Perfect World Is Now On Ice

Perfect World (PWRD) is down about 7% today after reporting second-quarter earnings and I wanted to give readers my thoughts on the numbers. The quarter was basically in line with expectations on the headline EPS and revenue numbers, and third-quarter guidance was pretty solid, calling for a 10% to 15% sequential increase in revenues. However, all is not perfect in this company's world. (bad pun intended)

Undoubtedly, Wall Street will come out and defend the stock, possible with slightly lower estimates and target prices, because the stock is cheap. And I'm definitely not arguing with that - this stock is DIRT cheap.

However, I don't see Perfect World moving higher any time soon, because of the disappointing ACU (average concurrent users) and APC (average paying customer) numbers. According to management, the big earthquake and subsequent interruption took a toll on these figures, but claims that they are rebounding this quarter. Given the bear market environment, investors are very likely to take a wait-and-see approach, creating a confidence problem.

Plus, investors are likely to start worrying about organic growth and earnings quality, given this disclosure:

"In addition, as the user base of the Company's games keep expanding while the accumulated number of inactive accounts has also continued to grow, in 2Q08 we began to enforce our rights to close a player's game account that has been inactive for 360 consecutive days. Revenues recognized from the inactive accounts were approximately RMB8.4 million in 2Q08. The Company will continue to implement this policy and recognize revenues from inactive accounts on a quarterly basis."

I don't think there is anything unreasonable about this move. However, there are two problems created here:

1) Back out this non-operating addition to revenue, and you have what looks like a second-quarter revenue miss. I doubt any analysts were incorporating it into their earnings models.

2) It just sounds fishy!

So when I look at Perfect World right now, my favorite thing about it is that it's cheap. That is simply not reason enough for me to buy, so I'm definitely not adding to my position, and I will look to get out of the stock on a bounce.