A Perfect World for Investors (Though Not Recently)

Aug. 5.10 | About: Perfect World (PWRD)

Perfect World (Nasdaq:PWRD) is one of my favorite Chinese companies because I have long believed it's one of the better managed companies. I also believe that their CEO, Michael Chi, is incredibly intelligent and way ahead of his time in terms of doing business in China.

Like many Chinese stocks, PWRD has been in a terrible correction which started after the stock peaked about a year ago, coinciding with a peak in the Chinese stock market. Once technical selling started, sellers fed off each other, causing what I believe is a dramatic over reaction to their last couple earnings releases. In good markets, bad news is often over looked and stocks can rise anyway. But when market sentiment is bad, even the slightest bit of negative news can cause panic and confusion. I believe this is the case with PWRD, and I have held off on discussing that case here until I saw the technical picture changing.

For those who are not familiar with PWRD, they are an online game developer and operator in China. They operate primarily massively multiplayer online role playing games (mmorpgs), where players create characters in fantasy settings. These types of games have become popular because they allow for player interaction. Literally over a million people could be playing at any given time. Some fight each other. Others simply play through the features and storyline, but most people in China use it as a social medium. Like the trend that was started several years ago, PWRD mostly allows players to play for free - only charging for premium services within the games in the form of virtual items that can make players better without devoting too much game time.

What sets PWRD apart is that they have one of the best game development teams, and have spent heavily acquiring additional talent from smaller game developers. They have also spent heavily developing, as well as acquiring, different game engines which have allowed them to produce new games more quickly while not sacrificing on the overall quality. Unlike many of their peers over the past half decade, PWRD has also spent heavily on marketing and branding. Often they have taken an out-of-the-box approach by using well known entertainers to promote their games, and hosting special live events that don't necessarily promote any particular game, but more their brand.

The results have been good, extremely good. PWRD went from being a late-comer just over four years ago, with not much to their name and less in their war chest, to, by revenue, among the top five online gaming companies in China. In the past three fiscal years, for example, their net income grew from 50m to 100m to 150m for 2009. But more importantly, PWRD has not been idle nor satisfied with being just a gaming company. Whereas some peers in the past simply milked successful games for as long as they could, PWRD has used the tremendous high cash flows generated by their games to finance and diversify into other entertainment businesses where synergies can be created. For instance, PWRD also operates an online literature site, and last year produced their first big screen production "Sophie's Revenge" which turned out to gross among the top five movies in China last year. They have also recently acquired additional stakes in other TV and film assets. In short, their aim is not to be just an online gaming company, but a major brand in China's entertainment future.

On the valuation side, one might wonder why PWRD has dropped so low? In my opinion, that has largely to do with technical issues, as described briefly earlier. The company has successfully grown every year, to earn 151m last year. Not bad for a company whose market capitalization dropped to as low as 1b in recent months. In other words, a company that has grown net income over 50% annually since being formed traded under 7x trailing earnings. This doesn't even factor in that PWRD has no debt and almost 300m in cash, with cash flow generating capabilities of roughly 50m quarterly. In a normal market, these types of valuations would seem mind-boggling, but after the dotcom collapse, the housing bubble, the credit crisis, and other general sentiment about Wall Street just being flat out crooked, it's perhaps more understandable how things could have dropped this low.

Looking at the more technical picture, PWRD has been in a downtrend for almost a year now, after peaking out at slightly over 50 dollars. Once PWRD dropped below key moving averages, it really got ugly fast. It also didn't help when certain news was misinterpreted in light of such negative sentiment.

In the most recent quarter, the company announced metrics that investors found troubling - average concurrent users as well as average paying customers went down sequentially by a large degree. This was followed by forward guidance that suggested a potential drop in revenues.

However for those who have been following the sector, there are explanations. PWRD released a new game, Fantasy Zhu Xian, in the prior quarter and marketed it heavily. This created a surge of new users who apparently did not find game interesting enough to continue playing after trying it out. The same scenario also played out similarly a year earlier after PWRD released a widely-hyped new game, Pocketpet Journey West. The new release drew in a large number of users but quickly faded, causing PWRD to report similar sequential declines in those metrics.

However it is important to note that while the "user" and "customer" count may range widely in any given quarter due to promotions or new releases, PWRD's revenue stream has been growing at a fairly stable rate. This is because outside of launch blips for new games, most of their established games generate stable revenue streams while newer games slowly attract larger paying player bases. So while the sequential player decline might seem scary, PWRD guided overall revenues to range from down 2% to up 2%. Did an essentially sequentially flat quarter warrant such a panic? Apparently it did because PWRD dropped about 20% on that news.

What is likely to happen is a potential stagnation of revenues until new sources can be introduced. Established games, especially those in its early life cycle, as is the case for PWRD games, can generate stable revenues for a very long time. In the case of some peers, games as old as eight years still generate significant and stable revenues. PWRD's games are only on average two to three years old. Outside of existing game expansion packs, which PWRD releases periodically, the company does not have any major new releases scheduled until the fourth quarter time frame. Thus, any revenue would have to come from existing games, international expansion, or other sources such as another film release. Whether they can expand revenues from these sources in the short term is questionable, but I believe PWRD should be able to keep revenues stable at least. If this is the case, then perhaps the recent decline in its share price is an extreme over reaction fueled by negative market sentiment.

The good news is that sentiment might be shifting. The Chinese market has been recovering after a year of declines to the degree that many have called a possible bottom. That might be a general relief for those who own Chinese stocks. For PWRD in particular, the technical picture is also potentially reversing. Most recently it crossed above its 50ma and has made higher highs. There is also an island inverse head and shoulders pattern with a neckline around the 26 area. If PWRD were to close above 27, it could be a confirmation of an end to the downward chart pattern. The only major resistance beyond this is the gap from its prior earnings at around 33, which is around where its 200ma is as well.

PWRD has always grown and generated profits. Despite a lot of general negativity, China has grown even through the last global downturn. But in both cases, stock prices fell victim to market sentiment. If sentiment has shifted, which can be explained through technical analysis to a degree, then perhaps the worst is over for PWRD investors, especially since the stock is at historically low valuations.

Disclosure: Author is long PWRD.