Perfect World (NASDAQ:PWRD) is a Chinese online gaming company that specializes in developing massively multiplayer online role playing games (MMORPGs) such as Legend of Martial Arts and Forsaken World among many others. It 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).
While the company’s Chinese user base has shrunk over the last couple of years, dragging down its overall revenue growth, its international gaming revenue nearly doubled in 2011, according to our estimates. However, Perfect World’s stock price has witnessed close to 50% downfall in value since August last year, which we believe makes the market valuation highly attractive for potential investors. We have a price estimate of $20 for Perfect World, which is at a premium of over 70% to the current market price. (Read our article justifying the valuation: Perfect World Shares Are Still Dirt Cheap)
Here we discuss certain factors that might lead to a potential downside to our price estimate:
1. Decline in revenues from games outside of China (-10%)
Perfect World’s revenues from international markets have posted a CAGR of 125%, increasing from $5.26 million in 2007 to $133.62 million in 2011. The company has been focusing on launching games in newer markets, and we expect its international gaming revenues to increase at a CAGR of 10% for the rest of our forecast period.
However, in the international markets, Perfect World not only faces increasing competition from established players but also from the increasing popularity of casual games. If, on account of growing competition, Perfect World’s revenues from the international markets drops down to $100 million by the end of our forecast period, we can witness a 10% downside to our price estimate.
2. Accelerating decline in active paying customers (-10%)
Though Perfect World was one of the primary MMORPG developers in China, it has witnessed a continuous decline in market share since 2009 due to the entry of giants like NetEase, Tencent, Shanda Interactive, Giant Interactive, and ChangYou. Additionally, the rise of casual gaming in China has also contributed to the growth slowdown of the overall MMORPG user base. However, we expect the decline in its user base to slow down considerably, going forward, as Perfect World has a number of new games and expansion packs for its existing games in the pipeline for 2013 and beyond.
If the rate of decline turns out to be higher than our estimates, the user base could drop down to 600 million, implying over 10% downside to our price estimate.
3. Research & development expenditure (-11%)
Historically, Perfect World has maintained low R&D expenses (as a percentage of revenues) thanks to its proprietary game engine and development platform, which enables it to develop new games at lower cost and minimal time-to-market. However, its R&D expenses have increased significantly in the past two years, and we believe the upward trend will continue as the company makes more investments in the development of new games and upgrades its proprietary game engine and platform to maintain a technological edge over competitors.
If Perfect World’s R&D expenditure (as a percentage of total revenue) goes up to 38% by the end of our forecast period, this will lead to close to 11% decline in our price estimate.
However, even the simultaneous occurrence of the above listed possible scenarios will leave Perfect World’s valuation at a considerable premium to the current market price.