July 14, 2010 - 2:41pm EST by
2010 2011
Price: 24.90 EPS $3.18 $3.77
Shares Out. (in M): 41 P/E 7.7x 6.7x
Market Cap (in $M): 1,272 P/FCF 5.6x 4.7x
Net Debt (in $M): -274 EBIT 187 228
TEV ($): 1,001 TEV/EBIT 5.4x 4.4x

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Perfect World is a leading online game developer and operator in China and the leader in the 3D segment.  The company was founded in 2004 and currently has four internally developed 3D massively multi-player online role-playing games (MMPORPGs) with six more MMPORGs (a mix of 2D, 2.5D and 3D) scheduled to be released over the next 18 months.   While the Chinese online gaming business is highly competitive and more often has offered short opportunities than longs, at the current time I believe the risk/reward for a long position in PWRD to be highly attractive at the current level of just under $25 per share. 

For those not familiar with the sector, there are about 12 publicly-traded Chinese online game companies led by Tencent (700 HK), which has other internet related businesses and commands a market cap of $32 billion.  The others are pure plays slugging it out for market share and are nowhere near that size, with market caps ranging from a few hundred million market cap to a few billion.  The stocks are down on average 40% this year and as a group, excluding Tencent which trades at over 30 times 2010 earnings, they trade at an average 11 times 2010 earnings and only 6 times when excluding the net cash hoards that most have accrued over the years.  On an EV/EBITDA basis the average 2010 multiple, again excluding Tencent, is 5 times.  While there is obviously lots of noise in industry valuation averages across time, theses multiples are approaching the lows from the global panic crescendo from early 2009.  I believe that there are three key reasons that the sector has fallen so far out of favor.  For each "headwind", I will outline what I believe to be the mitigating factors from the standpoint of the overall industry as well as reference how I believe PWRD to be positioned.

1) Intensified Competition: China now has an estimated 750 game studios, making product differentiation increasingly difficult and resulting in successful game titles being quickly mimicked by competitors. This has led to more money being spent on marketing and promotion both surrounding the initial launches and when player metrics on existing games being to fade, which is happening at a higher rate for games than in the past.

Mitigating Factors:  This is somewhat self-correcting in that the vast majority of studios are very small, poorly capitalized and have very narrow if not single game portfolios. Many will fold under the strain of higher development and marketing costs or be acquired be the larger rivals.  The barriers to entry for 3D games, in particular MMPORGs, which require extensive server capacity and frequent expansion packs and other post-launch tweaks, are somewhat higher and have been increasing as the Chinese gamers have increased their standards as far as graphics, features and storylines.  Also, the government of China has been actively encouraging consolidation which would allow for more effective regulation of the industry.

In addition, there is plenty of room for competition in the Chinese online gaming sector given the strong growth backdrop.  According to iResaerch, the total online game market in China was estimated to be $4 billion in 2009 and is expected to grow at a 20% annual rate to over $8 billion by 2013.  While 20% growth seems high even by Chinese standards, it would represent a sharp deceleration from the historical growth rates in active, paying online gamers.

PWRD Considerations: The company is well positioned competitively with the most balanced online game portfolio.  Zhu Xian is the largest contributor to global revenue with 30 to 35% followed by Perfect World 2 at 15% and Fantasy Zhu-Xian at 9%.   In contrast, competitors ChangYou (CYOU), Giant Interactive (GA) and Shanda Games (GAME) have an estimated 92%, 71% and 75% of revenues for each of their respective largest game titles.   PWRD has a very proficient internal R&D department, which has been augmented recently by several small studio acquisitions, that is capable of putting out up to four games each year, which is the highest of any of its peers.  The company makes frequent reference to its proprietary 3D game development platform as a key source of its ability to get the most productivity out of its 1,000 person R&D team but I have not been able to validate this claim.

2) Regulatory Overhang: The Chinese government clearly takes a keen interest in the internet usage habits of its citizens and this includes the online game sector. Aside from regulating the game content and policing the use of "virtual currencies" within the games, the authorities recently increased the requirements for gamers to verify their age when registering to play and also required internet cafes to install ID card readers and cameras connected to police networks. This may have a chilling effect on the growth in the number of user, time spent playing and ARPU.

Mitigating Factors:  Prior attempts to restrict access to online games have either been met with lax implementation or gamers have figured out clever workarounds.  However, as noted in a recent Roth survey (a quote from which is copied below) these regulations appear to have teeth. 

"We spoke with 25 Internet Cafes (in 6 different provinces) and visited 5 cafes in Shanghai. With the exception of just 1 café every single one we spoke with and visited had ID card readers (and sometimes cameras) installed and most of them were just installed within the past two months. While the majority of Café managers we spoke with only said they experienced minimal customer loss to date, we believe it may have been difficult to quantify as most card readers had been installed very recently."  Roth Capital Partners - 7/13/10

 PWRD Considerations: The game titles most at risk are likely to be the more casual games popular in internet cafes as opposed to the 3D,fantasy-oriented MMORPGs that comprise the bulk of PWRD's portfolio.  In addition, PWRD has entered other Asian markets as well as the U.S. and Europe.  While none of these online gaming markets are growing as fast as China's, the regulations are less onerous and the competitive landscape offers more opportunity for differentiation, particularly for higher end 3D content.  Ex China revenue is approximately 10% of the total.

3) Macro Environment: China might grow a ton, it might grow merely a lot, or, perhaps it is a massive speculative bubble and the economy will collapse. These are obviously discretionary purchases so any economic hiccup, or worse, would affect online gaming company revenues.

Mitigating Factors:  While I don't claim to have any unique macro insights, the bust scenario seems like a low probability outcome for a net creditor nation with massive foreign currency reserves and attractive long-term demographic trends.  Baring a spectacular collapse, clearly there is a compelling secular growth story underpinning the Chinese online gaming industry.  Of China's 1.3 billion people, only 29%, or about 380 million, are internet users.  However, according to a 2009 study by China Internet Network Information Center, among internet users, an estimated 265 million, or 69%, were online gamers, a higher proportion than internet users who shop online.  This figure was up 42% versus the prior year.  So there is plenty of room to add hundreds of millions of internet users and online gaming has already become widely accepted among the internet user base, which is key given the network affect of multi-player games.

PWRD Considerations:  The company is as susceptible as any of its peers to a slowdown in discretionary spending in China.  The company does have six MMORPGs in the pipeline with the releases staged out between the current quarter and the end of 2011.  The number of paying accounts and ARPU will undoubtedly disappoint company and Street expectations if the economy weakens materially, but due to the upfront, fixed-cost nature of game development, these new games should more than offset declines in the existing portfolio.


The analyst community in the sector does a good job tracking the online metrics that are available on a daily basis to track users and ARPU and also tends to make good estimates of the life cycles of new game launches based on the abundance of data on the performance of other similar games.  That was a long-winded way of saying that I am relying on the Street for revenue estimates rather than laying out a game-by-game revenue build-up.  The average of 13 estimates for 2011 sales is $448 million.  EBIT margins are expected to increase based on the ability to leverage corporate overhead, R&D and to a lesser degree cross promotion of games across a larger portfolio (note that PWRD's margins are higher than its peers due to a higher mix of internally developed rather than externally licensed games).  However, to be conservative and factor in the likelihood that one or more of their new launches will struggle and require a high degree of promotion, I will use the lower historical 51% EBIT margin achieved in 2008 and 2009 setting the EBIT estimate of $228 million.  Depreciation next year should be about $18 million so the EBITDA estimate is $246 million.  The current market cap is $1.3 billion with cash of $275 million of cash and no debt, leaving an enterprise value of $990 million.  So the EV/EBIT and EV/EBITDA multiples are a mere 4.3x and 4.0x, respectively.

On an after-tax earnings basis, using accounting for the company's guided tax rate and interest income on cash, the EPS is expected to be $2.70 next year so the P/E is 9.2x and 8.9x adjusting for net cash.  Prior to the panic selling in the fall of 2008, the ex-cash P/E averaged about 13x for PWRD.  This would put the stock at $35 from earnings plus $6.50 in cash or $41.5 total, representing 67% upside from the current level. 





- Key new MMPORGs like Dragon Excalibur, Forsaken World and Xiao Ao Jiang Hu meet or exceed lowered expectations
- FCF yield in the mid to high teens (depending primarily on studio acquistion CAPEX) should serve as its own catalyst as EV shrinks away
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