Business Context and Reporting Period
Company: The9 Limited (Nasdaq: NCTY)
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2005
Business Overview: The9 is a leading online game operator in China. In 2005, the company underwent a significant strategic shift, transitioning from a reliance on the game "MU" (operated via a joint venture, 9Webzen) to the commercial launch of "World of Warcraft" (WoW) in June 2005. By year-end, 98% of total revenues were attributable to WoW operations.
Key Financial Metrics (Year Ended Dec 31, 2005)
| Metric | 2005 (RMB '000) | 2005 (US$ '000) | 2004 (RMB '000) |
|---|---|---|---|
| Net Revenues | 465,027 | 57,623 | 34,723 |
| Gross Profit | 224,611 | 27,832 | 25,584 |
| Gross Margin | 48.3% | 48.3% | 73.7% |
| Operating Income | 59,713 | 7,399 | (9,763) |
| Net Income | 72,472 | 8,980 | 24,479 |
| EPS (Basic) | RMB 3.00 | US$ 0.37 | RMB 1.17 |
| Cash & Equivalents (Year End) | 488,245 | 60,500 | 793,405 |
| Total Assets | 1,213,735 | 150,397 | 1,026,595 |
| Total Liabilities | 271,750 | 33,673 | 149,265 |
Note: US$ amounts are translated at the rate of RMB 8.0702 to US$1.00.
Material Changes vs. Prior Period
- Revenue Surge: Net revenues increased 234% to RMB 465.0 million (US$ 57.6 million), driven almost entirely by the launch of WoW. Online game service revenues jumped from RMB 0.4 million in 2004 to RMB 466.6 million in 2005.
- Profitability: The company moved from an operating loss of RMB 9.8 million in 2004 to an operating profit of RMB 59.7 million in 2005. Net income increased 196% to RMB 72.5 million.
- Margin Compression: Gross margin decreased from 73.7% in 2004 to 48.3% in 2005. This was due to high royalty payments (22% of face value) and amortization of license fees associated with WoW, compared to the lower cost structure of previous operations.
- Equity Method Shift: In December 2005, The9 sold a 21% stake in 9Webzen (operator of MU) to Webzen Inc., reducing its ownership from 51% to 30%. Consequently, 9Webzen's results are no longer consolidated but accounted for via the equity method, resulting in a recorded equity loss of RMB 13.7 million for 2005 due to MU's declining popularity.
- Cash Flow: Net cash provided by operating activities increased to RMB 148.9 million. However, cash and cash equivalents decreased by RMB 305.2 million due to significant investing outflows (RMB 483.7 million) primarily for the acquisition of the remaining interest in C9I (WoW operator) and capital expenditures for server infrastructure.
Guidance, Outlook, Risks, and Unusual Items
Outlook and Management Commentary
- WoW Dependence: Management expects to continue depending on WoW for the majority of revenues in the near future. The company is obligated to pay recoupable advances totaling approximately US$ 51.3 million over four years and commit at least US$ 13.0 million for marketing.
- Future Growth: The company plans to launch proprietary games (e.g., "Joyful Journey West") and has secured licenses for additional titles including "Guild Wars," "Hellgate: London," and "Soul of the Ultimate Nation."
- Capital Expenditures: Expected capital expenditures for 2006 are approximately RMB 147 million.
Material Risks and Contingencies
- Internal Control Weakness: Management identified a material weakness in internal control over financial reporting as of December 31, 2005. This included adjustments related to the acquisition of C9I (goodwill and interest expense) and a reclassification of cash flows regarding RMB revaluation. Remediation is underway.
- Regulatory Environment: The company operates in China through contractual arrangements with Variable Interest Entities (VIEs) like Shanghai IT due to foreign ownership restrictions. There is a risk that PRC authorities may deem these structures non-compliant, potentially forcing a restructuring or cessation of operations.
- Single Product Concentration: 98% of 2005 revenue came from WoW. Any decline in WoW's popularity, server issues, or loss of the license from Vivendi Universal Games (VUG) would materially harm the business.
- Share-Based Compensation: Upon adoption of SFAS 123(R) in 2006, the company estimates an additional stock option compensation expense of approximately RMB 25.6 million (US$ 3.2 million), with RMB 13.8 million expected in 2006.
Key Facts for Investor Verification
- Revenue Concentration: Verify the sustainability of WoW revenue given the 98% concentration and the finite economic life of online games (typically 4-5 years).
- Internal Controls: Monitor the remediation of the disclosed material weakness in internal controls and the effectiveness of financial reporting processes in 2006.
- Regulatory Compliance: Assess the stability of the VIE structure with Shanghai IT and the risk of PRC regulatory changes regarding foreign ownership in the internet sector.
- Licensing Obligations: Confirm the company's ability to meet the US$ 51.3 million recoupable advance and US$ 13.0 million marketing commitment to VUG to maintain the WoW license.
- 9Webzen Transition: Verify the impact of the reduced 30% stake in 9Webzen and the declining performance of the MU game on future equity income.