This Gaming Stock Looks Like Chaff for Now, but Will it Become the Wheat?

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I have been quite bullish about the prospects of Chinese online gaming company Perfect World (NASDAQ: PWRD). However, it seems that the company is not able to tap the huge opportunity presented by online gaming in China, a fact that can be seen quite clearly in its quarterly reports.

After a strong start to the year, Perfect World’s earnings have been going down for a number of reasons. The company doesn’t seem to have a strong and addictive game in its portfolio so far, and lack of new titles has also made things worse. In addition, stiff competition from the likes of Giant Interactive (NYSE: GA), Shanda Games and NetEase (NASDAQ: NTES) is also making things difficult for Perfect World.

The Decline Continues

In its recently-reported third-quarter, Perfect World’s average concurrent users (ACU) declined once again. And this time, the drop was quite steep, as ACU crashed 27% from the same period a year ago. While the company’s anti-cheating efforts are indeed filtering out the cheaters and leading to a decline in the number of users, such a major drop in the ACU metric is a big red flag.

As a result, Perfect World’s top line decreased slightly from last year, coming in at $110.7 million. Throw in increased expenses, and you get earnings that were nowhere near last year’s levels. In comparison, peer Giant Interactive, one of the best performing online gaming companies, had posted a solid revenue jump of 19% last week, along with a 20% growth in non-GAAP net income.

But now the question is can Perfect World turn things around and benefit from the growth of online gaming in China? Honestly, the company can do better in the future, as it is looking to release new titles, expansion packs and expand its global footprint. However, there are a lot of challenges. But first we would take a look at the probable catalysts for Perfect World.

A Few Catalysts

Perfect World launched Torchlight 2 and Return of the Condor Heroes last quarter, and expects these games to push up its revenue to some extent. Also, Perfect World has a number of games under development, and they should help further improve its top line in the future. Swordsman Online, Saint Seiya Online and Legend of the Condor Heroes are the games from which Perfect World expects maximum returns, but only time will tell if these can turn the company's fortunes around.

Moreover, Perfect World is looking at global markets to mitigate its weakness in China. It has pinned a lot of hope on Neverwinter, which is a “highly-anticipated MMORPG” according to the company and might turn out to be a success. The game, which is being developed by Cryptic Studios, will be first released in North America in order to improve the company’s position in the continent. Also, Perfect World is expanding its network through licensing deals in countries such as the U.S., Japan, Turkey and Indonesia among others.  

Perfect World also landed the rights for operating Dota 2 in China. Dota 2, which is developed by Valve, is a very popular game which had won IGN’s People's Choice Award after its first showing. Thus, this game should help Perfect World get back some subscribers in the future.

A Stiffly Competitive Market

However, Perfect World’s declining user count in China is cause for concern, as performance in this country will determine the stock’s direction in the long run. The Chinese online gaming market is very lucrative, and is dominated by the likes of Tencent and NetEase.

Tencent is the biggest player in the gaming market, and its game, CrossFire, is the most popular online game in China. Tencent also operates Activision Blizzard’s (NASDAQ: ATVI) Call of Duty in China, which will undoubtedly provide stiff competition to Perfect World’s games. Throw in NetEase, which operates Activision’s World of Warcraft in the Middle Kingdom, and the space becomes even more tight.

Activision recently released Mists of Pandaria, the next expansion pack to the popular WoW, and the game is already winning over subscribers. Also, the emergence of Giant Interactive with its popular ZT Online game is another big threat for Perfect World.

The Takeaway

There’s huge opportunity in online gaming in China, but the players are more or less settled and Perfect World is trying to move up the ranks. Perfect World expects its revenue to decrease again in the ongoing quarter, and this isn’t good news. Also, even though the company is diversifying internationally, its decline in the Chinese market might have something to do with it.

There’s a big question mark on how its games are going to perform in the future, as there are other more famous games from companies who are either well settled or growing rapidly. In such circumstances, it would be best to watch Perfect World from the sidelines and wait until the company attracts users back into its fold.

TechJunk13 has no positions in the stocks mentioned above. The Motley Fool owns shares of Activision Blizzard. Motley Fool newsletter services recommend Activision Blizzard, Giant Interactive Group,, and Perfect World . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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