Is This the Perfect Way to Benefit From Online Gaming in China?

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Online gaming in China is booming. The industry, whose worth was estimated at around RMB 57 billion in 2012, is expected to grow to RMB 100 billion in the next five years, according to a report by market research firm IDC. So, the opportunity is undoubtedly substantial, but investors need to pick the right companies if they are to benefit from the booming Chinese online gaming industry.

A few online gaming companies have done really well this year; Perfect World (UNKNOWN: PWRD.DL  ) is one of them. Perfect World's year-to-date appreciation has been terrific and the stock has outperformed bigger peers such as Giant Interactive (UNKNOWN: GA.DL  ) and NetEase (NASDAQ: NTES  ) .

PWRD Chart

PWRD data by YCharts

But, aside from this appreciation, some things at Perfect World look imperfect. The company's shares may have outperformed peers this year, but a look at the financials may leave one wondering what's the reason behind this performance.

PWRD Revenue Quarterly Chart

PWRD Revenue Quarterly data by YCharts

Not convincing enough
In terms of both revenue and gross margin performance, Perfect World lags both Giant Interactive and NetEase. In the recently reported second quarter as well, Perfect World's revenue grew just 5% from the year-ago quarter to $115.4 million, while non-GAAP net income plunged 44% from last year to $15.9 million in the quarter.

Perfect World fell behind the curve in the online gaming arena and now the company is trying to get its footing back. As such, it is spending aggressively on marketing its new games. Its new games helped it record revenue growth in the previous quarter as compared to consistent declines earlier. However, operating expenses increased 19% in the quarter on the back of increased marketing and it looks like the trend is going to continue going forward.

Trying to get better
Perfect World launched a few games and expansion packs in the previous quarter, and the pipeline looks strong as well. Games such as Dota 2, Holy King, and Legend of the Condor Heroes are in development in addition to web and mobile games, according to management.

The company successfully launched Sensei Online, Neverwinter, and Swordsman Online in the previous quarter and it is working on a localized version of Neverwinter for the Chinese market. Swordsman Online has received positive reviews, according to management, and Perfect World expects the game to be a strong revenue driver in the future.

Aside from China, Perfect World is also present in the overseas markets of North America, Europe, Korea, and Southeast Asia. Perfect World states that one-fourth of its revenue comes from international regions and the company intends to strengthen the overseas business further. For instance, Perfect World has a subsidiary in the form of Cryptic Studios in the U.S., which developed Neverwinter, and management stated that the game has done well in North America and Europe.

Although China is the epicenter of online gaming, Perfect World needs to diversify. The company is trying to get a piece of the market by developing web games (Heaven Sword and Dragon Saber are in closed beta testing) in addition to developing massively multiplayer online games, but the road ahead looks difficult.

A difficult fight ahead
The MMO (massively multiplayer online) gaming market in China is highly competitive and Perfect World's peers are already ahead of it.

For instance, Giant Interactive, which already has a popular franchise such as ZT Online in its portfolio, will be launching World of Xianxia going forward. Giant expects this game to become its next blockbuster and management stated on its last conference call that World of Xianxia has already became accretive with the game being in closed beta testing.

In addition, the fact that Giant has collaborated with Qihoo 360 Technology (UNKNOWN: QIHU.DL  ) to operate online games is certainly an advantage. According to iResearch, Qihoo covers 96% of active PC Internet users in China and it witnessed a 112% jump in revenue from its gaming platform in the previous quarter. Qihoo is known for its security products, and as such, a combination of a secure platform and a wide reach should help Giant and make things difficult for Perfect World.

Then there's NetEase, which has been looking to decrease its dependence on Activision Blizzard's World of Warcraft by developing its own games. After launching Heroes of Three Kingdoms and Dragon Sword, NetEase is going to throw its marketing weight behind these games as it aims for more subscribers.

The strategy seems to be working so far as NetEase was able to overcome a drop of 600,000 subscribers for WoW in the previous quarter that witnessed revenue jump a commendable 20%. Hence, these moves by Perfect World's competitors will make things difficult for the company. Also, after comparing its valuation to peers, investors should consider booking profits enjoyed from Perfect World so far.

The takeaway
Trading at 12.6 times trailing earnings, Perfect World is slightly more expensive than Giant Interactive, whose trailing P/E multiple stands at 11.4. However, the key difference is that Giant's business is growing while Perfect World is trying to recover.

NetEase trades at a slightly expensive 15 times earnings but the company's growth has been picking up of late as evident in the previous quarter. Considering everything, Perfect World isn't the best way to benefit from online gaming in China and it would be prudent to look at its peers instead.

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