Business Context and Reporting Period
Company: The9 Limited (Nasdaq: NCTY)
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2010
Business Overview: The9 is a Cayman Islands-incorporated company primarily engaged in the operation and development of online games in the People's Republic of China (PRC). The company operates through a Variable Interest Entity (VIE) structure due to PRC restrictions on foreign ownership of internet content provision. Historically, the company relied heavily on the license to operate "World of Warcraft" (WoW) in China, which expired on June 7, 2009, and was not renewed.
Key Financial Metrics (Year Ended Dec 31, 2010)
| Metric | 2010 (RMB '000) | 2010 (US$ '000) | 2009 (RMB '000) |
|---|---|---|---|
| Revenues | 108,514 | 16,441 | 802,629 |
| Net Revenues (after sales tax) | 102,838 | 15,581 | 760,516 |
| Cost of Services | (103,257) | (15,645) | (712,473) |
| Gross Profit (Loss) | (419) | (64) | 48,043 |
| Operating Expenses | (353,365) | (53,540) | (530,884) |
| Operating Loss | (353,784) | (53,604) | (482,841) |
| Net Loss | (518,711) | (78,593) | (409,932) |
| Net Loss Attributable to Ordinary Shareholders | (499,612) | (75,699) | (405,152) |
| Cash and Cash Equivalents (End of Period) | 1,416,189 | 214,574 | 1,675,081 |
| Total Assets | 1,857,339 | 281,415 | 2,324,958 |
| Total Liabilities | 322,123 | 48,806 | 311,508 |
Note: US$ amounts are translated at the rate of RMB 6.6000 to US$1.00.
Material Changes vs. Prior Period
- Revenue Collapse: Total revenues decreased by 86.5% from RMB 802.6 million in 2009 to RMB 108.5 million in 2010. This decline is directly attributed to the expiration of the WoW license in June 2009 and the failure to identify a replacement product of comparable scale.
- Loss of Profitability: The company transitioned from a gross profit of RMB 48.0 million in 2009 to a gross loss of RMB 0.4 million in 2010. Cost of services (RMB 103.3 million) exceeded net revenues (RMB 102.8 million) for the first time.
- Impairment Charges: The company recorded a significant impairment loss on investments of RMB 196.1 million (US$ 29.7 million) in 2010, primarily related to an equity investment in a Korean online game developer. This compares to RMB 22.4 million in 2009.
- Operating Expenses: Total operating expenses decreased by 33.4% to RMB 353.4 million, driven by reduced sales and marketing spend and lower general and administrative costs following the WoW license expiration. However, product development expenses increased by 21.8% to RMB 139.4 million due to investments in proprietary game development (e.g., Red 5 Studios).
- Cash Flow: Net cash used in operating activities increased to RMB 247.6 million (US$ 37.5 million) in 2010, compared to RMB 106.1 million in 2009, reflecting the widening operating losses.
Guidance, Outlook, and Risks
Management Commentary & Outlook: Management states that as of the filing date, they have not identified a product to replace the WoW game. The company is pivoting toward developing proprietary games (e.g., "World of Fighter," "Winning Goal") and expanding into mobile social gaming through a strategic partnership and license with OpenFeint. The company expects operating expenses to increase as it expands operations and develops new products.
Key Risks and Contingencies:
- Product Replacement Risk: The company faces significant uncertainty regarding its ability to license, develop, or acquire a new "hit" product to replace the revenue previously generated by WoW. Failure to do so will result in continued losses.
- License Expirations: The license for "Granado Espada" expired in November 2010 and was not renewed. The license for "EA Sports FIFA Online 2" was prematurely terminated in December 2010, with operations expected to cease in 2011.
- Regulatory Environment (PRC): The company operates via VIEs (Shanghai IT, Huopu Cloud) due to PRC restrictions on foreign ownership. Changes in PRC laws or interpretations (e.g., the GAPP Circular) could invalidate these arrangements, disrupt operations, or lead to penalties.
- Legal Proceedings: A securities class action lawsuit regarding the non-renewal of the WoW license was dismissed in March 2011, though plaintiffs have 30 days to refile. The company is also involved in pending litigation regarding intellectual property rights with Beijing Founder Electronics Co., Ltd.
- Competition: The online game market in China is intensely competitive with major players like Tencent, Shanda, and NetEase, many of whom have significantly greater resources.
Investor Verification Checklist
- Product Pipeline Status: Verify the commercial launch dates and user adoption metrics for proprietary titles "World of Fighter," "Winning Goal," and the mobile social gaming platform.
- Red 5 Studios Integration: Assess the progress and commercial viability of "Firefall," the MMOFPS game being developed by the acquired subsidiary Red 5 Studios.
- Regulatory Compliance: Confirm the status of VIE contractual arrangements with Shanghai IT and Huopu Cloud in light of evolving PRC regulations regarding foreign investment in internet content.
- Liquidity Runway: Evaluate whether the current cash balance of approximately US$ 214.6 million is sufficient to sustain operations given the current burn rate and lack of a major revenue driver.
- Impairment Details: Review the specific details of the RMB 196.1 million impairment loss on investments to understand the remaining value of the company's equity portfolio.