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Perfect World IPO Is off to a Heavenly Start

Despite a one-day hiccup, shares of this IPO are still up 50% in four trading sessions.

Chinese online-gaming start-up Perfect World (PWRD) has proven a mostly refreshing tonic during these recent dog days of summer trading.

After a few short days as a public company, the stock came close to doubling, before getting knocked down Tuesday as bears once again overtook the broader market.

But there seems to be more room for this sleeper IPO to run.

Perfect World went public last Thursday at $16, with little fanfare and what appeared to be limited interest among investors. Visitors to Renaissance Capital's IPOHome.com site, where they can vote on whether an upcoming IPO is hot or not, gave Perfect World a less-than-enthusiastic rating.

It's been anything but cool. The stock closed its first day at $20.40, up 28% from the offering price. On Monday, it rose 10% to $28.30, before tumbling nearly 15% on Tuesday to $24.10.

Before Tuesday, Perfect World, with its small float of 12 million American Depositary Shares, has been no match for the investors' demand so far -- it had even outperformed

Baidu.com

(BIDU) - Get Baidu, Inc. Sponsored ADR Class A Report

, which was up 16% before its 3.5% drop on Tuesday.

The optimism surrounding Perfect World is from its recent numbers, which represent a remarkable turnaround from its earliest days. Founded in 2004, Perfect World posted big losses that year and in 2005: $820,000 in 2004 and $3.6 million in 2005 -- both years without a dollar in revenue.

In 2006, the company brought in $1.7 million, but still posted a loss of $3.9 million.

But in the first quarter of this year, it made a profit of $5.1 million off revenue of $11.3 million. That's a 46% profit margin. And that figure wasn't fluffed up by one-time benefits. The operating profit in the quarter was 48% of revenue.

Shortly before the IPO, Perfect World updated

the filings

with data from the second quarter, which continued to show impressive growth: Revenue rose to $17.1 million, up 49% from the previous quarter and more than eight times as large as the year-ago revenue.

Net income rose to $6.9 million, up 31% from the previous quarter and 23 times larger than the year-ago profit.

As encouraging as those numbers are, it's clear revenue grew faster than profit, which means falling margins. And sure enough, Perfect World's profit margin fell to 40% in the second quarter. That's largely due to a 57% rise in R&D expenses in the quarter and a doubling of sales and marketing expenses.

But none of this is unusual for growing tech companies. Perfect World is planning to introduce several new games this year and next, which may or may not bring future growth.

And it's that "may or may not" that makes Perfect World a tricky investment for investors, or at least the investors in Perfect World's U.S.-listed ADS who aren't steeped in

MMORPGs

-- massively multiplayer online role-playing games -- and, within that small subset, who don't speak Chinese and therefore can't easily navigate its flagship

Perfect World

game.

That makes Perfect World something of a black box as an investment. The historical numbers are strong, so why not plunge on in? Never mind the fact that video games are a notoriously fickle industry, and that another upstart could at any time emerge to steal Perfect World's thunder.

I looked around to find information on Perfect World's games. There is a pretty good

TheStreet Recommends

summation

in English on Wikipedia. Perfect World has expanded into nearly a dozen countries -- one of which, the Philippines, has its

site in English

, offering a good insight into why the flagship game is so popular in China.

My take is that the

Perfect World

game has replicated in China what the addictive

Worlds of Warcraft did in the West. But it anchored the game in Chinese traditional culture, adding more contemporary touches like floating cities and monsters. Crucially, it made its 3-D technology and customizable identities available to PCs that have both high- and low-bandwidth connections.

Then the company followed up with the

MMPORG Perfect World II

, as well as a game based on a popular Chinese TV drama,

Legend of Martial Arts

. It followed those with

Zhu Xian

, a fantasy game based not on a movie or TV show but on China's "most read Internet novel of 2005," according to the IPO prospectus.

Starting this year is another weapons-based game,

Chi Bi

, as well as a less-cerebral dancing game called

Hot Dance Party

and

Second World

, a transparent attempt to replicate in China the fizzled U.S. fad

Second Life

. One hopes it will work better there than it did here.

Not all will be smashes, but there's enough in Perfect World's stable that promises to grow its profit and stock price in the short term.

As usual, unpredictable regulations from the Chinese government can make ADS of Chinese companies a risk in the U.S, but there seems to be enough for now behind Perfect World to keep the stock going higher for a short time.