NCTY

Business Context and Reporting Period

Company: The9 Limited (NASDAQ: NCTY)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Third Quarter 2005 (Ended September 30, 2005)
Business Overview: The9 is a leading online game operator and developer in China. The quarter marked the first full period of commercial operations for World of Warcraft (WoW) in China, which commenced in June 2005. The company also completed the acquisition of the remaining 31.1% interest in its subsidiary, China The9 Interactive Limited (C9I), in late August 2005, making C9I a wholly-owned subsidiary.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Surge: Net revenues increased 232% quarter-over-quarter (QoQ) and 2,096% year-over-year (YoY). This growth was driven primarily by WoW operations, which generated RMB180.6 million (US$22.3 million) in revenue.
• Profitability Turnaround: The company swung from a net loss of RMB23.0 million in Q2 2005 to a net income of RMB37.7 million in Q3 2005.
• Operating Expenses: Total operating expenses decreased 24.9% QoQ to RMB42.2 million. This reduction was largely due to a significant decrease in product development expenses, as costs previously classified as development (e.g., server depreciation, data center rental) were reclassified to cost of services following the commercial launch of WoW.
• Foreign Exchange Impact: The company recorded a foreign exchange loss of RMB8.1 million due to the appreciation of the Chinese Renminbi against the US Dollar in July 2005.
• Minority Interest: Following the acquisition of the remaining interest in C9I, no minority interest was recorded in the consolidated statement of operations for the quarter, whereas two months of minority interest were accounted for in Q2.

Guidance, Outlook, and Management Commentary

• User Metrics: In Q3 2005, WoW attained peak concurrent users of approximately 467,000 and average concurrent users of 240,000. By October 31, 2005, peak concurrent users exceeded 500,000, with over 2.5 million paid accounts activated since launch.
• Strategic Acquisitions: The9 completed the purchase of the remaining 31.1% interest in C9I in late August 2005. Additionally, in October 2005, The9 secured an exclusive license to operate WoW in other parts of Greater China through a joint venture in which it holds a 30% equity interest.
• Non-GAAP Measures: Management introduced Adjusted EBITDA as a key metric to highlight expenses that do not result in future cash settlements (e.g., amortization of intangibles, share-based compensation).
• Risks and Contingencies: Forward-looking statements are subject to risks including Chinese government regulations on the internet and online gaming, political and economic policies, the ability to retain players, and competition. The company noted that purchase price allocation estimates for the C9I acquisition may be subject to adjustment in Q4 2005.

Investor Verification Checklist

• Revenue Concentration: Verify the extent of reliance on World of Warcraft, which accounted for approximately 97.7% of total net revenues in Q3 2005.
• Cash Flow Usage: Confirm the impact of significant cash outflows for WoW server purchases, prepaid royalties, and the C9I acquisition on future liquidity.
• Non-GAAP Reconciliation: Review the reconciliation of Adjusted EBITDA to GAAP Net Income, specifically the RMB7.4 million amortization of intangibles related to the C9I acquisition.
• Affiliate Performance: Monitor the performance of 9Webzen (operator of MU), which contributed a loss of RMB2.3 million in Q3 2005 due to declining revenues.
• Regulatory Environment: Assess ongoing risks related to Chinese government regulation of internet cafes and online game content.