Perfect World (NASDAQ:PWRD) is a Chinese online gaming company that specializes in developing 3D massively multiplayer online role playing games (MMORPGs). A MMORPG is a type of video game in which a large number of players assume the role of a character and interact with each other in a virtual game world setting. The company also operates its games in international markets through its subsidiaries in the US, Europe, Japan and Malaysia as well as licensing games to other international publishers in Indonesia, Brazil, Philippines, Azerbaijan, etc.
Perfect World has a market capitalization of close to $515 million and net cash balance of $399 million currently. This implies that the market values its entire business at $116 million, which is just slightly above what the company reported in its last quarter earnings. We feel the current price gives Perfect World a valuation hard to ignore. Our price estimate of $16.23 for the company marks our valuation at a premium of over 50% to the current market price.
Here we provide a quick snapshot of how Perfect World makes money and an overview of the important segments that contribute to its business.
How does Perfect World make money? What are the key markets/segments for the company?
Perfect World uses either a time-based revenue model or an item-based revenue model for its games. Under the time-based revenue model, it charges players based on the time they spend playing the game. In an item-based revenue model, the players can play the games for free, but players are charged when they purchase in-game items such as performance enhancing items, clothing, accessories, pets, etc. Perfect World earns a majority of its revenue from the item-based revenue model.
We have divided Perfect World’s business into three main operating segments:
1. China operations – Though declining, it remains an important driver for Perfect World’s valuation
Out of $474 million earned in sales in 2011, 63% was from Perfect World’s business in China. Though the percentage contribution has come down considerably over the years, the Chinese operations remain a key driver for the company’s valuation.
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.
However, Perfect World has a robust pipeline of games that are up for launch in 2013: Legend of the Condor Heroes, Swordsman, Heaven Sword, Dragon Excalibur, and Saint Seiya. Perfect World currently has around 1 million active paying customers compared to 1.8 million in 2009. We believe the deep and diverse portfolio of upcoming games would stabilize the decline in its Chinese user base.
While Perfect World’s active paying user base has been declining, its average revenue per user has increased over the years. We believe that new expansion packs and content enhancements would lead to a potential increase in average revenue per user in the future.
2. International operations – Will drive future growth in business
Perfect World witnessed more than 100% annual growth in revenue from international markets in 2011. Perfect World’s international operations contribute around 28% to its revenues, and we estimate the percentage contribution to increase over our review period. We feel that expanding its presence in international markets remains a key long-term strategy for Perfect World.
Partnering with Cryptic Studios and other such specialized R&D studios has strengthened Perfect World’s global R&D capabilities. Going forward, we expect it to continue to attract additional international gamers with new games and expansion packs, resulting in steady revenue growth.
Perfect World earns around 83% gross margins from its Chinese as well as international operations. The margins have declined over the years as the company’s operating expenses continue to rise with higher R&D expenses and an increase in sales, general and administrative costs. While the company 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 international markets as well as retain its foothold in the domestic gaming scene.
3. Games Licensing, Films & TV
Perfect World licenses its games to other game publishers around the world in multiple countries. It gets an initial licensing fee and ongoing royalties for each licensed game, which are operated and marketed by its licensing partners. It also produced a movie (Sophie’s Revenge) and a TV show (Fighting for my Marriage) through which it generated some revenue in 2009 and 2010.
Perfect World earns only 9% of its revenue from this division. While we forecast the games licensing revenue to continue increasing with its focus on overseas licensing, we estimate a steady decline in revenue from films and TV. Perfect World is focused on online game operations and licensing which is its primary business. We feel it is highly improbable that it will continue to produce any more movies or TV shows going forward.
The company earned around 85% gross profit on its overseas licensing business in 2011. We estimate a marginal decline in profits in the future. We feel that due to rising operational expenses and an increase in other related expenses such as personnel costs, high gross margins cannot be sustained in the long run.