Perfect World Looks Expensive After Its Stock’s Run

Perfect World (NASDAQ:PWRD), a Chinese online gaming company, has seen its stock price rise by over 90% in 2013. Some of the key factors that have driven its stock price include the launch of highly anticipated games such as Saint Seiya Online, Neverwinter, Swordsman Online and Holy King and accelerated top-line growth. The company’s revenue growth in Q2 2013 exceeded its initial guidance and it issued an optimistic outlook for the third quarter.

However, despite the price movement, our $17.14 price estimate for Perfect World is around 15% below the current market price. While the top-line outlook is encouraging owing to the launch of new games, a strong upcoming pipeline of games as well as international expansion, there are certain concerns that impact our valuation for the company. Perfect World’s profits are declining and we believe the company will continue to invest high resources in R&D and marketing in response to changing dynamics in the gaming industry. Along with increasing competition, the rising popularity of mobile games could impact the growth rate of MMORPG (massively multiplayer online role playing) games in China. In addition, any accounting issues with Chinese companies could have negative fallout on Perfect World’s stock.

Check out our complete analysis of Perfect World

Key Risks To Investing In Perfect World’s Stock

Profitability concern

Perfect World’s operating margin slumped to 9.5% in Q2 2013 as compared to 21.3% in Q1 2013 and 22.9% in Q2 2012, with sales and marketing expenses and R&D costs increasing by 102% and 10% q-o-q respectively. Increased sales and marketing expenses were attributable to promotional activities associated with new game launches. We believe profitability concerns will persist in 2013 as sales and marketing expenses will remain on the higher side due to the upcoming pipeline of games. Moreover, the company’s strategy to develop web and mobile games, in addition to MMORPG, will influence R&D costs.

Declining popularity of older games

The aggregate average concurrent users (ACU) for Perfect World fell to around 554,000 in Q1 2013 compared to 620,000 in Q4 2012 and 804,000 in Q1 2012. We believe this was due to waning popularity of older games. The company is slowing down the monetization of older games to enhance their lifecycle, and we believe this factor will negatively impact the overall top-line growth.

Intense competition in the online gaming industry

Perfect World faces intense competition from Chinese companies as well as international MMORPG developers. Tencent, NetEase, Shanda Games, ChangYou and Giant Interactive Group are the leading competitors to Perfect World. There are more than 100 online game operators in China and due to low barriers to entry in the business, competition can further rise in the future.

The increasing popularity of casual games and mobile games is expected to impact the growth rate of MMORPGs. Owing to the dynamic nature of the industry, we believe Perfect World will continue to invest significantly in R&D and marketing to stay ahead of the competition.

Trend towards mobile gaming could negatively impact Perfect World

During the first half of 2013, China’s online game market revenues stood at $5.1 billion. Revenue from mobile games increased by over 100% annually to more than $400 million during this period. The growth rate of mobile gaming revenue outpaced the growth seen in PC gaming. ^[1] We believe the Chinese mobile gaming market will expand at a rapid rate in the future due to increasing smartphone penetration in the country. Hence, it will be interesting to see how Perfect World responds to this changing dynamic in the gaming industry. While the company is developing its own portfolio of mobile games, they have a shorter life cycle. If Perfect World is unable to launch successful mobile games, it can mitigate its overall growth rate.

Chinese accounting risks

While Perfect World has not witnessed any accounting issues in the past, certain investors are cautious about accounting issues with Chinese companies. With more than 50% of our valuation associated with net cash reserves, the risk of accounting concerns is high.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. China’s Online Game Market Raked in $5.1 Billion in the First Half of This Year, Tech In Asia, July 25, 2013 [↩]