Tapping China's Gaming Gold Mine

A chinese man plays online games at an internet cafe in Beijing.
Liu Jin | AFP | Getty Images
A chinese man plays online games at an internet cafe in Beijing.

The U.S. is the profit center of the video game industry, and has been for years. But if trends continue, China might be taking that title before too long.

China represents a huge opportunity for U.S. publishers, which are quickly exploring ways to monetize the country's growing appetite for gaming. Meanwhile, some of the biggest firms in China are eyeing the U.S. market.

The Chinese games industry took in estimated total revenues of $9.7 billion in 2012—a 35 percent increase from the previous year, according to The NPD Group. While the U.S. market is more than twice as large, it's shrinking. Total consumer spending on the games industry in 2012 hit $20.77 billion—$4 billion less than the 2011 totals.

"With a country the size of China, that has a rising middle class, it's hard to ignore," said Eric Handler, senior equity analyst for MKM Partners. "That's a very lucrative market. ... You can generate some substantial profits from it."

But China isn't a market that's easily penetrated. For the past 13 years, consoles have been banned in the country. And while there was talk of that ban being lifted earlier this year, that chatter has died down. That essentially rules out packaged good sales that includes Xbox, PlayStation and Wii games. Gaming in China is done in online cafes with companies such as Tencent and Giant Interactive Group.

In contrast, the console-focused gaming model is the bread and butter of U.S. publishers. Instead,

The most lucrative business model in the Chinese video game market is free videogames—an area that has been growing domestically, but at a cautious pace.

Electronic Arts, for example, has generated nearly $50 million in revenues from "The Simpsons: Tapped Out" and Sony Online Entertainment has seen income soar since making all of its games free-to-play. Not all publishers are familiar with it, though.

"The Chinese consumer is not geared to the habit of 'I go to the store, spend X dollars to acquire this game, then go home and play it all night long.' That creates some challenges for [publishers]," said Edward Williams of BMO Capital Markets.

To get around that, some companies have opted for partnerships to more quickly introduce key brands to the market.

Take-Two launched "NBA 2K Online" in conjunction with Tencent—and the publisher said it's confident the game will become a meaningful contributor to content. Activision, meanwhile, has partnered with Netease to get "World of Warcraft" into the country—and is also working with Tencent to develop a multi-player online version of its "Call of Duty" franchise. Early game projections are minimal. But analysts said it has the potential to be huge, based on the success of similar games.

(Read More: At E3 Trade Show, Hoping for a Rebound)

"While we're modeling a fiscal 2013 sales contribution of only $15 million; we acknowledge a compelling, medium-term growth potential as identified through the comparative game experience of [Tencent's] 'Crossfire' in China, which is believed to generate $1 billion in annual sales," said Mike Hickey of National Alliance Capital Markets.

Other publishers, though, are investing internally in hopes of breaking into the Chinese market without a partner. That's a bigger gamble, but one that could have much bigger rewards, since they wouldn't have to share the income.

"This is an investment mode period for everyone to figure out what it is that Chinese online gaming audiences prefer," said John Taylor of Arcadia Research. "They need to get the content right and get the business model right. Activision has yet to try a free-to-play game, for instance."

Western Expansion

And while U.S. publishers try to figure out how to break into the market, some of the big Chinese companies are undertaking a Western expansion. Tencent has been aggressive on this front.

(Read More: Game On: Video Games May Be Making a Comeback)

In June 2012, the company acquired a minority stake in "Gears of War" developer Epic Games. In 2011, it invested $400 million in Riot Games, the developer of "League of Legends," a free-to-play multiplayer game that averages more than 12 million players worldwide per day.

Given Riot's massive success in free-to-play games—which are incredibly popular in China—the investment was a natural fit. With Epic, Tencent was less interested in the company's games and more focused on its Unreal graphics engine, which has been used in many of the biggest games. That trend seems poised to be just as widespread in the years to come.

In other words, while technology partnerships are likely to continue, don't expect Chinese publishers to bring their big titles over to the U.S. To do so would be counterproductive, analysts said.

"I don't expect to see any Chinese company making a massive step into the U.S.," said Handler of MKM Partners. "These are companies with margins of 50 percent-plus. If they buy into the U.S. market, they'd be getting lower margins in a more mature market. Is that the direction they want to take with their excess capital?"