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Earlier this week, Perfect World (NASDAQ: PWRD) released its first quarter 2011 earnings report. At an initial glance, PWRD topped Wall Street estimates by a wide margin. Earnings per share (EPS) were .76 in Q1 which beat analysts consensus of .55. Behind the large positive headline earnings surprise however, there are reasons to be both optimistic, yet cautious on the company’s growth prospects for the remainder of this year.

Credit should first be given to the company for one of the best quarterly performances in over a year. Unlike the past several quarters where Perfect World posted stagnant revenues coupled with continually rising operating costs, Q1 2011 earnings reversed recent trends. Total revenues soared over 21% sequentially to $110.1m on the back of strong online game performances of both existing as well as two new games launched late last year, Forsaken World and Empire of the Immortals.

In fact, Perfect World posted its highest sequential online gaming revenue growth last quarter, on an absolute dollar basis of $18.5m. Such large absolute dollar growth in a single quarter after new games were released is a promising signal that one or perhaps both games have become commercially successful. As mentioned in my prior article, a very small percentage of games achieve quarterly revenue above $10m, while new games which are able ramp sales beyond this level so quickly often continue to develop into “hit” titles that can generate $20m or more in quarterly income.

Due to its high gross margin nature, Perfect World’s margins improved dramatically in the first quarter. The company’s gross margin improved sequentially to 85% from 81.3% posted in the fourth quarter of last year. On a year over year basis, gross margin held historically stable around the mid-80s percentile as evidenced by the 86.1% recorded last year. As a result, gross profit grew 27% sequentially to $93.6m.

Where Perfect World has encountered more trouble, at least for the past couple of years, has been with surging operating costs. As detailed in my prior summary of the company, PWRD has made it clear it would not sacrifice long term growth for short term profitability in a market and industry that is still under-penetrated and under-monetized. Growth in operating costs has been consistent and significant each quarter, since the company embarked on a long term internal development phase started since late 2008.

In the first quarter of 2011 however, PWRD’s operating costs declined by over 9% sequentially, as the company reined in sales and marketing expenses. First quarter 2011 results clearly displayed the company’s operating leverage, as revenue growth coupled with cost controls almost doubled PWRD’s operating margin from 20.7% to 39.8% on a sequential basis. As a result, net income margin also expanded to 36.6%, but was still well below the company’s potential and historical average of around 50% net income margin. The fourth quarter of 2011 may have in fact marked a trough in Perfect World’s operating and net income margin.

As usual, the company’s conference call continued to signal conservatism while being sparse in details. Hope of operating costs reaching a plateau, at least for the near term, quickly eroded as management signaled expense items across marketing, administrative, and development were likely to all rise for the second quarter. Management did signal that the rate of operating cost increases would slow as new research and development hiring should start to decelerate and as new depreciation costs for the company’s $100m building, purchased in early 2008, get re-normalized into expenses.

In addition, Perfect World gave rather flat revenue guidance for the second quarter. The company expects Q2 2011 revenues to fall between $685m and $721m RMB which would represent flat or a slightly lower sequential revenues. The main factor, as explained in its earnings conference call, is due to lower monetization efforts in what the company described as a seasonally slower quarter due to student exams.

While it’s true the second quarter typically witnesses less activity due to exit exams for the core of PWRD’s customer base, historical data often suggests no seasonal weakness. Since Perfect World monetizes almost all of its revenues on an itemized basis instead of a time rate basis, generally short term player inactivity does not necessarily reduce revenues. In general any sequential pause in revenue growth may indicate lost momentum in some of the company’s game portfolio, implying future revenue growth may have to come from new drivers.

The good news however is that the company’s Q2 revenue guidance is still 4-9% above Wall Street consensus of $101.3m in revenues. Analyst estimates will most likely be raised from the current .55 in EPS as a result, even though sequential operating cost increases may drop operating margin slightly in the current quarter. If Perfect World’s Q2 guidance turns out to be as conservative as its guidance for Q1, then investors still have reason to hope revenues may not stagnate in the second quarter since PWRD topped its own revenue growth guidance of 8-12% by posting over 21% sequential growth.

Beyond the second quarter, management gave a more optimistic viewpoint for the rest of the year. While Perfect World expects Q2 to be somewhat flat due to the reasons listed above, management sounded quite optimistic that revenue growth would reaccelerate in the second half on its existing platform. Two new games, Heaven Sword and Dragon Sabre, are also expected to be released in the summer. A third game long in development, Swordsman Online, may also debut before the year is over. Unlike in the past where criticism was placed on PWRD for turning out games too frequently and with little differential, the company has since shifted strategy involving much bigger, longer lead time titles which may involve over two years of development. Swordsman Online for example, has been widely anticipated by gamers since their first glimpse in 2008.

In summary, Perfect World’s Q1 earnings and general guidance for 2011 is extremely encouraging for investors who have long waited for any signs of life out of the company. Yet until continued revenue growth is realized, Wall Street may be cautious as to give the company the benefit of the doubt. The Chinese internet gaming sector has been viewed on a “show me first” standpoint for many years now, often not rewarding companies until they first deliver solid revenue growth and earnings. If the same sentiment is maintained, PWRD’s shares are likely to take a step forward on its Q1 surprise but then take a wait and see approach until further news is delivered. Perhaps at the very least and given the company still has a $100m stock repurchase plan in place, investor risk may be limited at 8x first quarter annualized earnings.

Disclosure: I am long PWRD.

Source: Perfect World Shows Signs of Life in Q1