2 Ways to Play China's Market

Chinese stocks have been on fire lately, and Chinese gaming companies have been some of the hottest plays on China. In the past year, I discovered 2 companies that develop online role playing games, a genre of gaming that is swiftly attracting gamers by the dozens.

The Chinese duo that I’ve watched explode with growth are Perfect World Co., Ltd. (PWRD - Snapshot Report) and Shanda Interactive Entertainment Ltd. (SNDA). During the past year, both stocks have outpaced the S&P 500 and the widely followed Asian Hang Seng index. Perfect World outperformed both indexes by more than 100%.

While both stock picks have seen robust share price growth, valuations remain attractive, and the fundamentals are strong. Below I take a closer look at the fundamentals, which point to even stronger performance going forward.

2 Chinese Plays for 2010

Perfect World Co., Ltd. (PWRD - Snapshot Report) is an online game developer and operator. It develops online games based on its game engines and game development platforms. Perfect World’s games include massively multiplayer online role playing games ("MMORPGs") such as Perfect World, Legend of Martial Arts, Perfect World II, Battle of the Immortals and Fantasy Zhu Xian to name a few.

Perfect World says that a substantial portion of the revenues are generated in China. However, its games have been licensed to leading game operators in a number of countries and regions in Asia, Europe and South America. The company also generates revenues from game operation in North America and plans to continue to explore new and innovative business models.

PWRD shares have soared by more than 120% so far in 2009, surpassing the major averages by more than 100%. Despite the significant surge, the stock remains cheap with a forward P/E of 14.

Perfect World’s fundamentals point to even stronger momentum in 2010. Analysts polled by Zacks currently have 2010 earnings pegged at $3.65 per share. The forecast is up from $3.46 over the past 2 months and compares favorably to the current 2009 Zacks Consensus estimate of $2.91.

If history is any indication, earnings will exceed forecasts. Since 2007, Perfect World has consistently topped earnings expectations. Earnings surpassed estimates by an average of 31% over the past 4 consecutive quarters.

The company is expected to see 33% earnings growth over the next 3 – 5 years, well above the industry’s expectation of 18% growth. Other strong industry comparisons include Perfect World’s return on equity (ROE) of 55.5%, versus the industry average of 2.5%. The company boasts a net profit margin of 47%, while the industry average is in the negative. It is also worth noting that Perfect World sports a solid balance sheet, showing no debt.

The company saw robust results in the third quarter. Earnings per share of 81 cents came in 8% ahead of the Zacks Consensus Estimate. Total revenues jumped 13% year-over-year.

Management mentioned that third-quarter results exceeded the company’s expectations, adding that Perfect World continues to strengthen its competitive advantages in the industry by strategically crafting a highly diversified portfolio of truly differentiated games.

Recently, the company introduced a new 3D fantasy MMORPG, Forsaken World. Management explained that this game breaks new ground in terms of overall planning, programming and graphical designs.

Chairman and CEO Michael Chi said Forsaken World will be one of the major titles by Perfect World for 2010. He added that the game contains many new designs and uniquely blends the cultures of different regions in the game. “We integrate many western features in the game play in order to make it more appealing to international players,” said Chi.

Shanda Interactive Entertainment Ltd. (SNDA) is a Chinese interactive entertainment media company, offering a diversified portfolio of high quality content through its subsidiaries and affiliates, including Shanda Games, Shanda Literature, Hurray!, and various other online community and business units.

The company’s broad variety of content ranges from massively multi-player online role-playing games (MMORPGs) and advanced casual games, to chess and board games, e-sports, cartoons, literature, film, television, mobile ringtones and music.

Shanda is also attractively valued with a forward P/E of 15. Other stellar fundamentals include a return on equity (ROE) of 24%, squashing the industry average of 2.5%. The company’s net profit margin of 33% compares to a negative industry average.

Analysts polled by Zacks are upbeat on future earnings. For 2010, the Zacks Consensus Estimate of $3.76 per share surpasses the 2009 forecast of $3.42.

Third-quarter earnings per share of 90 cents topped the previous year’s 68 cents and exceeded the Zacks Consensus Estimate by 5%.

The company boasts an excellent record of outpacing estimates. Shanda’s quarterly earnings missed the Zacks Consensus Estimate only 3 times since March of 2005. During the past 4 consecutive quarters, earnings eclipsed the Zacks Consensus Estimate by an average of 7%.

Shanda’s consolidated net revenues jumped 48% year-over-year and increased12% from the second quarter.

Alex Kolb is the Growth & Income Stock Strategist for Zacks.com. He also writes the popular daily commentary column for the ZacksElite.com service.

Read the full analyst report on SNDA

Read the full analyst report on PWRD