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Last year (2010) was a tough period for Perfect World (NASDAQ:PWRD) as the company continued its transition from a strategy which involved frequent low budget game releases to a strategy focused on higher budget longer lead time game projects. As difficult as it was for Perfect World, last year was much harder on PWRD investors as the stock declined by 40% over the course of 2010. However, PWRD may have completed this transition based on their comments made in their fourth quarter and year end 2010 earnings report. In their corresponding earnings conference call, Perfect World's CEO, Michael Chi, went as far as to state:

"We are confident that the mismatch between our internal investments and the output of our new content will start to realign in 2011."

From a corporate standpoint, last year was far from a disaster for Perfect World. Annual revenues increased by slightly over 15% to $374.3m on increased online gaming monetization as well as continued growth in new non-core television and film divisions. Net income however declined to $127.4m from $151.9m recorded in 2009. As described, PWRD's change in strategy resulted in heavy internal investments which raised operating costs by a staggering 51% to $173.7m in 2010. Still, the high gross margin nature of Perfect World's business was still able to generate 2.41 in earnings per share ("EPS"), down marginally from the 2.68 EPS posted in 2009. PWRD's stock price performance in 2010 may thus be more market sentiment related than a true reflection of the company's actual corporate performance.

Much like during the past couple of years, management continued to state they would not sacrifice long term development for short term profit gains. Investors should not expect PWRD's net income to increase as a result of cost cuts, although costs unlike revenues could always be controlled if required. Perfect World would thus need to increase revenues to regain earnings growth. Because the company's gross margins are so high at over 80%, earnings momentum can come quickly as revenues increase.

Prior to the period Perfect World embarked on large internal development through acquisitions and increased research and development spending, the company enjoyed net income margin of approximately 50%. For fiscal 2010 however, net income margin collapsed to 34%. As a result, there is a large net income margin gap of over 15% that could be closed if PWRD were to "realign" as Mr. Chi stated. In order for this gap to narrow back to prior levels, the company would need to control costs while expand revenues.

Although PWRD did not give a detailed account on their overall operating expenses, management did state they expected sales and marketing expenses to trend down in the first quarter of 2011. If other operating costs have already reached an absolute peak level relative to revenues, then the company's operating margin should improve. In fact that's what management conveyed in their earnings conference call.

"So we are quite optimistic and confident that we can improve our margin quarter-over-quarter this year."

In contrast, Perfect World did guide for first quarter revenue expectations. The company expects revenues to increase 8-12% sequentially on increased revenues from two major game releases introduced in Q4 of 2010. While initial revenue spikes from new game releases should be viewed with a grain of salt, the absolute level of expected sequential revenue gain is very encouraging.

The midpoint of PWRD's revenue guidance implies a $9m sequential revenue gain, or the highest absolute quarterly gain in core online gaming revenues since their release of "Battle of the Immortals" ("BoI") in early 2009. Perfect World has posted high magnitude sequential revenue growth in the past but on new television and film revenues. The company stated that it does not expect any television or film revenues in the first quarter of 2011.

Historically, new game launches typically generated very little revenue while spikes in new users were often noticed. Successful games could generate over $20m in quarterly revenues while "hit" titles could generate well over $40m in quarter revenues. Many online games in China often fail to generate over $5m in quarterly revenues in comparison.

Although Perfect World does not break out revenues for each of their titles, the release of their last successful game BoI took their revenues levels from around $55m to $80-90m where revenues stalled throughout 2010. All of PWRD's releases since BoI failed to produce any meaningful sequential revenue growth at all. This is why the company's $7-11m sequential revenue increase is significant. It suggest the company finally may have found another successful game since their last two years ago.

While it's impossible to know if any of Perfect World's new games will maintain or augment success, the revenue potential should not be understated. Successful game launches in the past for PWRD and their peer group in China have often led to rapid earnings growth in subsequent quarters.

One of the most powerful was Sohu's (NASDAQ:SOHU) release of "Tian Long Ba Bu" ("TLBB") over three years ago. It took only a year to ramp TLBB's revenues towards $60m in quarterly revenues marking it as one of the most successful domestically produced games in China. At 85-90% gross margins typically experienced by game producers and operators, nearly all of the revenues trickled down to the bottom line. High earnings momentum due to TLBB contributed to Sohu's meteoric stock price appreciation in late 2007 while BoI's success played a part in PWRD's stock price gains in 2009.

For this reason, PWRD's Q1 2011 earnings report could play a key role in determining how the company and thus how its stock price performs for the rest of this year. Continued strong sequential revenue growth guidance for the second quarter would be confirmation the company has another successful game in their arsenal. If one of Perfect World's new releases can achieve "hit" status by reaching quarterly revenues of over $40m, and if the company's operating costs have reached a near term peak level, then it's possible PWRD's net income margins could start moving towards their historical 50% level. In other words, this scenario could result in EPS growth of over 50%.

Of course, this is the optimistic case. It is equally possible Perfect World's performance mirrors 2010. Revenues could continue to stagnate without another successful game launch as a growth driver. As a result, earnings would also flat line. In this case, the company's stock could continue to trend sideways indefinitely.

Luckily there should be protection for investors on the downside. Online games in China have extremely long lifecycles especially popular titles. In some cases, games older than 8 years are still going strong witnessed by Netease's (NASDAQ:NTES) "Fantasy Westward Journey." It is ironic in a period where so much hype is displayed for social networking, many investors forget what online games in China really are - social media platforms. This is the reason why popular games can have such longevity despite technical superiority of newer titles. It is also the reason why operators of popular online games rarely experience revenue declines. As a result, it's more likely than not Perfect World can at least keep their revenues stable through routine maintenance of their gaming portfolio.

If at the very least PWRD can maintain a stable level of earnings, the company is valued at roughly 10x earnings currently. Given the company's cash and cash flow position, such valuations are low by historical measures in a normal market environment. The company also has over 200m in cash and no corporate debt.

Tandem with their last earnings release, Perfect World also announced a $100m stock repurchase plan. It is also important to note PWRD has been aggressive in the past on stock repurchases. In late 2008 the company also announced a $100m stock repurchase plan and subsequently repurchased over 12% of its outstanding share basis through a series of open market and private transactions. The last major repurchase came in the middle of 2009 when they repurchased slightly over 4m shares at approximately $21.00 per share. The current repurchase plan could account for 4-5m shares at PWRD's recent price range, or about 8-10% of the company's share base.

With a potential earnings catalyst if Perfect World's revenue growth can be affirmed and combined with a potential base of support in the low 20s in share price, PWRD is a good risk reward play in the near term. In the longer term, Perfect World remains a solid investment for individuals who want exposure to China's entertainment sector. Business and product cycles are often hard to predict, but Perfect World's management team has shown their ability to grow the company in a sustainable fashion and increase shareholder value for investors.

Source: Perfect World Is Attractive Heading Into Q1 2011 Earnings