Perfect World (NASDAQ:PWRD) is a Chinese online gaming company that specializes in developing 3D massively multiplayer online role playing games (MMORPGs). The stock price gained momentum at the start of the year hitting a peak of $17, but has fallen to $11 since then.
Though Perfect World’s revenue has increased since 2008, the rate of growth has slowed considerably. While the Chinese online gaming market continues to grow rapidly, the entry of bigger players such as NetEase, Tencent, Shanda Interactive, Giant Interactive and ChangYou, has intensified competition for Perfect World.
Perfect World’s revenues in China have been shrinking for the last few quarters. The company has been slow in launching additional games which has led to a gradual decline in its user base. Additionally, some of its new games failed to reach the desired level of popularity.
Though Perfect World has been focused on expanding its international operations to revive its business, its Chinese operations remain a key driver for the company’s valuation. We believe that with a deep and diverse pipeline of upcoming games, Perfect World has the potential to stabilize its Chinese business in the future. (Read: Here’s Why We Think Perfect World Is Worth $16)
Growth Opportunities in the Chinese Online Gaming Market
China’s online gaming market is growing rapidly. The market, which includes MMORPGs, casual, social and web games, is forecasted to reach around $9.2 billion by 2014, a 40% increase from its estimated size of $6.6 billion in 2011. Strong revenue growth by Chinese game operators, including Perfect World, led to a 32% growth in the online gaming industry in 2011. 
The increasing popularity of web games poses a significant threat to Perfect World’s MMORPG. Web based games have a lower development cost compared to MMORPG and do not require sophisticated PC hardware, which has contributed to their growing popularity. Revenue from web based games is expected to reach $1 billion in 2013, compared to $800 million in 2011. ((China online games market to grow 39 percent, Games Industry Blog, March 30, 2012))
However, Perfect World claims that MMORPGs continue to capture the largest market share (over 60%) in China and are expected to continue doing so for the next few years.
Where Does Perfect World Stand in the Chinese Online Games Market?
Presently, Perfect World features among the top five online game operators, which represent around 80% of the Chinese online gaming market. The other operators include much larger players such as Tencent and NetEase. Perfect World accounted for a mere $474 million of the $6.6 billion Chinese gaming market in 2011. This was considerably lower than the three leading players in the market – Tencent ($2.5 billion), NetEase ($1 billion) and Shanda Games ($838 million). ((China online games market to grow 39 percent, Games Industry Blog, March 30, 2012))
Tencent’s CrossFire game is arguably the most popular online game in China. Additionally, Activation Blizzard’s Call of Duty, NetEase’s World of Warcraft and Giant Interactive’s ZT online game, have expanded the user base for these companies.
Reasons for Perfect World’s Declining Share in China
Besides competition there are other factors that have contributed to the decline of Perfect World’s Chinese user base:
– Some of the games launched by Perfect World failed to gain traction in the market.
– Perfect World has delayed launching new games, with no big title launches in the past two years.
– Rise of casual gaming in China has led to slower growth of the overall MMORPG user base.
Factors that Can Stimulate Perfect World’s Chinese Business
While Perfect World’s user base has been declining, its average revenue per paying user has increased steadily, from $9.24 in 2008 to $18.90 in 2011.
Perfect World’s average number of concurrent users (ACU) have declined in the last few quarters. It reported close to 601,000 ACUs in Mainland China in Q3 2012, a 19% q-o-q and a 27% y-o-y decline. Perfect World believes that its anti-cheating efforts, which were stepped up during Q2 2012 to maintain a healthy and fun gaming environment, were partly responsible for the sharp decline.
Going forward, we expect ACUs to stabilize and the average revenue per user to increase marginally by the end of our forecast period.
1. New games to stabilize the decline in active paying customers
While games such as Perfect World II and Forsaken World continue to generate significant sales for Perfect World, the company has been building a rich pipeline of games. It recently launched open beta testing of Raider Z and the Return of the Condor Heroes and is set to launch two martial arts MMORPGs, Heaven Sword and Dragon Saber, by the year end. Swordsman Online, Saint Seiya Online and a series of casual web-based games are some of the other games that Perfect World is currently working on.
Perfect World won the rights to operate Dota 2 in China, which will add to its revenue going forward. Dota 2 is a popular game which had won IGN’s People’s Choice Award after its first showing. Hence, we believe that though Perfect World’s active paying customers may drop this year, the rate of decline will slow down and stabilize by the end of our forecast period.
2. Launch of expansion packs would increase average revenue per user
The rapid introduction of games is an encouraging trend for Perfect World. However if the expansion in user base is faster than the retail sales in new games, it can erode the company’s average revenue per user. Thus, while we forecast an increase in the average revenue per user, we estimate the growth rate to slow down considerably.
To ensure long term sustainability of existing games, Perfect World 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. As Perfect World continues to introduce expansion packs and enhance the content of its current games, we forecast an increase in the average revenue per user.
Thus, we believe that a deep and diverse pipeline of new games and expansion packs will help stabilize Perfect World’s Chinese business. However, even if the company’s user base declines to 500 million and the average revenue per user remains constant, it still leaves our valuation at a considerable premium (35%) to the current market price.
Our price estimate of $16.23 for Perfect World is at a premium of around 50% to the current market price.Notes: