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Last week China-based Perfect World (PWRD) disappointed shareholders with third-quarter earnings per ADS of $.45. Analysts expected earnings of $.67 per share. Revenue was down 10% from the previous quarter but up 22% year over year. Following the announcement shares declined over 14%.

Costs

Perfect World primarily produces free-to-play, online role-playing video games (RPG) and monetizes them through selling in-game items and upgrades. The company adopted a cycle tactic of increasing content of its titles, increasing advertising, followed by increasing in-game promotional and monetization activities at select times. The company intends for the tactic to lengthen the lifespan of titles. The previous quarter represented the start of the cycle for most major titles.

While in-house content expansion was a major factor in costs during the third quarter, Perfect World recently acquired U.S.-based Cryptic Studios from Atari. Consolidation costs from this acquisition weighed heavily on margins. Also adding to costs in the quarter were expenses related to beta testing the in-house developed franchise, "Heaven Sword and Dragon Saber."

Growth

On the quarterly conference call officials warned that the aforementioned trends would continue in the short term. However, CEO Michael Chi stressed the long-term focused strategy the company was undertaking would continue to yield “sustainable long-term growth.” Chi listed the following as central to the plan: the investments in the pipeline, acquisition of Cryptic Studios, a new alliance with Nexon Korea, and participation in a venture capital fund.

Forefront in the pipeline is "Swordsman Online," "Saint Seiya Online" and Cryptic’s "Neverwinter." These anticipated titles should release over the next two years. The company will also see non-organic growth through revenue from Cryptic Studios’ "Champions Online" and "Star Trek Online." The alliance with Nexon Korea will allow additional Perfect World titles to be played in Korea, improve customer service, and expand the user base.

While Perfect World faces stiff competition in China from companies like NetEase (NTES), its focus on the free-to-play model differs from some peers and is reminiscent of Zynga (ZYNG) in the United States. Zynga’s games are free to play with monetization coming from the purchase of in-game items and upgrades. However, Zynga is not a direct competitor as its games are not traditional RPGs. NetEase operates free-to-play games but its top RPG titles run on a time-based charge model and attract a somewhat different user base.

Though small, Perfect World outperforms its Chinese peers outside of China. One quarter of the company’s revenue is derived overseas. Once again, the competition it is facing in the RPG arena uses a different model. Activision’s (ATVI) hit "World of Warcraft" is subscription based and EA’s (ERTS) upcoming Star Wars RPG will run on subscriptions as well. Interestingly, Perfect World is converting "Star Trek Online" from subscription to free-to-play in January, while EA’s Star Wars title is set to release at the end of December. The conversion is an obvious maneuver by Perfect World to maintain user base in its newly acquired franchise.

Fundamentals

In addition to Perfect World’s growth prospects, the company has a strong balance sheet. Net cash represents 45% of market cap. They are using this strength to add shareholder value through a real share buyback and future dividend. The company has bought back over 4 million shares (total outstanding shares number 46 million). The ongoing buyback will total $100 million (market cap is 480 million). Although, a dividend has not been declared, the company set aside over $10 million dollars for tax liabilities on eventual distribution of dividends.

Perfect World’s stock price is low relative to its valuation. The company has a forward PE of 4 and a PEG Ratio of .32. Perfect World has cash and cash flow. Its current ratio is 1.75. When one takes the revenue growth prospects, future increase in margins, strength of balance sheet, share buyback, and coming dividend into account, a 2012 reversal of stock price decline is evident.

Source: Perfect World's Disaster Quarter Cloaks 2012 Reversal