Short/Long Term Disconnect a Boon for Perfect World Shares

Perfect World (PWRD) reported a blowout third quarter earlier in the month. While analysts had expected revenue of $22.8m and earnings of $0.15, the company came in with $28.5m in revenue and earnings of $0.29 (nearly double the consensus estimates). Supplemental information was encouraging with average quarterly spend per user rising to $18.20 from $13.30. Average concurrent users were 513,000 which is up 15% from Q2 and up 80% from Q3 of 2006. Yet with all the positive surprises the stock has taken a hit and dropped below $20 testing the initial price point from when the stock began trading after the IPO. Analysts have attributed the weakness to management’s flat guidance for Q4 but this is an odd explanation as “flat” guidance from a blowout quarter is still higher than consensus expectations for Q4 and furthermore, management is likely guiding conservatively as the trends obviously point to higher growth.

Much of the stock weakness is likely due to sympathy with both the China indexes as measured by the Xinhua China 25 (FXI) as well as a high profile miss by competitor The9 Limited (NCTY). Weakness in China would obviously spell trouble for Perfect World, but the pullback in the FXI is much more likely to represent a technical correction in an overheating investment market than a structural downtick in the Chinese populations ability to maintain discretionary spending levels. Since PWRD priced its IPO at $16.00 the stock is still well above those levels which should act as support from a technical perspective.

Looking at the year ahead, PWRD has a number of promising titles coming out. In Q4 the company will launch Chibi which is a MMORPG (Massively Multiplayer Online Role Playing Game) and is based on a movie which will be marketed at the same time the game is released. A successful launch could propel revenue levels quickly while continued revenue from existing games should be stable. Hot Dance Party is a second game that will be released in Q4 and is the company’s first foray into the casual game market. According to Pali Capital research, new game launches serve as a driver for revenue growth while expansion packs in existing games serve to maintain those levels.

The revenue recognition model for item based gaming is much different than one might expect. When the sale of a particular game feature such as a vehicle or weapon is made, the company cannot recognize the full amount of revenue from that item. Instead, PWRD must estimate the useful life of the item and amortize the revenue over that time period. While this treatment depresses revenue numbers initially, it creates a stable platform of ongoing GAAP revenue as items continue to feed into the revenue line quarter after quarter. For this reason it is more accurate to look at cash flow statements to understand the true degree to which PWRD is able to monetize its gaming platform.

The company has a strong balance sheet with cash of $189m which equates to $3.34 per ADR. This allows future development of games to go on with little need for cash infusions or accessing the capital markets. Flexibility in this area decreases the operating risk and should be rewarded with a higher multiple than more leveraged competitors. Speaking of multiples, the stock is trading in the low 20’s with expected earnings of $1.50 in 2008. While many things could happen between now and next year, management has been very successful in executing on the growth strategy and it would be reasonable to expect them to continue to exhibit talent in that area. In a more healthy market environment, I would expect a significant multiple expansion on earnings that are stable and quickly growing.

When reading the analyst reports I was a bit disturbed to see how much of a short-term focus is placed on company’s operating in this area. To quote one analyst: “We believe it is important to look into Q1 2008 and beyond.” In other words, the analyst is barely paying lip service to expectations of what the company can do 6 months from now. This attitude creates an opportunity for traders who are able to spot a disconnect between the short-term fear of limited growth and the long-term opportunity of a growing franchise. This disconnect appears to have PWRD shares at an attractive buying point and I would not discourage traders from picking some shares up at these levels.

Disclosure: Author does not have a position in PWRD