Investment Summary

Perfect World engaged in Film and TV series creation as well as Gaming development in China, together with strong game development and film production capabilities. Besides, it is one of the few who has gaming and film & drama business in the market. Those two businesses could create a robust synergy, so Perfect can maintain rapid growth in the future. We project the net profit growth to be 19%/32% in 2018/19F. Assuming a target P/E of 23x in 2018, we initiate a “Accumulate” rating and give a target price of $31.19 with a potential upside of 11.0%. (Closing price at 30 July 2018)

Corporate Background

In 10 Dec 2014, Perfect injected the assets of Film and TV drama into “Jinlei co.” to list in A share market, and renamed to “Perfect World Pictures”. In 6 Jan 2016, the assets of gaming development are also injected into the listed company at a price of 12 billion RMB, and renamed to “Perfect World” in July. In addition, it acquired Jindian Studios, Jindian Cinema, and Jindian Culture for 1.353 billion RMB in 13 Sep 2016, in order to enhance the distribution channel. However, Due to the poor performance of cinema business, perfect transferred its assets of cinema business to the Perfect World Holdings, the controlling shareholder of the listed company, at a price of 1.665 billion RMB.

Film

Most of Perfect's original films are low-cost romances, including "Sofie's Revenge", "The Piano in a Factory", "Love is Not Blind" and "Let's Get Married" and so on. The most successful work was "Love is Not Blind" released in 2011, which was adapted from a popular online novel from Bao Jingjing, and directed by Teng Hua-Tao, the director of “Wo Ju”. The film was blockbuster, grossing 189 million RMB in its first week, and 350 million RMB eventually. However, the production and promotion cost were only about 10 million RMB. The film was also highly recognized by the industry, winning the "Outstanding Feature Film Award" in the 15th China Watch Award and the "Excellent Feature Film" Award in the 31st Flower Awards. In 2017, Perfect produced a relatively costly action movie for the first time: “Extraordinary Mission”, but the return is not so remarkable.

Perfect actively participated in the production of foreign blockbusters, including: “Jason Bourne”, “Fifty Shades Darker”, “Divergent” series and “Pacific Rim 2: Uprising”. In 2016, Perfect and Universal Studios reached strategic cooperation agreement, where Perfect will contribute 250 million USD, supported bank revolving loans, and will participate in the global movie film project investment share of about 25% in the next five years, with no less than 50 products. Perfect is entitled to receive the permanent global benefits of each film, including box office, audio and video revenue TV, multimedia channel distribution revenue, and peripheral product licensing revenue. At the 90th Oscar Awards, “Darkest Hour”, “Phantom Thread” and “Victoria and Abdul”, invested and produced by Perfect and Universal Studios, are nominated for 14 awards, and won 9, including the best film, best director, and best actor.

In addition to film production, Perfect is also engaged in film distribution business, indicating that it can handle the film from production to distribution.

TV series

Perfect is one of the companies with the highest outputs in TV series, with about 500 episodes every year and a wide range of genres, such as Costume, Mystery, Teen, Contemporary and Romance. The TV series includes “Legend of Chu and Han”, “Hot Girl 2”, “Soul Ferry”, “"Let's Get Married”, and “The Legend of the Condor Heroes”. “Hero Dog” series is one of the successful works of Perfect, which is about the story of people and dogs in pet hospitals. According to the CSM50, the drama ranked 8th in the year, and launched season two and three in 2016 and 2017 respectively. Perfect also plans to launch season four in 2018. In addition, the “Soul Ferry” series and “Agni Cantabile” also released on the online platforms such as Youku and Iqiyi. The video view of “Agni Cantabile” exceeded 100 million after 18 hours, and more than 5.5 billion on April 5.

Variety Show

Perfect adopted the strategy of “Fine quality” and “Innovation” in variety shows, and produced programs through original production, project cooperation or cross-border cooperation. The works include: “Go Fighting”, “King Cross”, “Unlimited Song Season” and “Back to field”. “Go Fighting” is one of the most popular works, an inspirational experience reality show. The main members are Huang Wei, Sun Honglei, Huang Lei and Luo Zhixiang. For every episode, different guests will be invited to the show in order to retain the freshness of the show. The season four has broadcasted in Dragon Television.

PC gaming

Perfect launched in-house developed and licensed games, and mastered a variety of game engines, such as Angelica 3D game engine, Cube engine and Eparch 2D engine. The in-house developed games include “Perfect World”, “My Own Swordsman” and “Jade Dynasty”. “Jade Dynasty” is the most successful work for Perfect, which operated almost 10 years, and the latest version is called “Jade Dynasty 3”. The licensed games include “DOTA2”, “CS:GO” and “Crossout”, where the highest monthly gross billing for “DOTA2” even reached 100 million. These games all aim for e-sports. “DOTA2” holds international tournament every year, and the prizes for top three even reached 17 million USD, the highest prizes among the e-sports competition ever. In addition to the international competitions, Perfect also holds e-sports competition in China.

Mobile gaming

Most of the mobile games of Perfect are developed in-house, including “Jade Dynasty Mobile”, “The Sword and the Knife” Mobile, “The Return of the Condor Heroes” Mobile and “Legend of Condor Hero” Mobile, and “Dream book”. Many mobile games are adapted from the PC version, such as “Jade Dynasty Mobile” and “My Own Swordsman” Mobile. The average gross billing of “Jade Dynasty Mobile” in 2017 has reached 200 million. Perfect also released the games to other countries, where Taiwan has recorded a 50 million monthly gross billing in 2017. It is believed that Perfect will focus on Mobile gaming than PC gaming in the future.

Industry overview

The number of TV series that have been produced and licensed for release has been declining since 2012 from 506 to 313. Yet, the average number of episode for single unit has steadily increased from 31.9 in 2011 to 43.1. The number of production on TV series has remained above 400 in 2003-2014. However, since January 1, 2015, after the launch of new policy “一劇兩星”, the production of TV series began to decrease, and for the first time, lower than 400, and fell to 313 in 2017. Under the previous 4+X policy, each TV series can be broadcasted simultaneously on up to four TV stations and several terrestrial channels, so the cost of TV series can be shared by multiple TV stations. Under “一劇兩星”, the same TV series should be aired on no more than 2 satellite TV channels each night during prime time. This undoubtedly increase the purchase cost of TV stations, where TV station will in turn require a higher quality of products. In light of this, we believe that the industry will gradually integrate, and low-quality drama producers will be eliminated. The number of outputs is going to be lower than the past, while the quality of works will significantly increase.

In 2017, 57% of the TV series with more than 10 billion views are adapted, demonstrating that those dramas are more acceptable to audiences because they may be exposed to the original in advance or the original itself has gain certain popularity, so its adapted works are easier to be successful.

In 2017, except for Sohu, the view of TOP30 dramas significant increases, with iQiYi, Tencent and Youku increasing by 79.3%, 62% and 81.8% respectively. This shows that the audience's habit of watching TV series gradually shifts from TV to video platforms.

With the rise of the video platform, video platform operators began to create their own drama series, reducing the dependence on existing drama makers. Among them, Tencent's self-made dramas raised the most, from 4 in 2015 to 32 in 2017. In addition, iQiyi's self-made drama has also risen from 15 to 24, and only the number of Youku's self-made dramas has fallen. We believe that these three major video platforms will continue to enhance their own production level in the future, and it is likely to become a major competitor for existing drama makers.

The domestic gaming revenue has been climbing steadily, from 44.6 billion RMB in 2011 to 203.6 billion RMB in 2017, with 23% increase YoY. PC gaming revenue fall after 2015 and recorded a negative growth of 5%. However, it rebounded in 2017, mainly due to the strong performance of the survival game, “PUBG ".

Mobile gaming revenue continued to grow, rising significantly from 1.7 billion RMB in 2011 to 116.22 billion RMB in 2017. However, the growth rate has slowed down, from the highest growth of 247% in 2013 to only 42% in 2017. The ARPU in mobile gaming kept rising, from RMB 17.9 in 2011 to RMB 129.12 in 2017. We believe that the mobile gaming market will continue to grow steadily, but due to the base effect, the growth rate for revenue and ARPU is likely to decline.

Competitive advantage

Strong in-house R&D capabilities

Perfect has a strong in-house R&D capabilities. Angelica is the self-developed game engine by Perfect, and now is the third generation. The third generation of Angelica not only fully supports the PhysX physics engine, but also incorporates the world's top gaming technologies such as refined modeling, high-quality compressed normal map rendering, multi-threaded rendering and FFT-based fluid sea surface. The works that adopted this engine includes “My Own Swordsman”, “Perfect World”, “Jade Dynasty”, and “Swordsman Online”. Although the Angelica engine has been used to develop MMORPG, it is also used in a casual online game "Hot Dance Party." for the first time.

Diversified product, strong adaptation ability

Perfect has different divisions in its gaming business, such as PC games, Mobile games, Browser games, and Console games. Besides, Perfect is able to both develop and operate the game, which enhance the sustainable development of the business and the ability to resist risks. On the other hand, the diversified product mix will facilitate the adaption, exploring the maximum value from the original. “Jade Dynasty Mobile” is an example of mobile gaming adaption. The retention rate of players is as high as 83.82% for two close betas, and the payment rate is also as high as 54%.

Gaming and Film & Drama complement one another

In addition to the mobile gaming adaption for Pc game, it is very common to adapt film and drama works into mobile games. Therefore, robust synergy can be created by the gaming and Film & Drama business for Perfect. Adapted from a novel written by Ming Xiaoxi, the TV series “Agni Cantabile” released in 1 Mar 2018 via Youku, and became the first webisode that exceeded 5 billion views in 2018. As of 21 Apr 2018, the views have reached 7.7 billion. After the end of the webisode, Perfect and AlibabaGames launched a mobile game with same name immediately. It became the 9th in the App Store free app list on the first day of the launch. The success of the drama can serve as a promotional role to the mobile game, and the drama can boost the interest of the players, so that the chances are the mobile game will be successful.

Cooperate with Valve to run game platform Stream China

In June 2018, Perfect and the renowned game developer Valve Corporation will cooperate to establish, operate and promote the computer (PC) digital distribution platform Steam China in mainland China. Under the agreement, Valve provides software licensing and related technical support for the launch and operation of Steam China, and authorizes the use of its trademarks and related promotional materials in Steam China's promotion to Perfect; Perfect is responsible for introducing overseas game products to Steam China and conducting localization, and is responsible for recommending and supporting the issuance and operation of Chinese game products in Steam China. By partnering with Valve to run Steam China, it is able to expand its gaming business, not only in game products, but also into the game platform.

Professional production team

Perfect's experienced production team ensures the quality of works in the future, allowing the direction of “Fine quality”. The main production teams of Perfect include Xinbaoyuan, Huamei Shikong, Perfect Pengrui, Perfect Jianxin and Jianghe Studio, which are led by well-known directors and producers such as Zhao Baogang, Teng Huatao, Liu Jiang, Guo Jingyu, He Jing and Wu Yujiang. . For example, Zhao Baogang won the "Flying Awards Best Director Award", "Golden Eagle Award for Best Director Award" and "Hua Ding Award Most Popular Director", while directed by Teng Huatao, the low-cost romance "Love in not blind" recorded 350 million RMB box office, becoming a dark horse in that year.

Earnings forecast

We expect revenue from Film & Drama to reach 1.78 billion in 2018, drop to 1.68 billion in 2019, 6% decrease YoY, due mainly to the loss on revenue from cinema business. In addition, the revenue from gaming is expected to reach 7.03 billion, and to 8.98 billion in 2019, an increase of 27.6%. Among them, the mobile game business will record the highest growth. In 2018, Perfect and Tencent will launched two mobile games《完美世界手游》和《雲夢四時歌》and it is expected to achieve an increase of about 40% in both 18 and 19 years, while the PC gaming is gradually rebounded due to the e-sports boom.

As the gross profit margin of the gaming business is higher than that of the Film & drama, as the revenue proportion of the gaming business gradually increases, we believe that the overall gross profit margin will gradually increase, which is 59%/61% in 2018 and 19, respectively.

We forecast that net profit in 2018 will reach 1.74 billion RMB, up 19% YoY; to 2.30 billion RMB in 2019, with 32% growth YoY.

.Valuation

Perfect has strong game development and film production capabilities, and corporate with foreign companies in order to explore the oversea market. Besides, Perfect is one of the few who has gaming and film & drama business in the market. We believe those two businesses could create a robust synergy, so Perfect can maintain rapid growth in the future. Assuming a target P/E of 23x in 2018, we initiate a “Accumulate” rating and give a target price of $31.19 with a potential upside of 11.0%.

Risk

1. Lower-than-expected growth in Mobile gaming

2. Giant entering the film & drama production

3. Loss in production team

Financials

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