Perfect World (NASDAQ: PWRD) is set to report its fourth quarter earnings this week. Below we take a look at the general trends in the gaming ecosystem in China, where Perfect World competes. We also analyze the performance of the company in terms of factors such as innovation and cost management.
We currently have a $15 price estimate for Perfect World, which is about 20% below its current market price.
New Developments In the Chinese Gaming Market
Early in Q4 2014, the Chinese Government completed a two-year project that gave a big boost to Internet speeds in China. This project, which cost almost $500 million, is also expected to reduce the cost of a new Internet connection. Therefore, the benefits from such a project to online gaming companies are twofold: more online players for their games, and a possible shift of gamers from smaller, less monetizable games to more data intensive games. In Q2 2014, the average download speed in China was 3.39 Mb/s. While this was close to the global average, it was less than half the speed in developed countries. Speeds in China can be expected to start to catch up now, as the major bottleneck – in the form of a low level of national level exchange points – has been removed. This has been done through the addition of seven more such exchange points to the existing three at Beijing, Shanghai, and Guangzhou.  It remains to be seen if there was any beneficial impact of such infrastructure improvements on Perfect World’s performance in Q4.
An important development in the Chinese online gaming scene in 2014 was the introduction of gaming consoles, which were banned in China earlier. To cater to console gaming enthusiasts, Perfect World announced that it would release a Microsoft Xbox version of its popular game Neverwinter.  Such efforts at monetizing the console gaming ecosystem may also receive assistance from Alibaba (NYSE:BABA). Alibaba is developing a product to compete with foreign-made consoles such as the Sony PlayStation and Microsoft Xbox.  It will be interesting to see how the introduction of consoles has influenced Perfect World’s revenues.
Another aspect of the online Gaming industry in China is the dominance of Tencent in the shooting and sports gaming categories. It reinforced this dominance in Q3 2014 through the release of new games which went on to do exceedingly well. FIFA Online 3 became the number one sports title in China shortly after it was launched in June 2014. In the shooter genre, the category leader is CrossFire, which is licensed by Tencent in China. Last year, Tencent claimed the second spot as well, with Assault Fire, a game developed in-house. In Perfect World’s Q4 results, we will be looking at whether the company intends to compete more aggressively in this category. 
R&D And Other Expenses
Perfect World’s R&D (Research and Development) expenses, which are almost completely on account of game development, registered an increase in Q3 2014 to the tune of 7.7% year-on-year. This was attributed to the increase in the number of personnel.  However, in Q3 2014, the company spun off its R&D division into 5 separate companies. (See: Our Q3 2014 Earnings Preview). We expect to see a considerable decline in the company’s R&D expenses in 2014 on account of this restructuring.
We also expect the company’s sales and marketing expenses to be higher, for two primary reasons. First, the games released earlier in the year will have required some marketing expense to retain player interest. Additionally, the attempts by Tencent to have a greater presence in MMORPGs (Massively Multiplayer Online Role-Playing Games) will have prompted Perfect World to match its level of promotional and advertisement spending.
View Interactive Institutional Research (Powered by Trefis):
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- Perfect World’s 2014: The Quest For Sustained Gamer Interest
- Perfect World Q3 Earnings: Mobile Games Deliver Revenue Growth
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- Weekly Chinese Internet Notes: Perfect World, Sina and Baidu