NCTY

Business Context and Reporting Period

The9 Limited (NASDAQ: NCTY), a leading online game operator in China, reported its unaudited financial results for the third quarter ended September 30, 2007. The filing was submitted on November 19, 2007. The company's business focuses on operating and developing high-quality MMORPGs in mainland China, including licensed titles such as World of Warcraft and Soul of the Ultimate Nation (SUN), as well as proprietary titles like Joyful Journey West.

Key Financial Metrics

Material Changes vs. Prior Periods

• Revenue Growth: Net revenues increased 17% quarter-over-quarter (QoQ) and 35% year-over-year (YoY). This was driven by a 16% increase in online game services revenue, primarily due to the launch of the World of Warcraft: The Burning Crusade expansion and full-quarter contributions from Soul of the Ultimate Nation.
• Profitability Decline: Net income decreased 25% QoQ and 41% YoY. Operating profit increased 9% QoQ but decreased 31% YoY.
• Expense Increases: Operating expenses rose 19% QoQ and 99% YoY. This was largely due to increased sales and marketing for the World of Warcraft expansion and a full-quarter impact of share-based compensation expenses (RMB 17.2 million in Q3 vs. RMB 9.2 million in Q2).
• Other Expenses: The company reported other expenses of RMB 16.1 million, compared to other income of RMB 4.1 million in the prior quarter. This shift was caused by increased foreign exchange losses and the absence of a financial subsidy received in the previous quarter.
• Share Count: Diluted weighted average shares outstanding increased from 26.7 million in Q2 to 29.6 million in Q3 due to the issuance of approximately 4.5 million shares to Electronic Arts Inc. in May 2007, impacting EPS.

Guidance, Outlook, and Management Commentary

Management expressed satisfaction with record total net revenues and strong bottom-line earnings. Chairman Jun Zhu highlighted the strong organic growth of World of Warcraft and the stable revenue from SUN. The company reported aggregate peak concurrent users of approximately 985,000 and over 27.6 million total registered users as of September 30, 2007.

Regarding future outlook, management noted:

• Expansion: Continued growth momentum for World of Warcraft is expected with continuous content upgrades and potential new server sites.
• Diversification: The company launched Granado Espada into full-scale open-beta testing in late October 2007 with promising user feedback.
• International Licensing: The9 signed a license agreement to operate its first proprietary game, Joyful Journey West, in Malaysia, marking a milestone in marketing self-developed products overseas.
• Accounting Change: The company changed the depreciation life of servers to four years, effective July 1, 2007, which is expected to decrease quarterly depreciation charges by approximately RMB 12.6 million prospectively.

Risks: The filing includes a Safe Harbor statement noting risks such as limited operating history, Chinese government policies, internet regulations, and the ability to retain players and acquire appealing games.

Investor Verification Checklist

• Revenue Sustainability: Verify the longevity of the revenue spike from the World of Warcraft: The Burning Crusade expansion and the performance of the newly launched Granado Espada.
• Expense Management: Monitor the trajectory of share-based compensation and marketing expenses, which significantly impacted net income in Q3.
• Foreign Exchange Exposure: Assess the impact of RMB/USD fluctuations on future earnings, given the significant foreign exchange loss reported in Q3.
• Share Dilution: Confirm the impact of the increased share count (due to the EA investment) on future earnings per share calculations.
• Regulatory Environment: Review updates on Chinese government regulations regarding online gaming and internet cafes, as cited in the risk factors.