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Perfect World (NASDAQ:PWRD) is a Chinese online gaming company that specializes in developing 3D MMORPGs (massively multiplayer online role playing games). Peaking at $17 in March 2012, Perfect World's stock price has dropped by more than 30% since then and currently trades around $11-$12. The company has a market capitalization of $572 million and net cash balance of nearly $400 million, which implies that the market presently assigns a value of near $175 million for Perfect World's entire business.

In this article, we evaluate some of the factors that have led to a decline in its stock price and the key risks that impact Perfect World's valuation.

Declining Revenues, Profitability And User Base

While the Chinese online gaming industry recorded a high annual growth rate of 35.1% in 2012, Perfect World's revenues declined during the period. ((Chinese games industry hits $9.7 billion in 2012, GamesIndustry International, Jan 08, 2013)) Revenues dropped by 13% and 2% in Q2 and Q3 2012, respectively, on account of declining active user base and intense competition within the gaming industry. Additionally, Perfect World's net margins declined from 20.3% in Q3 2011 to 12.4% in Q3 2012 on account of higher sales, marketing and R&D expenses.

The aggregate average concurrent users (ACU) for Perfect World games operated in China declined to 601,000 in Q3 2012 from 828,000 in Q3 2011. Anti-cheating measures undertaken by the company was one of the key factors that led to the drastic decline in user base.

Intense Competition In The Gaming Industry

The online gaming industry is characterized by low barriers to entry and there are more than 100 online game operators in China. Perfect World faces stiff competition from other big Chinese online gaming companies such as Tencent, NetEase, Shanda Games, ChangYou and Giant Interactive Group. Some of its competitors have greater financial resources and hence can divert significant capital to R&D and marketing.

Perfect World not only faces competition from these Chinese companies but also from other international MMORG developers such as Activision Blizzard. Additionally, growing popularity of casual online games such as Farmville and Cityville could limit the growth potential of MMORPGs. Casual games are easy to learn and play and are thus attractive to new users.

Given the changing nature of consumer tastes and preferences, Perfect World will continuously need to invest significant resources to keep ahead of the competition. Increasing competition in the gaming market could further reduce Perfect World's user base.

Online Gaming Is Highly Regulated In China

The online gaming industry is highly regulated in China with regulatory authorities governing various aspects of the industry. The government regulations are aimed at controlling the time users spend on online games. Any adverse policy change by the government could negatively impact Perfect World. Recent news reports suggest that the Chinese government is reviewing the possibility of opening up the Chinese game console market. ((China considers lifting its ban on video game consoles, The Verge, January 28, 2013)) If the ban on video game consoles is lifted in China, users may switch to consoles instead of PC games, leading to a possible decline in Perfect World's user base.

Risks Stemming From Item-Based Revenue Model

Perfect World currently earns most of its revenues through the item-based revenue model, under which users are able to play games free-of charge for an unlimited time but need to pay for in-game items (including clothing, accessories, etc.). This contrasts with the time-based model wherein users are charged for the time they spend playing the games. The item-based model introduces uncertainties as the company continuously needs to monitor consumer tastes and develop games to encourage consumers to spend on in-game items. Moreover, the item-based revenue model is vulnerable to any change in Chinese regulations which could further restrict the time Chinese youth spend on online games.

Problems Arising From Hacking and Cheating Activities

Perfect World has also faced problems due to hacking and cheating activities wherein certain users have gained an unfair advantage by installing cheating software. The company's anti-cheating initiatives in Q3 2012 caused a significant drop in average concurrent users. A continued recurrence of such activities can impact growth in user base and can lead to a decline in user interest in buying in-game items, thus affecting Perfect World's top-line growth.

Disclosure: None

Source: Why Perfect World Is Struggling Despite Its Stock Being Incredibly Cheap