74 billion yuan and 4.54 billion yuan, respectively.

But ZX has also paid handsomely for those revenue gains. Over the past three and a half years, it spent 11.2 billion yuan, or more than 66% of its total revenue each year, mainly on fees to acquire traffic from partner online media platforms, offline marketing expenses and for celebrity endorsements.

The company recorded a loss of 1.3 billion yuan in 2020 due to a one-time share-based payment of 1.82 billion yuan to employees. It moved into the black to the tune of a 616 million yuan profit last year, and continued that streak with a profit of 338 million yuan in the first half of 2022. But its heavy promotional spending has squeezed its profitability. The company posted a net profit margin of 10.7% last year, and the figure fell to only 7.5% in the first half of this year as its spending grew by 72% to 3 billion yuan.

Peripheral products

In a bid to diversify from the fiercely competitive gaming industry, ZX launched food, “blind box” collectibles and other peripheral products two years ago. Its fast food products, branded with the famous Nick Cheung line, have fared particularly well, selling out at about 16,900 offline stores in more than 20 provinces across China.

Last year ZX also jumped on China’s recent craze for collectible toy series sold out of “blind boxes,” which add an element of fun for collectors by hiding the actual toy they are buying until after an opaque box is purchased and opened. Last year, the company launched its “Bro Kooli” series of broccoli-headed figurines sold from blind boxes, which proved to be a hot item among Chinese collectors.

Those two businesses raked in an additional 66.77 million yuan in revenue for ZX in the first half of this year, up 120% from the second half of last year. Still, the sum was still quite small at just 1.5% of overall revenue.

Earlier this year, the company also jumped on the metaverse bandwagon with its announcement of plans to build a metaverse community called “Project Z.” ZX plans to use its Bro Kooli intellectual property (IP) in that initiative, while also looking for strategic alliances and acquisitions to populate the new realm.

Growing liabilities

ZX says it plans to use IPO proceeds to strengthen its interactive entertainment and innovation businesses and to expand and deepen cooperation with key players in the full lifecycle value chain. It will also use funds to improve technology and enhance internal R&D capabilities, expand overseas and explore strategic acquisitions.

But its ambitions aren’t the only thing on the rise. A review of its financial statements shows its net current liabilities are growing quickly, jumping from 216 million yuan in 2019 to 2 billion yuan at the end of June this year. A big part of that comes from its bills payable, which stood at 4.86 billion yuan at the end of June – far higher than its 496 million yuan of trade and bills receivable at that time.

But while its net liabilities mount, ZX only had 290 million yuan in cash and cash equivalents at the end of June, down nearly 60% from the 690 million yuan at the end of last year. It also faces risk from five pending IP-related lawsuits. Its combination of big debts, dwindling cash, pending litigation and need for cash to fund its metaverse project make it no wonder the game developer needs new funds from an IPO.

ZX could also get a boost from a recent shift in Beijing’s attitude toward the gaming sector after nearly two years of clampdown. Last month, the influential People’s Daily, the main newspaper of China’s Communist Party, suddenly published an article describing online games as a “lifetime opportunity” – a huge shift from the “spiritual opium” moniker of the clampdown era. Chinese officials also resumed approval of new game titles in April this year, ending an eight-month pause, restoring investor confidence in the industry.

In terms of valuation, ZX might expect to get similar multiples as mobile and online game developers CMGE Technology (0302.HK) and IGG Group (0799.HK), which have price-to-earnings (P/E) ratios of 5.8 times and 9.3 times, respectively. Using their average of 7.55 times as a reference and ZX’s first-half profit extrapolated to the whole year would value the company at about $5.1 billion yuan.

With such a mixed bag to offer, ZX’s success will depend on how well it can use its effective but also expensive marketing techniques to sell itself to investors.

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