Perfect World (PWRD) is a Chinese online game company that develops and publishes Massively Multiplayer Online Role Playing Games (MMORPGs) both in mainland China and abroad. In fact, Perfect World is one of the only game developers based in China to license and publish many of their titles over seas. International revenue for Perfect World currently accounts for ~25% of total revenues.
Despite strong sales growth, international expansion, and consistent profitably, Perfect World has drifted from its 52 week high of $23 to under $10 as of this writing. The reason for the collapse in stock price from a high of $46.69 in November 2009 has more to do with anxiety surrounding Chinese companies than fundamentals. Many retail investors, and even world-renowned hedge fund managers (John Paulson for example) have been left holding the bag once Chinese firms like SINO-Forest, China MediaExpress, and RINO International have been exposed for the frauds that they are.
Even though Perfect World was never accused of being a fraud the company's stock seems to have sold off as investors have seemingly thrown out the baby with the bath water when shedding their exposure to smaller Chinese companies. So is Perfect World a fraud? I think not, but lets look at the facts.
Like all Chinese companies traded in the U.S., Perfect World has an odd corporate structure. Each share of Perfect World traded in the U.S. Represents 5 ordinary shares of Perfect World Co., LTD, which is based in the Cayman Islands. The Cayman Islands-based company is a holding company for the various Perfect World subsidiaries around the world.
Due to various regulations in China, foreigners cannot own licenses to operate online games. In order to "get around" this rule, Perfect World's wholly owned Chinese division PW Software doesn't directly operate any games or generate any actual business. Instead, all of Perfect World's game operating activities in China are done through a company called PW Network which isn't directly owned by Perfect World, but PW Software (The Chinese subsidiary of Perfect World) has various contracts with PW Networks which essentially allows PW Software to control every aspect of PW Network's business operations. Despite PW Networks not being directly owned by Perfect World, the company is still, for all intents and purposes, a subsidiary of Perfect World.
So if Perfect World doesn't directly own PW Network, who does? Mr. Michael Yufeng Chi - Perfect World's CEO. This may seem shady at first glance, but the shareholders of PW Network have pledged ALL of their equity interests in their company to PW Software, which severely limits their ability to control PW Network, until the equity pledge expires on March 9th, 2024. On top of the equity pledge, PW Software owns a call option for PW Network which allows PW Software to purchase all of PW Network for the higher of RMB 10,000 or the minimum amount permitted by applicable law. PW Software can exercise this call option at its sole discretion up until the call option agreement expires on March 9, 2024.
Lastly, to further cement PW Software's control over PW Network the company has Power of Attorney over PW Network's assets. Despite the complex corporate structure shareholders in Perfect World do have claims to the Chinese assets, as Perfect World's Chinese subsidiary has full control of PW Network. All of this is clearly explained in Perfect World's 20-F filing under the headline "Risks Related to our Corporate Structure".
On July 7th, 2012 Fosun International Ltd revealed in an SEC 13D filing that it had acquired 8.31%, or 3,443,230 American Depository Shares, of Perfect World on the open market at an average price of ~$10.32 per share. This investment in Perfect World is a major boost in the company's credibility, as the largest privately owned conglomerate in Mainland China would not be purchasing shares of a company without first verifying its legitimacy.
This isn't the first time Fosun International has purchased shares in Chinese companies traded in the U.S. at opportunistic times. As per their SEC filings, Fosun purchased 13.33% of shares in Focus Media Holdings (FMCN) back in December, 2008 and further increased their stake through numerous purchases to 28.65% by March 24, 2009. The stock traded at around $5-$8 during this period. On September 24, 2010 Fosun sold down its stake in Focus Media to 21.05% by selling shares at $21.
Buying at $5-$8 and selling at $21 netted Fosun international a phenomenal return on their investment. Focus Media is trading at around $19 now. Fosun was purchasing shares in Focus Media at dirt cheap prices because the company's stock price had just plummeted after Muddy Waters accused the company of fraud.
I suspect that Fosun took a large stake in Focus Media because they did their own homework and determined that the company was in fact legitimate. I suspect Fosun did their homework with Perfect World as well.
Dividend / Solid Balance Sheet
Perfect World issued a cash dividend of $98 million ($2 per share) in April 2012. The fact that the company had $98 million to distribute to shareholders is further proof that the company does in fact have the cash it claims it does. The $2 dividend in April was the first dividend to ever be paid out by Perfect World, and the company hinted that it may continue to pay dividends annually going forward. Even after paying the $98 million dividend, the company still had $221.5 million in cash and cash equivalents as per their 6-K filing.
The company's entire market cap is less than $500 million (as of July 31, 2012) - which means that nearly half of the market cap is net cash. The company has some short-term bank loans outstanding, but these were offset by the company's restricted cash, which was not included in the $221.5 million figure quoted. Add in the $197 million in property, equipment and software - and we're at $418.5 million in value simply counting the company's cash and headquarters. The company's book value (assets - liabilities) as per the most recently quarterly report is $574.9 million (Q1 2012). Even if you discount the intangible assets and goodwill, the company is trading below its current market cap.
As per the SC-13G filing with the SEC on February 13, 2012, the CEO of Perfect World Michael Yufeng Chi owned 17.5% of the outstanding shares in perfect World through his holding company. The CEO of Perfect World clearly has a vested interesting in seeing the company succeed, and would benefit from continued dividend payments.
Auditor with a Flawless Record
Perfect World's annual reports are signed off by PWC Zhong Tian - the same independent auditor responsible for auditing the financial for NetEase.com (NTES), SINA Corporation (SINA), Sohu.com Inc (SOHU), and many other large Chinese companies. As an auditor, PWC Zhong Tian has a flawless record. Fellow Seeking Alpha contributor Adam Gefvert has a great write up on PWC Zhong Tian which is worth reading.
With a P/E of less than 4, solid balance sheet, and growing international presence - I strongly believe that Perfect World is severely mispriced at current levels. The current stigma surrounding small to medium sized Chinese companies traded in the U.S. has created a buying opportunity for those willing to buy and hold until sentiment changes.
Disclosure: I am long PWRD.