Perfect World (NASDAQ:PWRD) is a Chinese online gaming company that specializes in developing 3D MMORPGs (massively multiplayer online role playing games). A MMORPG is a type of video game in which a number of players assume the role of a character and interact with each other in a virtual game setting. The company earns revenues from its games in China, as well as the international markets, either through its subsidiaries in various countries, or by licensing its games to other international publishers.
Peaking at $17.09 in March 2012, Perfect World’s stock price has declined by over 30% since then and currently trades around $11-$12. The company has a market capitalization of $562 million and net cash balance of $399 million, which implies that the market presently assigns a value of $163 million for Perfect World’s entire business.
With a current price estimate of $16.23 for the company, we feel that Perfect World has fundamentals to support a higher valuation. While potential growth in the Chinese online gaming industry and Perfect World’s rapid expansion into the international markets augur well for its growth, increasing competition and stringent government regulation are risks that can limit its future growth potential.
Chinese Gaming Industry Is Witnessing High Growth
According to a report published by Techweb, the Chinese gaming industry witnessed y-o-y growth of 35.1% in 2012, and is currently worth $9.7 billion. With the increasing internet penetration in the country, the gaming market is estimated to reach $21.7 billion by the end of 2017. ((Chinese games industry hits $9.7 billion in 2012, GamesIndustry International, Jan 08, 2013))
Online games currently account for more than 90% of the Chinese gaming market and dominate the video gaming industry in China as video consoles (such as XBox and Playstation) have been banned in the country since 2000. As one of the earliest entrants in the industry, we feel that Perfect World has the potential to leverage strong growth in the Chinese gaming market.
Perfect World Faces Stiff Competition
While the Chinese gaming industry is experience high growth, Perfect World faces intense competition from other leading Chinese companies such as Tencent, NetEase, Shanda Games, ChangYou and Giant Interactive Group. These six companies together account for around 80% of the online gaming market.  However, Perfect World accounted for only around 7% of the Chinese gaming market in 2011.
Perfect World’s revenues from China have declined over the last few quarters. The company’s active paying customers in China also shrunk from 1.8 million in 2009 to around 1.1 million in 2012, on account of its slow pace in launching new games. Moreover, some of its new games did not meet the desired level of popularity. However, Perfect World is expected to introduce a rich pipeline of games in 2013, such as Legend of the Condor Heroes, Swordsman, Heaven Sword, Dragon Excalibur, and Saint Seiya.
We believe that the Chinese user base of the company will stabilize in the future as Perfect World launches a diverse set of games and introduces expansion packs for its existing games.
International Operations Will Further Drive The Business
Perfect World recorded over 100% annual growth in its revenue from international markets in 2011, according to our estimates. While international operations account for around 28% of its revenues, we believe that the percentage contribution will rise in the future as the company increases its focus on international markets to drive its revenues.
In 2012, Perfect World introduced various games such as Dark Blood and RaiderZ in international markets through its subsidiaries. It also licensed its games to overseas operators to enhance its revenues. Perfect World’s acquisition of US-based Cryptic Studios has further strengthened its R&D capabilities. Along with Cryptic Studios, Perfect World is developing games such as Neverwinter, which is expected to be launched in 2013.
As its international user base expands, we feel Perfect World’s revenues from international operations will continue to increase in the future.
Major Threats To Its Business
Perfect World faces stiff competition from not only other Chinese gaming companies, but also from other international MMORG developers such as Activision Blizzard, which are currently more popular among international users.
Moreover, the growing popularity of casual online games such as Farmville and Cityville has also taken away some user base from MMORPGs. These games are comparatively easier to learn and play and are thus attractive to new users.
Other risks to Perfect World can stem from government regulations in the Chinese gaming market. Recent news reports show that Chinese government is reviewing the possibility of opening up the Chinese game console market.  If the ban on video game consoles is lifted in China, this may lead to a decline in Perfect World’s Chinese user base as some users may switch to consoles instead of PC games.Notes:
- Top online game companies suffer drop in Q2 income, People’s Daily Online, August 31, 2012 [↩]
- China considers lifting its ban on video game consoles, The Verge, January 28, 2013 [↩]