NCTY

Business Context and Reporting Period

This summary covers The9 Limited's (The9) Annual Report on Form 20-F for the fiscal year ended December 31, 2008. The9 is a Cayman Islands-incorporated company primarily engaged in the development and operation of online games in the People's Republic of China (PRC). The company operates through a Variable Interest Entity (VIE) structure due to PRC restrictions on foreign ownership of internet content provision licenses. The reporting period is characterized by the impending expiration of the company's license to operate World of Warcraft (WoW) in China on June 7, 2009, which accounted for approximately 91% of total revenue in 2008.

Key Financial Metrics (Year Ended Dec 31, 2008)

Note: US$ amounts are translated at the rate of RMB 6.8225 to US$ 1.00.

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 33.8% to RMB 1.71 billion, driven primarily by a 35.3% increase in online game service revenues. This growth was fueled by the continued popularity of WoW following the launch of the "Burning Crusade" expansion and full-year contributions from new titles Soul of the Ultimate Nation (SUN) and Granado Espada (GE).
• Profitability Decline: Despite revenue growth, Net Income plummeted 59.8% to RMB 96.8 million. Profit from operations dropped 43% to RMB 134.5 million.
• Margin Compression: Gross margin decreased from 45.3% in 2007 to 41.7% in 2008. This was caused by higher royalty payments and a significant increase in depreciation expenses (RMB 68.4 million) related to WoW servers due to the shortened expected useful life following the non-renewal of the license.
• Impairment Charges: The company recorded RMB 82.1 million in impairment charges for equipment and intangible assets in 2008, compared to RMB 18.7 million in 2007. This included write-downs on upfront license fees for games with unsatisfactory market acceptance.
• Operating Expenses: Total operating expenses surged 68.5% to RMB 579.0 million. General and administrative expenses increased 77.1% due to asset write-offs related to the WoW license expiration and increased professional fees.

Guidance, Outlook, and Risks

Outlook and Management Commentary

Management explicitly states that the license to operate World of Warcraft expired on June 7, 2009, and was not renewed. As of the filing date, The9 had not identified a product to replace WoW. The company warns that if it cannot acquire, develop, or license a replacement product, revenues will be materially impacted in the next 12 months.

Subsequent to year-end, the company announced additional charges expected in 2009, including:

• Full impairment of goodwill related to WoW (RMB 30.2 million).
• Impairment of prepaid royalties paid in 2009 but not consumed (RMB 104.0 million).
• Refund costs for unactivated WoW game point cards (estimated maximum RMB 28.0 million).

Key Risks and Contingencies

• License Expiration: The loss of the WoW license, which generated 91% of 2008 revenue, poses an existential threat to near-term financial performance.
• Regulatory Environment: The company operates in China through contractual arrangements with affiliated entities (VIEs) due to foreign ownership restrictions. Changes in PRC laws or enforcement could disrupt operations.
• Competition: The online game market in China is highly competitive with low barriers to entry. The company faces risks from competitors with greater resources and the potential for "hit-driven" market dynamics.
• Internal Controls: While management concluded that internal controls were effective as of December 31, 2008, a material weakness regarding U.S. GAAP knowledge was identified and remediated during the year.
• Legal Proceedings: The company is involved in litigation with Blizzard Entertainment regarding the termination of the WoW license and with Beijing Founder Electronics regarding font infringement.

Investor Verification Checklist

• Replacement Strategy: Verify the status of negotiations for new game licenses or the development timeline for proprietary games (e.g., World of Fighter) intended to replace WoW revenue.
• 2009 Financial Impact: Confirm the actual magnitude of the subsequent charges mentioned (goodwill impairment, royalty write-offs, and refund liabilities) in Q1/Q2 2009 filings.
• Liquidity Position: Assess whether the RMB 2.15 billion cash balance is sufficient to sustain operations and fund new game acquisitions without additional equity dilution, given the projected revenue drop.
• Regulatory Compliance: Monitor any changes in PRC regulations regarding VIE structures or foreign ownership in the internet gaming sector.
• Legal Outcomes: Track the resolution of lawsuits against Blizzard Entertainment and other intellectual property disputes.