The Market Doesn't Have A Perfect Understanding

By Chad Henage - April 18, 2012 | Tickers: NTES, PWRD | 0 Comments

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I wrote a post back in January about Perfect World (NASDAQ: PWRD). In summary, I said that though the stock had taken a serious beating over the last year or so, that investors were overreacting. Since writing this prior post, the stock is up about 27% from the price at the time of $10.75. One slightly confusing development, is analyst estimates going forward have switched from USD to RMB. This could cause novice investors to mis-read earnings estimates and could cause for a disconnect between the company's performance and valuation. If at $10.75 Perfect World looked like a good deal, and today the stock is up 27% from that value, is the stock still a buy? Let's look at recent developments and find out.

At the current stock price of $13.65, the stock sells for just 4.57 times 2012 full year estimates. The company is expected to grow earnings by about 10%. Compare this to arguably the leader in the international gaming field NetEase (NASDAQ: NTES) which sells for 12.85 times future earnings and is expected to grow by 16.30%. With NetEase you get a company selling for a 0.79 PEG, versus Perfect World's 0.45 PEG ratio. With both companies growing at over 20% in the last five years, you would expect their future growth rates to be similar. However, NetEase's more consistent performance and thus higher expected future growth, causes the stock to sell for a multiple that is 75% higher than Perfect World.

There are at least three factors that I see that could lead Perfect World to beat current estimates. First, the company has shown earnings growth of 20.88% in the last few years. With future earnings growth expected at 9.78%, this seems a drastic cut. The company has seen some seasonality to its games, and has slowed down promotions to lengthen the life span of its existing games. However, even with these adjustments and challenges, the company grew revenues at over 25% in 2011. While I know one concern that analysts have is the drop in the last year of average concurrent users (ACU), this trend seems to have reversed in the most recent quarter. Look at the last four quarters:

You can see a clear turn in the number of ACU in the last four quarters. Second, the company has established a pattern of beating analyst estimates. In the last four quarters, the company beat earnings in three, and their average beat for the full year was by 30.48%. Last, analysts have increased their full year 2012 and 2013 expectations in the last 90 days. Full year 2012 earnings have increased by 2.38%, and 2013 estimates have been increased by 6.44%. These three factors make me believe that Perfect World could outperform analyst expectations going forward.

A recent major development that hasn't gotten enough attention is the company's new dividend policy. This change first appeared in the company's third quarter results. The company said that “...Management recently proposed a change in the company's dividend policy to reflect the Company's intention to distribute part of the earnings of our wholly-owned PRC subsidairies to our shareholders from time to time.” In the most recent quarterly earnings release the company announced, “...the board of directors declared special cash dividends in the aggregate amount of approximately $95 million to our shareholders of record April 6, 2012.” While the release does say “special cash dividends” it continues to say, “We intend to distribute dividends annually in the future.” (emphasis mine) This is a critial sentence in that, it seems the company will be looking at what excess cash is available and declaring an annual “special” dividend.

This is different from a one time event and is not being accounted for in the stock price. In the last year, Perfect World increased it's net cash and investments from $282.6 million to $439 million (subtracting $8.9 mil. In short term debt). This increase of $156 million is significant. The company's annual dividend is $95 million, or about 60.90% of the additional cash added to the balance sheet in the last year. If Perfect World can generate as much cash flow in 2012 as in 2011, and pays out a similar amount, this would become a $2 annual dividend instead of a one time event. A $2 per share dividend on an ongoing basis would give Perfect World shares a yield of over 14%! While these dividends are paid on an annual basis, based on business factors and cash considerations, this potential annual dividend is impossible to overlook. The fact that the stock dropped nearly $3 a share just days after this April 6^th record date, shows that investors don't realize the company has told investors this will be a recurring event.

In summary, while Perfect World in the past might not have been...perfect, today the company seems to have turned a corner. Average users are up, the company is growing internationally as well, and if this dividend policy statement is correct, this is just year one of a string of dividend payments. Add to this the fact that the company is beating analyst estimates, and those estimates are being raised, and you have possibly the criteria for a perfect investment.

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