Why Perfect World's Recent Surge Might Not Last

On Tuesday, Perfect World (NASDAQ: PWRD  ) will release its latest quarterly results. The key to making smart investment decisions on stocks reporting earnings is to anticipate how they'll do before they announce results, leaving you fully prepared to respond quickly to whatever inevitable surprises arise.

The video game industry in the U.S. has gone through a lot of changes in recent years, as the rise of social and online gaming has thrown traditional game-makers for a loop. In China, the growth of the gaming market has been nothing short of phenomenal, with Perfect World and a host of competitors fighting for dominance in the rising industry. Let's take an early look at what's been happening with Perfect World over the past quarter and what we're likely to see in its quarterly report.

Stats on Perfect World

Analyst EPS Estimate

$0.48

Change From Year-Ago EPS

(38%)

Revenue Estimate

$98.78 million

Change From Year-Ago Revenue

(13%)

Earnings Beats in Past 4 Quarters

1

Source: Yahoo! Finance.

Can Perfect World score higher this quarter?
Over the past few months, Wall Street has gotten a lot more pessimistic about Perfect World's earnings prospects, slashing their estimates for the March quarter and the full 2013 year by almost a third. The stock, though, has rebounded from a brief drop earlier in the year and is up 14% since mid-February.

China has seen explosive growth in video gaming, with the industry multiplying more than 50-fold over the past decade. Giant Interactive (UNKNOWN: GA.DL  ) has done an excellent job on the domestic front, with most of its offerings oriented toward the Chinese market. Meanwhile, NetEase (NASDAQ: NTES  ) has benefited both from its own proprietary new game releases as well as its licensing agreement with Activision Blizzard (NASDAQ: ATVI  ) to offer World of Warcraft to Chinese users.

But Perfect World has struggled to keep up with its peers in the video game space. Given its failure to attract many gamers within the domestic Chinese market, Perfect World has focused more on international markets in the U.S. and Europe. Yet despite attempts to reduce its promotional activities in favor of boosting quality of existing games and accelerating development of new games, Perfect World said in March that it expected first-quarter revenue to fall 4% to 8% short of analysts' projections.

One interesting prospect for Perfect World and the rest of the industry could come from future consolidation. Giant Interactive, NetEase, and Perfect World all have pristine, cash-rich balance sheets, giving them plenty of potential to make acquisition bids that could help unify a somewhat fragmented industry. That would likely have the important side benefit of making the Chinese government happy, as it would create a force to be reckoned with not only in China but around the world. Even more interesting would be for Activision or Electronic Arts to make some sort of play for Perfect World, although in that case, the relationship would likely have to be a partnership similar to Activision's WoW licensing agreement in order to satisfy government concerns.

In Perfect World's report, look for breakouts of the company's relative success in China versus the rest of the world. For its international strategy to succeed, Perfect World needs to get what has been dramatically slowing sales growth to accelerate upward at a faster pace. Otherwise, the stock's recent rise will likely prove short-lived.

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