The9 Limited — FY2016 Form 20-F
Reporting period: Year ended December 31, 2016. This is an annual report, not a quarterly filing; the supplied filing does not provide standalone 2016 Q4 results. Financial statements are prepared under U.S. GAAP. Amounts below are in RMB unless otherwise stated.
Business context
The9 develops and operates online games and related services, including PC, mobile, web and TV games, primarily in China. Revenue is mainly generated from sales of in-game items and game services. Its operating portfolio included commercialized games such as Song of Knights and Firefall, while CrossFire 2, CrossFire New Mobile Game, Soul Awake and Audition AR were in development or awaiting launch. Several investments and ventures, including System Link, are not consolidated.
Financial performance and liquidity
| Metric | FY2016 | FY2015 |
|---|---|---|
| Revenue | RMB56.3m (US$8.1m) | RMB46.6m |
| Net revenue | RMB56.2m | RMB46.4m |
| Gross profit (loss) | RMB7.7m; approximately 13.7% of net revenue | Loss of RMB21.3m |
| Operating loss | RMB295.6m | RMB326.5m |
| Net loss | RMB667.1m (US$96.1m) | RMB354.2m |
| Net loss attributable to ordinary shareholders | RMB676.7m (US$97.5m); RMB28.34 per share | RMB384.6m |
| Operating cash flow | Outflow of RMB181.0m | Outflow of RMB175.6m |
| Cash and cash equivalents, year-end | RMB38.9m (US$5.6m) | RMB49.0m |
| Total assets, year-end | RMB350.9m | RMB538.1m |
| Current liabilities, year-end | RMB573.7m | RMB428.0m |
| Total equity (deficit), year-end | Deficit of RMB702.1m | Deficit of RMB241.1m |
- Revenue rose 20.8% year over year. Online game services increased 20.0% to RMB48.6m; management attributed growth mainly to Firefall and Song of Knights. Average quarterly paying users increased from 10,364 to 11,049.
- Cost of revenue fell 28.4%, primarily because impairment of intangible assets reduced subsequent amortization. Gross results moved from losses in 2014–2015 to a profit in 2016.
- Operating expenses were broadly flat at RMB306.9m. Product development fell 42.3% to RMB78.0m and sales and marketing fell 32.8% to RMB21.3m; general and administrative costs declined 2.1% to RMB129.0m.
- The larger net loss reflected, among other items, RMB244.8m impairment of the L&A available-for-sale investment, RMB68.0m impairment of intangible assets, RMB10.6m goodwill impairment, RMB56.5m interest expense and RMB110.5m share of losses in equity-method investments. A RMB48.1m favorable fair-value change on convertible notes and warrants partly offset expenses.
- Financing cash flow was RMB190.1m, including a pledged loan, Bank of Shanghai borrowing, related-party loans and RMB57.5m raised for CrossFire New Mobile Game. Investing cash flow was an outflow of RMB10.4m.
- Net current liabilities were RMB485.7m at year-end. Accumulated deficit was RMB2,897.8m. The company reported total current liabilities exceeding total assets by RMB222.9m.
Debt, liquidity and going concern
- Year-end borrowings included RMB107.5m in short-term borrowings, RMB35.1m in long-term borrowings and RMB197.3m carrying value of convertible notes. The filing’s contractual-obligations table reports RMB539.5m in total obligations, including scheduled interest, purchases and leases.
- The US$40.05m secured convertible notes bear 12% annual interest and mature in 2018, with a holder option to extend by two years. They are secured by equity in two PRC subsidiaries and the Shanghai office building; conversion and warrant exercise could dilute shareholders. Interest expense included RMB50.4m of convertible-note accretion and interest in 2016.
- A subsidiary’s HK$92.3m loan, secured by L&A shares, was in default after the share price fell below the contractual collateral threshold. The lender may foreclose on the pledged shares and seek any remaining balance from the borrower.
- Management said it believed available financing alternatives and cost controls could fund obligations for the 12 months following the annual report. However, management and the auditor disclosed substantial doubt about the company’s ability to continue as a going concern; the auditor’s report states the financial statements contain no adjustments for the outcome of this uncertainty.
Outlook, risks and unusual items
- Management planned 2017 launches of proprietary titles including CrossFire New Mobile Game, Soul Awake and Audition AR. CrossFire 2 remained in development by Smilegate, with regulatory approvals, launch success and commercial acceptance uncertain.
- The CrossFire 2 arrangement involves substantial potential commitments: the initial license fee was US$50m, with additional fees tied to milestones and a possible extension; The9 and its related parties provided guarantees proportional to their interest in System Link. Failure to launch or generate sufficient revenue could materially affect finances.
- The company cited continued losses, negative operating cash flow, limited cash, financing needs and dependence on a small number of games. Its prospects depend on developing or licensing successful titles, controlling costs and obtaining financing.
- Further material risks include China’s evolving restrictions on foreign participation in online games and uncertainty around the company’s variable-interest-entity contractual structure; dependence on Shanghai IT and its licenses; competition and game-user preferences; and a dispute between Red 5 and Qihoo 360 concerning System Link and Firefall.
- Nasdaq had notified the company in January and February 2017 that it did not meet minimum market-value listing requirements. Compliance periods extended to July 19 and August 21, 2017, respectively; delisting or a transfer to another market could impair liquidity and financing access.
- A RMB170.0m liability remained for unconsumed World of Warcraft points; the company expected legal release in 2029 under its interpretation of applicable law. A former Red 5 employee’s lawsuit was settled in December 2016, and the company said it had no material impact.
- The company reported effective disclosure controls and internal control over financial reporting as of year-end, but the filing includes no auditor attestation on internal controls. Grant Thornton replaced Deloitte as auditor in December 2016; the filing reports no disagreements with Deloitte.
Most important facts for investors to verify
- Whether the company obtained sufficient financing and met near-term obligations after the filing, including the status of the defaulted L&A-share-secured loan and any lender enforcement.
- Whether the company continued as a going concern, given the auditor’s substantial-doubt paragraph, limited cash, current-liability shortfall and continuing operating cash outflows.
- Actual launch timing, approvals, user traction and economics for planned games, and the remaining CrossFire 2 license, guarantee and funding commitments.
- The valuation and recoverability of remaining investments and assets after the L&A, intangible-asset and Red 5 goodwill impairments.
- Nasdaq listing compliance status and potential dilution from convertible-note conversion, warrants and outstanding equity awards.
- Whether PRC regulatory developments or challenges to the VIE arrangements could affect operating licenses, control of Shanghai IT or consolidation of its results.