NCTY

Business Context and Reporting Period

Company: The9 Limited (Nasdaq: NCTY)
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2007
Business Overview: The9 is a leading online game operator in China, primarily focused on Massively Multiplayer Online Role-Playing Games (MMORPGs). The company operates through a holding company structure in the Cayman Islands, utilizing contractual arrangements with affiliated PRC entities (Variable Interest Entities) to hold necessary operating licenses due to foreign ownership restrictions. The company's revenue is heavily concentrated in the operation of World of Warcraft (WoW) in China.

Key Financial Metrics (Year Ended Dec 31, 2007)

Note: US$ amounts are translated at the rate of RMB 7.2946 to US$1.00 as of December 31, 2007.

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 30% to RMB 1.28 billion (US$175.4 million) from RMB 985.8 million in 2006. This growth was driven by the launch of the Burning Crusade expansion for WoW and two new MMORPGs (Soul of the Ultimate Nation and Granado Espada). WoW accounted for approximately 92% of total revenues in 2007.
• Profitability Decline: Despite revenue growth, Net Income decreased 23% to RMB 240.9 million (US$33.0 million) from RMB 312.5 million in 2006. Operating profit declined 13% due to a 79% increase in operating expenses.
• Expense Increases:
  • Operating Expenses: Rose to RMB 343.7 million from RMB 191.6 million. Increases were driven by sales and marketing (up 73%), general and administrative (up 80%), and product development (up 35%).
  • Impairment Charges: Impairment of intangible assets increased significantly to RMB 18.7 million (from RMB 0.9 million) due to the termination of the Guild Wars license.
• Other Income/Expense: Shifted from a net income of RMB 28.4 million in 2006 to a net expense of RMB 30.1 million in 2007. This was primarily due to a RMB 51.0 million foreign exchange loss resulting from the appreciation of the RMB against the US dollar and a decrease in government financial subsidies.
• Liquidity: Cash and cash equivalents more than doubled to RMB 2.22 billion (US$303.7 million), bolstered by a US$167 million equity investment from Electronic Arts (EA) in May 2007 and strong operating cash flows.

Guidance, Outlook, Risks, and Contingencies

• Management Commentary: Management expects to continue depending on WoW for the majority of revenues in the near future. The company is pursuing a "4D" strategy: Dedicated services, Diversifying portfolio, Developing proprietary games, and Delivering enriched community experiences.
• Key Risks:
  • Concentration Risk: Extreme reliance on a single game (WoW), which accounted for 92% of revenues. The exclusive license with Vivendi Universal Games (VUG) expires in June 2009.
  • Regulatory Risk: Significant uncertainty regarding PRC laws governing foreign ownership of internet content. The company relies on contractual arrangements with Shanghai IT (a VIE) to hold necessary licenses. Changes in regulations could disrupt operations.
  • Internal Controls: Management concluded that internal controls over financial reporting were not effective as of December 31, 2007, citing a material weakness due to a lack of sufficient knowledge and training in U.S. GAAP interpretation.
  • Foreign Exchange: The company is exposed to currency risk as revenues are in RMB while significant obligations (royalties to VUG) and assets are in USD. The appreciation of the RMB resulted in significant translation losses.
• Contingencies:
  • Legal Proceedings: Awaiting an initial hearing date for a lawsuit filed by Beijing Founder Electronics Co., Ltd., alleging that WoW client installation packages infringed on their font intellectual property rights.
  • Contractual Obligations: The company has committed to pay approximately US$51.3 million in recoupable advances against royalties for WoW over a four-year period, plus marketing commitments.

Important Facts for Investor Verification

• WoW License Renewal: Verify the status of negotiations for the renewal of the exclusive WoW license with VUG, which expires in June 2009. Failure to renew would be catastrophic given the 92% revenue concentration.
• Internal Control Remediation: Monitor the progress of the remediation plan for the material weakness in internal controls over financial reporting to ensure future financial statement reliability.
• Regulatory Compliance: Assess the stability of the contractual arrangements with Shanghai IT and the risk of PRC regulatory changes regarding foreign ownership of internet content providers.
• Game Portfolio Diversification: Evaluate the commercial success and user adoption of new proprietary and licensed games (e.g., Joyful Journey West, Granado Espada) to determine if the company can reduce its dependence on WoW.
• Foreign Exchange Exposure: Review the company's hedging strategies (if any) and the impact of continued RMB appreciation on future USD-denominated earnings and royalty obligations.