A MMORPG (massively multiplayer online role playing game) is a type of video game in which a number of players interact with each other in a virtual world setting by assuming the role of a character. Perfect World (NASDAQ:PWRD) is a Chinese online gaming company that specializes in developing 3D MMORPGs. The company generated $143 million in revenue from online games in Q1 2014. Although revenues were down by about 2.5% sequentially, we believe that the performance was still impressive given that annual growth was 44%, and the company slowed down promotional activities for its client-based MMORPGs compared to the last quarter. We believe that Perfect World's revenues will continue to grow strongly in the future since the company has a rich pipeline of games and expansion packs. 
We are in the process of updating our $18.85 price estimate for Perfect World's stock, based on the recently announced results.
Gross Margins Will Come Down As Mobile Contribution Increases
Lately, Perfect World has increased its focus on mobile games due to the increasing usage of mobile devices for playing games online. Driven by the strong performance of its popular RPG game, Return of the Condor Heroes, and the launch of its first 3D RPG mobile game, Fantasy of the Immortals, the contribution of mobile to Perfect World's revenues increased from under 10% in Q4 last year to about 15% in Q1 2014. 
Mobile revenues are recorded by Perfect World on a gross basis. This means that the distribution channel's share is recognized as cost of revenues, leading to thinner gross margins for mobile as compared to PC. Mobile gross margins are usually between 40%-50%, while PC margins are higher at 75%-80%. The company intends to launch a number of new mobile games in the second half of the year, including games such as Forsaken World, Touch, CrossGate Mobile and Swordsman Mobile.  We believe the new games will further increase the contribution of mobile to total company revenues. This in turn will pull back the company's overall gross margins which stood at 73% in Q1.
Usage Dips Due To Anti-Cheating Efforts, Expecting Growth To Revive
After remaining depressed for many quarters, the number of average concurrent users (ACU) for Perfect World's Chinese operations started to grow fervently in 2013. It increased from 554,000 during Q1 2013 to 803,000 during Q4 2013, mainly due to the strong performance of new and existing games, and due to the initial commercialization of the world famous game DOTA2. However, ACU fell to 662,000 in Q1 2014, as the company stepped up anti-cheating efforts for certain games, in order to maintain a healthy and fair gaming environment.  The Chinese New Year during which people travel more and spend less time on games also affected usage.
DOTA2 has won several awards and accolades such as "Best PC Strategy and Tactics Game" and "Best PC Multiplayer Game" of 2013 by Imagine Games Network. The game is ramping up its contribution and is expected to have a full-scale open beta testing in China soon. We believe that user activity on Perfect World will reaccelerate as DOTA2 and more new game launches start attracting more users.
International Expansion To Cannibalize Licensing Business
Perfect World is trying to strengthen its overseas network by licensing games to partners and by operating games through some of its own subsidiaries. The company generated $7.3 million in licensing revenues in Q1, nearly even with the prior quarter. We estimate that licensing revenues will remain close to this level in the coming quarters, as the company is increasingly expanding into international markets via its own subsidiaries which will cannibalize licensing activity. 
Disclosure: No positions.