Perfect World's Q2 Earnings Reach Record Levels

Aug.23.11 | About: Perfect World (PWRD)

Perfect World (NASDAQ:PWRD) added to its Q1 2011 earnings momentum with an equally impressive Q2 report. For the second quarter, revenues increased 8.5% sequentially to $120.6m. Net income grew at even a faster clip to $49m, up from the $40.6m reported in the first quarter. On an earnings per share basis (“EPS”), PWRD Q3 earned 0.93 which was well ahead of the Wall Street consensus of 0.57 in EPS. For the second straight quarter, Perfect World topped expectations on the top and bottom line by a significant degree.

Perhaps more important than PWRD’s earnings beat was its revenue momentum growth. As noted in a prior article, it was important for Perfect World to build on sequential revenue growth. For over a year, the company has posted stagnant revenues which when coupled with heavy internal investments resulted in weaker earnings. New potential revenue drivers experienced false starts as several new game launches which initially appeared successful quickly faded by its second quarter of operations. The company needed a new successful game to propel its quarterly revenues above the $100m mark.

PWRD’s Q1 showed indications the company could be on a new revenue expanding product cycle. Either or both of its recently released online games, “Forsaken World” and “Empire of the Immortals” helped in contributing to a 21.2% first quarter sequential growth in revenues. Since the company’s policy is not to disclose specific revenues for each title, it’s impossible know which game has been better received. Perfect World as usual gave general indications that both games were well received and made contributions to the company’s revenue growth.

Given that the vast majority of online games in China only experience marginal success, the absolute revenue increase quarter over quarter suggested PWRD may have finally stumbled on a hit game which typically generates revenue momentum for several quarters as it ramps in users. However with only a quarter of data, it was too early to draw conclusions. This is why Perfect World’s performance in Q2 became even more important.

The company did not disappoint as it delivered a 10% core Chinese online gaming revenue jump in Q2 over Q1. Overall revenues grew at 8.5% quarter over quarter and came in well above PWRD’s prior guidance of “flat or slightly lower” second quarter revenues. In just two quarters, the company’s core Chinese online gaming revenues increased by almost $28m. While the company contributed the rise to a number of factors, it is most likely related to the two new games released in late 2010. After all, Perfect World’s gaming revenues had been stagnant for over a year on its prior existing titles.

Games which can generate over $20m in quarterly revenues are generally regarded as hits and can sustain or even grow in popularity for many years. Some even become blockbusters generating over $40m in quarterly revenues. Sohu’s (NASDAQ:SOHU) “Tian Long Ba Bu,” for example, accelerated quarterly revenue contribution above the $60m mark and has been going strong for over three years. Even more impressive, Netease’s (NASDAQ:NTES) “Fantasy Westward Journey” has been contributing similar levels of revenues for the company for over eight years.

Online gaming is a very big business in China and successful titles can become cash cows for companies for a very long period. This is why hints of a game reaching hit status should never be discounted because a single hit game could lift the operator’s earnings profile extremely quickly. Perfect World may have finally come across another hit title after over two years of heavy investments in trying to develop one.

What separates PWRD from NTES and Changyou (NASDAQ:CYOU), Sohu’s online gaming subsidiary spin off, is not business performance but perhaps more in terms of perception. Both Netease and Changyou have recently experienced more stable revenue and earnings growth than Perfect World.

In NTES’s case, the company had already gone through its digestion phase of internal development several years ago after its core games started to stagnate on the revenue front. While it took NTES several years to realize heavy internal development was necessary, the company’s investments finally paid off as revenues and profits exploded particularly in 2010. The same was similar for CYOU although most of its investments were made by its parent SOHU prior to its IPO spin off. Luckily for the company, its first developed game “Tian Long Ba Bu” became a mega-hit almost instantly.

However, until gaming companies are able to produce a hit, the same heavy internal research and development required to produce games can become a major drag on the company’s near term earnings picture. That has been PWRD’s issue for roughly two years. Without accelerating revenues, earnings lagged and made Perfect World appear much less attractive than peers NTES and CYOU even though earnings on an absolute basis for all three companies were extremely comparable in recent years.

For example, in the second quarter PWRD earned 0.93 in EPS compared to NTES’s 0.86 and CYOU’s 1.02 in earnings per share. Yet CYOU trades at around $36 and NTES at $43 recently compared to PWRD’s under $19 share price. With Q3 revenues guided to be flat to slightly higher, Perfect World’s earnings are not likely to decline by much if at all. Perfect World’s revenue guidance has typically been conservative as witnessed in the past two quarters. In addition, if PWRD’s revenue momentum continues from its recently released games, quarterly earnings would likely increase disproportionately higher as witnessed in Q2 due to the high gross margin nature of the business.

Lastly, Perfect World’s management has been aggressive in share repurchases in the past. Prior to this year and as detailed in a prior article, the company has bought back over 12% of its float with prior repurchase plans. Under the company’s current $100m share repurchase plan, management reveals that the company has already repurchased slightly over 2.3m shares, or almost 4.4% of its current float. At recent prices, this repurchase approximately totals half the allotted amount. As long as Perfect World’s business momentum continues in the positive direction, these share repurchases will play an accretive role in forward earnings for the company.

While recent news pertaining to Perfect World may not change near term negative sentiment that has been an overhang for Chinese stocks in general, at least from a business perspective, things are improving for the company and as a result shareholder value is being increased.

Disclosure: I am long PWRD, NTES, SOHU.

Additional disclosure: No position in CYOU.