Perfect World (NASDAQ:PWRD) is one of the top Chinese online gaming company specializing in developing 3D MMORPGs (massively multiplayer online role playing games) such as Legend of Martial Arts, Zhu Xian, Forsaken World and Battle of the Immortals. The company also operates localized versions of some popular games in the United States, Europe and Japan, where it competes with games such as World of Warcraft by Activision Blizzard (NASDAQ:ATVI), and Warhammer Online by Electronic Arts (NASDAQ:EA).
Compared to its Chinese peers such as Netease, Giant Interactive, Shanda as well as its American competitors such as Electronic Arts or Activision Blizzard, the company has a very low price-to-earning ratios (3.34x). The stock has been quite volatile, reaching a high of $22 and a low of $8.8 in the past year. Perfect World has a current market cap of close to $465 million and net cash balance of $445 million. This implies that the market values Perfect World’s entire business at only $20 million.
Our price estimate for Perfect World at $20 is a premium of over 100% to the current market price. We believe that the company continues to trade at an attractive valuation. Even after projecting an increase in operating expenses, a slowdown in revenue growth in China, and a modest boost in international gaming revenue in our model, there is a considerable upside to the stock value that the market fails to account for.
Higher International Revenues To Drive Growth
While its Chinese user base has shrunk over the last couple of years, dragging down its overall revenue growth, Perfect World’s international gaming revenue nearly doubled in 2011, according to our estimates. The company has been focusing on expanding its presence in international markets such as Europe, America and Japan through its subsidiaries as well as by licensing its games to other game publishers in other countries such as Indonesia and Brazil.
It recently launched Blacklight: Retribution and Forsaken World in multiple internationals markets, and we expect it to continue to attract additional international gamers with new games and expansion packs, resulting in steady revenue growth.
Perfect World not only customizes its existing games for international markets, but also works on several new games to expand its user base and revenue. In the coming months, it will launch two new martial arts MMORPGs — Heaven Sword and Dragon Saber, and the Return of the Condor Heroes — which could significantly boost revenue growth if they turn out to be hits.
Going forward, we expect Perfect World to focus more on its international gaming operations and overseas gaming licensing to drive revenue growth as its Chinese game operations have gradually taken a back seat. However, the company faces stiff competition in the global MMORPG market which itself has seen users being siphoned off by casual social games.
Considering that Perfect World’s estimated international revenue increased 5x in the last two years, we believe that we have a pretty conservative forecast for the same.
Stagnant Chinese User Base
Perfect World was one of the first MMORPG developers in China. However, the company has registered a decline in its market share in the past couple of years, primarily because of increasing competition in the online gaming space due to the entry of heavyweights such as NetEase, Tencent, Shanda Interactive, Giant Interactive, and ChangYou. Part of the decline in the company’s user base was because of a delay in launching new games, most of which failed to gain much traction. The rise of casual gaming in China has also contributed to a slowdown in the growth of the overall MMORPG user base.
However, going forward, we expect the decline in user numbers to slow down considerably as Perfect World launches expansion packs for its existing games such as Forsaken World. It is also working on other games such as Swordsman Online, Saint Seiya Online and a series of casual web-based games.
Even if we assume that the user base declines to around 800 million by the end of our forecast period, it will lead to only a 7% downfall in our price estimate, still leaving our valuation way above the current market price.
Higher Operating Expenses
The company’s operating expenses continued to rise, with its R&D spend jumping nearly 30% due to investments in new games and its platform last quarter. While it has mostly clamped down on SG&A spending, we expect its R&D spend to continue to increase going forward, as it will be forced to invest more in R&D to remain competitive in the international as well as retain its foothold in the domestic gaming scene.