By AMY REEVES
Investor's Business Daily

In the U.S., the growing number of 3-D films has some people wondering if 2-D entertainment will go obsolete. But Perfect World (PWRD) is betting otherwise.

Since its 2006 launch, Perfect World has been using its 3-D Angelica game engine to create massive multiplayer online role-playing games (MMORPGs) for the Chinese market. Its two self-titled games as well as "Legend of Martial Arts," "Zhu Xian" and others have brought its revenue from nowhere to more than $200 million annually in just three years.

But the drawback of 3-D gaming is that a lot of Chinese don't have the technology for it. So last October, Perfect World rolled out its first 2-D game, "Fantasy Zhu Xian." So far, the reception has been a pleasant surprise to Wall Street.

350,000 Players

"It's doing better than I was expecting, better than most were expecting," said ThinkEquity analyst Atul Bagga. "The ACU (average concurrent users) is about 350,000, which is impressive for a game like this."

This gives a needed boost in an area where the firm had been struggling. In the third quarter, the concurrent user count, that is, the number of players active at any one time, averaged 713,000, down from 717,000 a year earlier, even though several new games had been launched.

The sheer number of users isn't the only metric that matters, however. Following a common Chinese model, Perfect World's games are free to play but charge users as they go along for such items as weapons and tools. The company also periodically releases expansion packs for its existing games, creating more opportunities for sales. Thus, even a hit game doesn't translate into instant money.

"In the online game world, the initial monetization is slow and then it ramps," said analyst Andrey Glukhov of Brean Murray, Carret & Co. "We will not see much of a revenue benefit (from "Fantasy Zhu Xian") in Q4, and the impact in Q1 will be to a decent degree subject to the ramp in monetization."

Fortunately for Perfect World, it has a track record. In fact, despite the flat ACU in the third quarter, revenue jumped 55% over the prior year due to players' willingness to spend more. Total revenue was $86.4 million, while profit rose 65% to 81 cents a share.

Even in the older games, there still might be room to increase average revenue per user (ARPU). Bagga estimates that the ARPU for "Mir 2," the blockbuster game from industry giant Shanda Games (GAME), is more than twice Perfect World's average.

"I don't think ARPU has peaked," Bagga said.

Another way Perfect World is expanding revenue is by branching into other media. Last year, it co-produced its first movie, a romantic comedy called "Sophie's Revenge."

In the fourth quarter of this year it plans to release a game called "XiaoAoJiangHu," based on a popular historical adventure novel usually translated as "The Smiling, Proud Wanderer." The company is planning to release a film adaptation shortly after the game. According to a Jan. 5 Credit Suisse report, the firm has already chosen the director and lead actors, but is still looking for investing partners.

Such multimedia efforts are nothing new in the game world. Shanda has long since established TV and literature branches and last year even spun off its gaming division so that the parent, Shanda Interactive (SNDA), could focus on building out the nongame business.

"Digital entertainment will continue to converge in the future," said Glukhov. "Perfect World so far has been reasonably prudent with their investment. Directionally, it's the right theme."

Meanwhile, Perfect World has more games in development. This quarter should see the launch of both a new 2-D game, "Dragon Excalibur," and a 3-D game, "Forsaken World."

Going West

Down the road, analysts are looking forward to "Torchlight," a game Perfect World is co-developing with U.S.-based Runic Games. This would be the first game the company has created specifically for the Western market, rather than simply adapting one of its Chinese games.

Still, management said last year that it's focusing more on the quality than quantity of new games.

The Angelica engine has always allowed Perfect World to crank out new games faster and cheaper than many of its competitors. But as the Chinese gaming industry has matured, both gamers and investors are getting pickier. A recurrent criticism is that Perfect World's games are too much alike.

"Each game is similar to an expansion pack of another big game," said Pali Capital analyst Tian Hou. "That's why the margin is low. You have to spend a lot of money to market small games. They have seven games compared to Shanda's 30-some games. The challenge is still ahead of them as an emerging, growing company."

Analysts polled by Thomson Reuters estimate that 2009 profit grew 83% to $2.92 a share. This year they expect earnings to climb 26% to $3.68 a share.