Despite being one of the early entrants in the Chinese online gaming market, Perfect World's (NASDAQ:PWRD) market share has declined over the years. With the entry of heavyweights such as NetEase, Tencent, Shanda Interactive, Giant Interactive, and ChangYou, as well as the increasing popularity of web-based games, the competition in the online gaming market has increased manifold.
Perfect World specializes in developing 3D massively multiplayer online role playing games (MMORPGs) such as "Legend of Martial Arts," "Zhu Xian," "Forsaken World," and "Battle of the Immortals." Apart from the Chinese market, it also operates localized versions of its games through its subsidiaries in the U.S., Europe, and Japan. Additionally, the company licenses its games to other game publishers in certain other markets, including Indonesia, Brazil, Turkey, and Azerbaijan.
Reaching a high of $17 in March this year, Perfect World's stock has declined considerably since then. We have a price estimate of $16.23 for the company, which marks our valuation at a premium of around 50% to the current market price.
Perfect World has a current market capitalization of close to $515 million and net cash balance of $399 million. This implies that the market values its entire business at $116 million, which is just slightly above what the company reported in its Q3 2012 earnings. (Read our earnings article: "Perfect World Banks On New Games To Drive Revenue Growth.")
Here's why we feel that Perfect World continues to trade at an attractive valuation.
Chinese User Base to Stabilize With New Product Launches
Perfect World was one of the first MMORPG developers in China. However, the company has registered a decline in market share over the years. Part of the decline in the user base was due to delays in launching new games (Perfect World has had no big title launch in the last two years), most of which failed to gain traction. The rise of casual gaming in China has also contributed to the slowdown in growth of the overall MMORPG user base.
However, the company claims that MMORPGs continue to capture the largest market share (over 60%) in China and are expected to continue doing so for the next few years. Moreover, while Perfect World specializes in client-based MMORPGs, it has also been investing in developing certain web-based games and mobile games.
Perfect World has a robust pipeline of games that are set to launch next year: "Legend of the Condor Heroes," "Swordsman," "Heaven Sword," "Dragon Excalibur," and "Saint Seiya." We believe the deep and diverse portfolio of upcoming games would stabilize the decline in its Chinese user base.
Additionally, the company has been increasingly focused on introducing expansion packs and enhancing content to increase the life cycle of its existing games. We feel the same could be a contributing factor for a potential increase in average revenue per user in the future.
Global Expansion Remains a Key Strategy for Perfect World
While its Chinese user base has shrunk over the last couple of years, dragging down its overall revenue growth, Perfect World's international gaming revenue nearly doubled in 2011, according to our estimates. Though the Chinese market continues to be of importance, expanding its presence in international markets remain a key long-term strategy for Perfect World.
Perfect World recently acquired U.S.-based Cryptic Studios with the aim to add additional world-class titles to its portfolio. The latter is working toward developing the much-anticipated game "Neverwinter" and certain other projects, which will be launched in 2013.
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.
We forecast the company to register a 6% CAGR in revenue until the end of our forecast period. That's a conservative estimate in our view, considering that Perfect World's estimated international revenue increased five times in the last two years.
High Operating Expenses Could Limit Growth
Perfect World'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.
Operational capabilities, a quick development cycle, and R&D capabilities remain the key competitive advantages of Perfect World. We believe that combined with an active games pipeline will help the company increase its top line over the years.
Disclosure: No positions.