Perfect World Earnings: New Games, International Presence & High R&D In Focus

Though Perfect World (NASDAQ:PWRD), a Chinese online gaming company, has seen a continuous increase in revenue over the years, the growth rate has slowed down. Owing to increasing competition in the online gaming space from heavyweights such as NetEase, Tencent, Shanda Interactive and Giant Interactive, Perfect World has lost share in the Chinese market over the last few years. The company posted a weak Q2 2012 with 6% decline in revenues and 34% q-o-q decline in operating profit. It is set to release its Q3 2012 earnings on Monday, November 19, and we do not expect the results to be significantly different from last quarter.

While the high R&D expenditure could hurt growth, we feel that the rich and diverse portfolio of games and expansion packs along with increasing international presence will help the company get back on to growth 2013 onward.

Check out our complete analysis of Perfect World

Robust Pipeline Of Games & Expansion Packs

Perfect World was one of the first MMORPG developers in China. However, the company has registered a decline in market share over the years due to rising competition. Part of the decline in the user base was due to delays in launching new games, most of which failed to gain traction. The rise of casual gaming in China has also contributed to the slowdown in growth of the overall MMORPG user base.

However, Perfect World has been actively working towards building a rich pipeline of games. While Perfect World II and Forsaken World continue to deliver strong performances, the company is gearing for the launch of two martial arts MMORPGs, Heaven Sword and Dragon Saber, in the latter half of 2012 . The company recently launched open beta testing of Raider Z and the Return of the Condor Heroes. It is also working on other games such as  Swordsman Online,  Saint Seiya Online and a series of casual web-based games.

Thus, we believe the rate of decline in Perfect World’s active paying customers will slow down and stabilize by the end of our forecast period.

Additionally, to ensure long-term sustainability of existing games, Perfect is focusing on content enhancement. Recently the company released a series of expansion packs, including Tournament of Warrior Couples for Dragon Excalibur, Dance of Lucky Stars for Hot Dance Party, Fantasy Zhu Xian 2.0 for Fantasy Zhu Xian, and Scroll of Time Travel for its flagship title Zhu Xian. The average revenue per ACU for the company increased marginally by 2% in Q2 2012, and we expect the same to increase further by the end of our forecast period.

Increasing Opportunities In International Markets

While its Chinese user base has shrunk over the last couple of years, dragging down its overall revenue growth, we estimate Perfect World’s international gaming revenue to have nearly doubled in 2011. 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 game publishers in other countries such as Indonesia, Brazil, Turkey and Azerbaijan.

Perfect World recently acquired US-based Cryptic Studios with the aim to add additional world-class titles to its portfolio. The latter is working towards developing the much-anticipated game Neverwinter and certain other projects.

Going forward, we expect Perfect World’s overseas gaming licensing to drive revenue growth as its Chinese game operations have gradually taken a backseat.

Increasing R&D Investment

Owing to increased R&D expenses and higher sales, general and administrative costs, Perfect World’s operating profit dropped to $24.4 million in Q2 2012, registering a 34% decline compared to the previous quarter. We expect Perfect World’s R&D spend to continue to increase going forward as it will be forced to invest more in R&D to remain competitive in international markets as well as retain its foothold in the domestic gaming scene.

However, if revenue growth fails to catch up with rising R&D costs, the same could have an adverse impact on Perfect World’s valuation.

We will update our price estimate of $17.68 for Perfect World post the Q3 2012 earnings release.

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