Summary

For 2.5x earnings ex cash (or a 20% normalized yield), you get a company that is far from a perfect world, yet Perfect World ("PWRD") is a Chinese company that is presently returning cash to shareholders (!!!) and appears to have a compelling risk reward profile at these levels

Even after Chinese stocks have fallen out of favor with investors, a downward earnings revision (9/15), poor 3Q11 results (11/22) and allegations of fraud by the CEO (1/9) have dragged PWRD from $20 in September to below $9; and while PWRD has recovered partially since then to $12, it remains in the doghouse

While we don't see PWRD returning to the $40 level it traded at in 2010, we believe there is an asymmetric return profile with a chance for 50%+ upside and some catalysts to get there in the next 9 months: (a) further return of capital to U.S. ADS shareholders in the form of a dividend and / or continued share buyback; (b) final resolution of recent fraud allegations; and (c) clarity on the release date of XAJH / Swordsman Online which should rejuvenate the user base.  Additionally there is a chance of a buyout or a take-private transaction which we will discuss but not ascribe value to.  We believe this creates a path for PWRD to trade up to $20 (still representing ~5x earnings ex-cash)

Company and industry overview

Perfectworld ("PWRD") is a Chinese online video game developer and operator that was founded in 2004 and has launched 13 internally-developed games to date, some with more success than others.  Since late '07 / early '08, PWRD expanded internationally and now generates over a quarter of total revenues outside China: part of this is the overseas licensing business (9% of revenues and primarily Taiwan, Russia, Korea) as well as operated revenues (U.S., Japan).  PWRD's core strength is its development team (over 2,300 of a total 4,000 employees) which allows it to release a larger number of quality games than most competitors

All but one of PWRD's games are in the MMORPG (massive multiplayer online role-playing games).  We estimate that Perfect World 2, Zhu Xian and Fantasy Zhu Xian account for just under 50% of revenues

Unlike most video game companies with a traditional software licensing model (one-time upfront payment for the game, common in western markets) or a subscription model (monthly subscription fee, such as Activision's World of Warcraft), PWRD has a free-to-play ("F2P") model where users are charged for additional items

We believe this is a more attractive model to traditional software licensing (which is lumpy and susceptible to piracy).  While a regular subscription model is more predictable, the F2P model allows the game developer / operator to capture more of the consumer surplus from the most dedicated gamers (i.e., a 'stickier' type of subscription revenue) as well as offering users a 'gateway' drug onto the platform

A brief industry overview for those not familiar with the Chinese video gaming market: gaming remains an incredibly popular pastime and the Chinese online gaming market is a $5B+ market growing rapidly, linked to China's broader economic growth.  It is dominated by Tencent, followed by a host of smaller companies (e.g., Shanda Games, NetEase, Changyou, Giant Interactive, Nineyou, The9, Kingsoft and NetDragon).  Unlike Western markets, video games are primarily PC-based with a tiny console market (partially due to cost and piracy), and 'F2P' remains the primary monetization model.  A sizeable portion of gaming (estimated from 20-40%) takes place in LAN cafes, which have been subject to stricter regulation recently to curb addictive underage gaming; in 2010, LAN cafes were required to start checking  photo IDs of gamers.  While this has tempered growth, the industry is still expected to grow at a double digit rate in the near future

3Q11 "trainwreck"

PWRD disappointed investors by cutting its quarterly revenue outlook by $8.5M on 9/15 and shares fell 18% in response to $14.  PWRD claimed that they were slowing down in-game promotional activities to lengthen the life cycle of existing games. 

When PWRD announced earnings, shares fell another 14% to below $10 as revenue hit the low-end of revised guidance (-9% q/q but still +22% y/y) and the company gave weak 4Q11 guidance (-2% to +4% q/q but +18-26% y/y) in-line with peers (Shanda guided for flat revenues, Giant guided for 'some' q/q growth and Changyou guided for 3-5% growth)

We believe that slower monetization is a legitimate tactic for a F2P game to avoid gamer fatigue; fortunately, a lower monetization rate appears to be priced in at current levels.  However, we are concerned with the margin deterioration as R&D and marketing costs continue to grow even as monetization slows.  R&D jumped 50% y/y as R&D staff increased from ~1,800 to ~2,300; while sales and marketing increased 20% y/y.  Going forward, we expect operating margins to return to the low 30s but will watch this closely.

For a company trading at 4.5x earnings (2.5x ex-cash), we can live with these results and believe there could be upside if PWRD can demonstrate some semblance of cost control, especially by controlling the S&M (relating to product launches) and G&A (relating to the Cryptic integration) more tightly

Fraud allegations ("extortion attempts")

On January 9th, an anonymous blogger on Tianya made a couple of damning accusations:

• CEO Michael Chi enriched himself at shareholders expense in a number of related party transactions (e.g., acquiring a 20% stake in Zhizhu network without board approval, milking PWRD over the sale of the film business)
• Used organized crime to avoid paying taxes relating to the IPO and for illegal currency conversion
• PWRD was under investigation by Chinese and U.S. regulators concerning related party transactions

https://docs.google.com/open?id=0BzAhfxYuDZqtODJjMTU1M2QtYmZjNy00OGI5LTgwNjYtMGFkOGEyN2I2NmNk

Later that day, Tianya pulled the story and a sell-side analyst stated that PWRD had refuted these claims.  On January 10, PWRD released a 9 point statement that 'firmly and forcefully' refuted the claims and alleged that several extortion attempts had been attempted.  Seriously.  Additionally, PWRD stated that the independent audit committee would work with an independent legal counsel to review all of the allegations

http://sec.gov/Archives/edgar/data/1403849/000119312512008435/d280675d6k.htm

Since these events, the stock has recovered somewhat and no further claims have surfaced.  A few things to note:

• The sale of the film business was disclosed in a prior 6-K filing, and was approved by a special committee of all the independent directors.  Looking through financials, it was a ~$15-20M run-rate business that sold for $60M; which does not seem outrageous to us (http://sec.gov/Archives/edgar/data/1403849/000119312511207661/d6k.htm)
• Similarly the Zhizhu / 178.com investment was previously disclosed as PWRDs investment (not Mr Chi's), and PWRD further stated Zhizhu's marketing services was <1% of PWRDs total spend and conducted at market prices
• While PWRD acknowledges that PWRD and Mr. Chi were subject to inquiries by the local public security and tax bureaus in Beijing in recent months, PWRD made it clear that no misconducts were found, and that Mr Chi had informed PWRD that he had paid all his personal taxes in accordance with applicable laws and regulations

In all, we believe that PWRD made as good as a response as possible to some suspect accusations that nonetheless have eroded investor confidence.  We have not yet found any further evidence suggesting any wrongdoing, and believe this is still an overhang on the stock that can be lifted with more information and improved operating results.  Furthermore, if PWRD were a fraud, wouldn't they have at least made up results that showed a business continuing to grow at breakneck pace?  And why would they set aside money for taxes for a dividend or waste cash on buybacks instead of just siphoning it away?

Wait - a Chinese company returning cash to U.S. shareholders?

PWRD is a Chinese company that has started returning cash to U.S. shareholders and will likely continue to do so.  In 1Q11, PWRD announced a $100M repurchase program lasting to 3/12.  As of 9/30, PWRD has repurchased 4.4M ADS shares for ~$60-70M (worth noting at levels above the current share price).  The ~$30-40M remaining represents 5-6% of outstanding shares at current levels

In 3Q11, PWRD incurred a dividend withholding tax of $10.7M.  Chinese regulation requires a further 10% taxation of net after-tax profits before dividends can be paid out; PWRD signaled that the board had approved a change in the dividend policy, but that the eventual declaration and distribution of dividends had yet to be finalized.  As a precedent, Giant paid a special dividend of ~$710M in September and maintains a ~30% payout ratio (4-5% dividend yield). 

While we do not have any further details, we believe any substantial return of cash to shareholders (whether by dividend or buyback) will be welcomed by the market (as opposed other uses such as the Nexon JV and the venture fund contribution)

Where to from here? ("Waiting for the Swordsman")

One thing to keep in mind that is that PWRD's biggest revenue contributors are Perfect World 2 and Zhu Xian which were launched November '06 and May '07 respectively, and that any substantial multiple expansion will need to be driven by new games.  While PWRD's development team is capable of the highest output of the industry, they have not put out a blockbuster title in recent times...and investors and gamers have been waiting for Swordsman Online / Xiao Ao Jiang Hu ("XAJH") to change this.

XAJH is PWRD's most anticipated game and folks have been talking launching as early as mid 2010.  Through a series of delays that are reminiscent of Blizzard its best, PWRD has kept pushing back the launch of this game, resulting in significant investor and gamer fatigue.  In the 3Q11 call, PWRD announced that Swordsman Online / XAJH is targeted to launch in 2Q12.  We view any announcement of this game as a positive that could drive a multiple rerating, but any further slippage or negative reviews is likely to weigh on the stock and could force PWRD to further lower their monetization of existing games.

We remain lukewarm on the rest of the pipeline.  We are negative on the Nexon JV which appears to be focused on entering the Korean market, which is tricky as Nexon primarily focuses on casual games vs. PWRD's MMORGs.  We are cautiously optimistic on Cryptic (formerly Flagship, which in turn is formerly Blizzard North) as fantastic developers but are concerned with the impact on cost structure we have seen to date

Potential go-private transaction or take-out

Lastly, there is the remote chance of a takeout or go-private transaction that we will not ascribe value to, but treat as additional gravy

There has been some discussions about 'good' (read: legit) Chinese companies considering relisting in Hong Kong or China as a result of the blanket China discount applied by U.S. investors in the wake of Chinese accounting scandals (FMCN, CCME, etc).  Harbin Electric (no stranger to VIC) completed a transaction in November, and other companies have listed plans to potentially delist in the U.S. and relist overseas, such as SNDA and CRIC.  While this is an option for PWRD, it appears to be willing to continue the good fight of winning over U.S. investors for the time being, given he $30-40M left in the buyback program and potential dividend on the horizon.

Slightly less likely is a take-out.  The Chinese video gaming market is still fragmented behind Tencent, and PWRD has a strong position outside of China that could make it a desirable target for either other Chinese media / gaming companies or for global video game publishers looking to bolster their presence in China

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Note: I am using a net cash number of $255M, which consists of cash, restricted cash, ST investments, time deposits net of short-term debt and a $100M contribution to a VC fund which I am not giving them any credit for.  I have excluded equity investments and restricted time deposits.  On the 3Q11 call, CFO Kelvin Lau guided to ~$350M of net cash (~$450M gross less short-term loan).  It gets even cheaper on an ex-cash basis if you include these