Creating a Perfect Virtual World

05/05/2009 1:00 pm EST

Focus: STOCKS

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, says a Chinese online gaming company has what it takes to succeed in that rapidly changing market.

A few Chinese companies have been able to find success in online gaming over the years. Much of their success can be attributed to focusing on three things: a strategic business model, licensing agreements, and creating content that appeals to the Chinese audience.

Prior to 2006, the most successful business model for online gaming companies was the pay-for-play model. Future online games would gradually use another business model—one where the online games would be free and companies would profit by selling virtual items for real money.

Basically in this type of business model, players are able to purchase more powerful virtual weapons or armors for up to $200 for an item. For players who spend a significant part of their lives in a virtual world, paying a few hundred dollars can make their gaming experience much better. Many of the new hit games in China that emerged since 2006 used the free-play and pay-for-items business model.

One of my favorite online gaming companies, Perfect World (Nasdaq: PWRD), took this shift in business models to heart, creating other online games that allow players to play for free but pay money for virtual items. Perfect World has been very successful with this, as serious gamers try to outdo one another by buying more and better virtual items from PWRD.

Perfect World’s management has also been strategic in the way it adapts popular Chinese stories for its games. Its first blockbuster game, Perfect World, was based on the well-known Chinese creation myth of Pangu, and it became a hit because of the story's familiarity to Chinese gamers. Perfect World then followed up with another blockbuster game, Jade Dynasty, based on one of China's most popular online novels.

That is where Perfect World has an edge. The company has developed an in-house game- production technology that allows it to develop high-quality new games at a much lower cost than its competitors. This important competitive advantage makes Perfect World a good long-term bet in China's highly competitive online gaming industry.

In China, online gaming has already surpassed movies and music sales in total revenue. With the growing popularity of broadband Internet and the free-play model of online games, online games are growing despite the global economic slowdown. And I expect the business to continue to grow.

I like companies with proprietary game production technology, a free-play model, and a proven ability to adapt popular Chinese stories into online games. Perfect World is a leader in all three, so as I already mentioned, I recommend you continue to buy shares of this promising company under $19. (It closed above $18 Monday—Editor.)

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