Seeking Alpha
Long only, deep value, growth at reasonable price
Profile| Send Message|
( followers)  

With changing economics come evolving social and cultural dynamics. The advent of Internet technology in China is a pertinent example as the number of Internet users reaches the highest in the world. Domestic online gaming companies are the ones capitalizing on this technological growth. Not long ago, China's gaming industry was dominated by foreign enterprises -- for instance, South Korea's presence accounted for 70% of the Chinese online gaming market.

The changing trend in the gaming industry can be attributed to two key aspects. First, the growth in the Chinese economy translated into higher income per capita coupled with increase in consumer spending. Second, the innovatory nature of the industry has allowed these newly established companies to convert millions of social media users into paying clients. Furthermore, growth in this particular sector is backed by government support. In the beginning of the year, the IT ministry announced an aggressive growth strategy in the electronics sector via mergers and alliances to help the domestic firms compete against the foreign global giants.

Perfect World (NASDAQ:PWRD), operating in the online gaming industry, is subject to similar trends. In this article, I would discuss the growth potential for this small-cap stock by conducting an in-depth analysis of the company as a whole.

What the Company Does

Perfect World is one of the leading game developers operating in China. It excels in providing online games based on proprietary engines and development platforms. Its strong technology and creative game design capabilities, combined with its broad knowledge and experience in the online game market, enables the enterprise to introduce popular games designed to cater to the changing customer preferences and market trends. The company went public in 2007 with an issued capital of 9 million ADSs, consisting of 45 million Class B ordinary shares at an opening price of $16 per share.

Product Portfolio

The company has been extremely active in updating its product portfolio to keep up with the industry trends. Since 2004, it has launched and currently operates seven 3D MMORPGs -- "Perfect World," "Legend of Martial Arts," "Perfect World II," "Zhu Xian," "Chi Bi," "Pocketpet Journey West," and "Forsaken World" -- one 3D online casual game, "Hot Dance Party;" two 2.5D MMORPGs, "Battle of the Immortals" and "Empire of the Immortals;" and two 2D turn-based MMORPGs, "Battle of the Immortals" and "Empire of the Immortals." Other sources of revenues include selling user licenses and pay-per-install games organized by its subsidiary under the name of Runic Games. It has managed to diversify its portfolio in film, television, and other related products.

Business Model

The company employs two operational models namely time-based and product-based. For functionality purposes it has resorted to item-based revenue model and continues to use it for expansion plans. Under this model, players are allowed to play games free of cost without any time restriction. Charges are placed on purchases of in-game items. On the other hand, the time-based model derives revenue from the playing time. The item-game model has been newly developed and provides higher profits. However, it is relatively riskier since it requires the games to be attractive enough for players to make purchases. The two most profitable games of Perfect World Co. -- namely "Zhu Xian" and "Perfect World II" -- employ the item-based model contributing around 47% of the total revenues in 2012.

The company reports its consolidated revenues based on three core segments namely online game operations, licensing revenues, and other revenues. In 2012, the online game segment contributed around 90% to its total sales, whereas licensing revenues and other sources together contributed the remaining 10%.

Financials

The company was incorporated a few years ago, which magnifies its growth potential. Perfect World financials reveal its ability to generate growth from within. The consistent increase in its product portfolio authenticates the claim. The recent quarter performance in 2013, however, showed a decline in earnings of 13%. Similarly, 2012 did prove to be a profitable year for the company with a decline in its revenues of 7%. The company's performance in the last three years reveals a revenue growth of 8.9, above the industry average of 0.7. Efficiency ratios such as the operating margin and net income margin stand at 15.3% and 17.3%, respectively. The key advantage for its investors is the relatively high EPS ratio of 11.15 in 2012. The management recently declared dividends of $0.43 with a dividend yield of 2.63%.

The asset base of the company showed a modest increase of 2.56% in 2012. The change was attributed to an increase its current liabilities. The liquidity position of the company improved with total current assets standing at $3515 million for the same year. Albeit given the decrease in revenues, it was only obvious that cash from operations declined by 36% year over year. The brunt was borne by capital expenditure as the management decided to cut it by 32% to maintain its liquidity position.

Growth Strategy

The management commits to its growth strategy by announcing plans to expand its product portfolio in coming years. The recent fluctuations in the past two years had adversely affected the business. For the coming years, revenue growth is expected to be driven by a launch its user-friendly games, monetization of existing games, and, lastly, expansion in its overseas operations. In January 2013, the company launched its 2-D turn-based cartoon style RPG web game under the name of "Adventure In The Three Kingdoms," with more in the pipeline. The management constantly needs to replace its existing online games due to the short life cycle of usually three to five years. It also plans to update its operational and financial system such as online payment and related security systems.

Its recent collaboration with Cryptic Studios under the label of Cryptic North will prove to be a lucrative alliance in the near future. The company is soon expected to release its highly acclaimed superhero MMORPG, "Champions Online," as well as "Star Trek Online" and "Dungeons & Dragons Neverwinter." It is for this reason that the coming quarter sales revenues are expected to increase by 5%-10%. Michael Chi, the chairman of Perfect World believes that these past two years decline in sales were temporary backed by sustainable growth in the company. The CAGR for the last five years stand 15%.

Risks

Before undertaking a long position in this small-cap stock, investors should familiarize themselves with certain associated risks. First, the earnings of the company are subject to fluctuations attributed to the nature of the industry it operates in. Growth in the online industry and the level of market demand is subject to changes in users preferences. Second, the degree of competition faced by the company is immense. Currently, there are 100 online gaming companies operating in China.

The key competitive factors include the design, quality, popularity, and price of online games and in-game items, the ability to upgrade its systems. Its biggest competitors include Tencent, NetEase, and Shanda Games with greater operational and financial leverage. Furthermore, growth in the internet industry is hindered by the lack of infrastructure. Majority of the telecommunication industry is state-owned raising pertinent concerns. More direct risks associated with its trading price include the impact of future acquisitions on the price of ADSs. Issuance of new stock to finance expansion projects will exert a downward pressure on its trading price or finance its takeovers.

Future Outlook

The booming IT sector and increase in the number of user base opens a positive outlook for Perfect World. For 2013, the average estimate has moved up from a profit of $12.32 to a profit of $12.36 over the last 90 days as per Wall Street estimates. PWRD currently trades at $16. The current P/E ratio stands at 10.6 with the downward projection of 6.7 for the coming quarter. The P/B and P/S stand at 1.2 and 1.8, correspondingly. The enterprise multiple for the recent year equals 35.81 with the projected ratio for the next 12 months to reach 31.82. The downward projection in the ratios is consistent with the industry trend.

The upside potential of PWRD cannot be denied. Given the increase in its anticipated earnings brought about by its augmented product portfolio, the stock price is likely to appreciate. The strong demand for internet products and positive government regulations will ensure a stable market in the future.

Conclusion

The company is growing at an impressive rate and will prove to be a solid investment. However, it does face certain degree of risks, which are likely to be superseded by the company's future prospects. This small-cap stock is attractive due to the growth potential as well as steady dividend income.

Source: Perfect World: An Attractive Small-Cap Pick In The Gaming Industry