Business Context and Reporting Period
Company: The9 Limited (Nasdaq: NCTY)
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2006
Business Overview: The9 is a leading online game operator in China, primarily focused on operating Massively Multiplayer Online Role-Playing Games (MMORPGs). As of December 31, 2006, the company operated World of Warcraft (WoW) in China, which accounted for approximately 99% of total revenues. The company also operated MU through a joint venture (9Webzen) and launched its first proprietary MMORPG, Joyful Journey West, in September 2006.
Key Financial Metrics (Year Ended Dec 31, 2006)
| Metric | Amount (RMB '000) | Amount (US$ '000) |
|---|---|---|
| Net Revenues | 985,826 | 126,322 |
| Gross Profit | 461,794 | 59,173 |
| Gross Margin | 46.8% | 46.8% |
| Net Income | 312,477 | 40,040 |
| Diluted EPS | RMB 12.72 | US$ 1.63 |
| Cash and Cash Equivalents | 937,846 | 120,173 |
| Total Assets | 1,624,585 | 208,171 |
| Total Liabilities | 288,427 | 36,959 |
| Shareholders' Equity | 1,336,158 | 171,212 |
Note: US$ amounts are translated at the rate of RMB 7.8041 to US$1.00 (Dec 29, 2006).
Material Changes vs. Prior Period (2005)
- Revenue Growth: Net revenues increased 112% to RMB 985.8 million (US$126.3 million) from RMB 465.0 million in 2005. This was driven by the full-year commercial operation of World of Warcraft in China (compared to seven months in 2005).
- Profitability: Net income surged 331% to RMB 312.5 million (US$40.0 million) from RMB 72.5 million in 2005. Operating income increased to RMB 270.2 million.
- Cost Structure: Cost of services rose to RMB 524.0 million due to increased royalties paid to Vivendi Universal Games (VUG) and server costs associated with the full-year WoW operation. Gross margin decreased slightly from 48.3% in 2005 to 46.8% in 2006.
- Operating Expenses: Total operating expenses increased 16% to RMB 191.6 million. General and administrative expenses rose 62% primarily due to increased staff costs and the adoption of SFAS 123(R) for share-based compensation.
- Investment Activity: The company recognized a gain of RMB 23.4 million from the disposal of its interest in a joint venture operating WoW in Greater China regions outside mainland China. Conversely, it recorded an impairment loss of RMB 20.4 million on an equity investment in Object Software.
Guidance, Outlook, Risks, and Unusual Items
Outlook and Recent Developments
- Product Pipeline: The company obtained licenses for several new games in early 2007, including Ragnarok Online 2, Emil Chronicle Online, Huxley, EA Sports FIFA Online, and Audition 2.
- Strategic Investment: In May 2007, Electronic Arts (EA) made an equity investment of approximately US$167 million for a 15% stake in The9.
- Expansion: The company secured the license for the Burning Crusade expansion pack for WoW in January 2007.
Key Risks and Contingencies
- Concentration Risk: The company is heavily dependent on World of Warcraft, which generated 99% of revenues in 2006. Any decline in WoW's popularity or loss of the license would materially harm operations.
- Regulatory Environment: Operations rely on contractual arrangements with Shanghai IT (a Variable Interest Entity) to hold necessary PRC licenses due to foreign ownership restrictions. Changes in PRC laws or interpretation could disrupt operations.
- Government Policy: New regulations require the implementation of an "anti-fatigue system" to limit playtime for minors, which could reduce user engagement and revenue.
- Intellectual Property: Risks include illegal game servers, unauthorized character enhancements, and potential infringement claims.
- Foreign Exchange: The company earns revenue in RMB but has significant obligations (royalties) in USD. Appreciation of the RMB could result in translation losses and increase the cost of USD-denominated obligations.
Investor Verification Checklist
- WoW License Status: Verify the terms and remaining duration of the exclusive license with Vivendi Universal Games/Blizzard, including royalty obligations and minimum guarantees.
- Regulatory Compliance: Confirm the status of the "anti-fatigue system" implementation and the stability of the contractual arrangements with Shanghai IT under evolving PRC regulations.
- Revenue Recognition: Review the methodology for recognizing revenue from prepaid cards and online points, specifically regarding the estimation of usage rates and expiration policies.
- Equity Investments: Assess the valuation and future prospects of remaining equity investments (e.g., 9Webzen, Object Software) given the impairment charges recorded in 2006.
- EA Investment Impact: Analyze the strategic implications and financial terms of the May 2007 investment by Electronic Arts.