Perfect World’s a Value Pick for 2012, $21 Fair Value

Perfect World (NASDAQ:PWRD) is one of the top online gaming companies in China where it competes with the likes of NetEase (NASDAQ:NTES), Tencent, Shanda Interactive, Giant Interactive, and ChangYou. It also operates localized versions of its games in international markets like Europe, North America and Japan, and licenses its games to publishers in other markets where its offerings compete with games like World of Warcraft by Activision Blizzard (NASDAQ:ATVI), and Warhammer Online by Electronic Arts (NASDAQ:EA).

We have a $21 Trefis price estimate for Perfect World, which implies around 90% upside from the current market price. Games in China account for around 38% of its value while International Games account for 20%.

We believe that the market is grossly undervaluing Perfect World. Here’s why:

Enterprise value almost equal to net profit in 2011

Perfect World currently has a market capitalization of $530 million while its cash balance comprising cash equivalents, restricted cash, short-term investments and time deposits, net of short-term debt added up to $375 million as of September 30, 2011. This implies that the market values Perfect World’s entire business at only $155 million, which is ridiculously low, considering that it made a net profit of $127 million in 2010 and is on track to generate close to $150 million in net profit in 2011.

Chinese user base expected to decline, but not as rapidly as expected

Perfect World was one of the first MMORPG developers in China. It has been losing market share in the past couple of years, primarily because of increasing competition in the online gaming space due to the entry of giants like NetEase, Tencent, Shanda Interactive, Giant Interactive, and ChangYou. Part of the decline in its user base was because of a delay in launching new games, most of which failed to gain much traction. The rise of casual gaming in China has also contributed to a slowdown in the growth of the overall MMORPG user base.

However, we expect the decline in user numbers to slow down considerably going forward, as Perfect World launches expansion packs for its existing games as well as new games like Heaven Sword and Dragon Saber. Perfect World has been able to generate much higher ARPU (average revenue per user) than any other MMORPG developer in China in the past. We expect it to increase its ARPU by a minimum of 2-3% throughout the forecast period, considering it managed to increase its ARPU by more than 25% in each of the last two years.

International gaming revenue expected to increase slowly

Perfect World also generates a substantial amount of revenue from its international gaming operations in markets like Europe, North America and Japan. We expect its international gaming revenue to increase at a CAGR of less than 10%, which is a conservative estimate considering that its revenue increased 5x in the last two years.

Despite the increasing competition in the global online gaming market, and the rise of casual games, we expect Perfect World to show a net increase in its international user base, as it continues to launch localized versions of its popular Chinese games in other markets that have seen huge demand for its games in the past.

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