The9 (NCTY)

TOP CONTRIBUTORS

Alan Hsieh

The9 is a China-based online video game operator with the exclusive license to operate and distribute World of Warcraft in mainland China. It has licensed the software from Blizzard Entertainment, owned by Vivendi (EPA: VIV), and marketed it to to China's growing middle class and internet-consuming youth.

Gaining the license to distribute pre-paid game time cards for World of Warcraft in June 2005 altered the structure and growth prospects for The9's business, and the company saw over 100% revenue growth and an increase in operating margins between 2005 and 2006, from 12.2% to 26%, due to the agreement with Vivendi Universal Games.^[1] In 2008, The9 primarily licenses hugely scaled online games (Massively Multiplayer Online-games) from other developers, typically based outside of China, and handles the marketing and distribution efforts within the People's Republic of China. The company has a portfolio of over 10 titles, but 99% of the company's total revenues in 2006 came from World of Warcraft.^[2] In 2008, the company acquired new licenses, including the Korean game Atlantica on April 24th, 2008^[3] and most importantly, the right to distribute Blizzard's second expansion game for World of Warcraft: Wrath of the Lich King.^[4]

In April of 2008, The9 announced that it had achieved peak concurrent users of World of Warcraft of over 1 million, meaning at any given time over 1 million users were logged on playing the game.^[5] In Q4 of 2007, the company reported average concurrent logins of 470,000.^[6] Blizzard reported that there were over 3.5 million subscribers to World of Warcraft in China in the beginning of 2007, while there were only 2 million subscribes in North America, and 1.5 million in Europe.^[7]

Business Description

The company's primary business is selling and operating World of Warcraft in mainland China. As part of the licensing agreement, 22% of the each game-time card sold is passed on to Vivendi games as a royalty, and many of the other titles also have this sort of royalty based structure. For each end-user's hour of play time, the company earns ¥0.39.^[8]

In addition to the pre-paid game card business model, The9 has also been employing a free-to-play, pay-for-items model in some of its other games, such as Soul of the Ultimate Nation and Granado Espada. Soul of the Ultimate Nation and Granado Espada had in total 252,000 accounts that were active and paying in 2007, which on average generated ¥73 per month. At present, these titles make up only a fraction of the company's revenues, but do help give ideas on how the company's future games will generate revenues.^[9]

Many of the games in The9's portfolio are under localization development and have not launched yet. These include FIFA online, Hellgate:London, and Audition 2.^[10] The company is also building-out its ability to internally develop games, rather than just licensing them, and plans to release MJSG and Fantasy Melody Online.^[11]

Financial Analysis

^{[12] [13]}

The9's revenues grew 112% between 2005 and 2006, largely due to the launch of China's World of Warcraft in June of 2005. Growth has slowed afterwards, to 30% between 2006 and 2007, as the revenue generation by software is in two parts: first in software sales, and second in game-time card purchases. Sales of software are a one-time event per customer, whereas game-time cards are recurring per user. The company can expect the latter to grow, but cannot sell more software unless it launches new titles. The company's margins suffered in 2007 due to increased internal development^[14], as well as hardware expenses related to upgrades required for the World of Warcraft: Burning Crusade expansion game^[15]

^{[16] [17]} The company's revenues are largely (>95%) earned by its games business, with supplemental revenues coming from associated business such as game support and merchandising. Game-related merchandising has not been aggresively pursued by the company.

Above are the growth rates and margins summarized for the different stages of the company. Assuming that all revenues come from World of Warcraft, (a fair approximation since even though the company owns other titles, almost all revenue comes from this game) the company loses approximately 22% of game-subscription based revenues as a royalty to Blizzard. The remainder of Gross Margin is lost through cost of operating and servicing the game, such as hardware and internet costs. Operating margin is affected by sales and marketing , as well as product development expenses. Operating margin increased between 2005 to 2006 due to the launch of the World of Warcraft game, which required fewer operating expenses as the title was fully developed. However, they have increased again in 2006 to 2007 due to increased internal product development operations for new games in the pipeline, and expenditures required for the expansions to World of Warcraft. ^{[18] [19]}

Trends/Forces

NCTY is a one-trick pony

Given that 99% of all game-related revenues are brought in by World of Warcraft, the company is vulnerable to any problems or issues with the game's popularity. This lack of diversity can be an issue. Other companies, such as Microsoft (MSFT), have experienced significant user backlash when their software has been unavailable for use, such as Holiday season 2007, when the XBox live service was down.^[20] A failure could occur in The9's servers which would not only anger users, but also threaten The9's agreement with Vivendi (EPA: VIV). The contract is set to go until mid-2009, and it is speculated that The9 has an "option" on all expansions of World of Warcraft (which follows naturally, since the expansion requires the original software, which The9 would still hold license to).^[21] There is a risk that this license will not be renegotiated in 2009, and that would be a huge blow to The9's revenue generation.

World of Warcraft's popularity will decline

Prior to June of 2005, the company's primary revenue driver was the title MU Online, a RPG-type game (similar to World of Warcraft) created by a Korean company (WebZen) that helped found The9. Due to a drop in popularity of the title, the company sought to replace it with World of Warcraft, promising Vivendi (EPA: VIV) upfront approximately $74MM and variable unit royalties on the playtime cards.^[22][23] While Blizzard games have had significant staying power in the Asian sphere (Starcraft and Warcraft), it can be expected that World of Warcraft will not stay at the front of gamers' imaginations forever. The company will have to continue to innovate or find popular titles to license to remain viable in the long term.

Diverse game pipeline is an execution risk, but presents potential for growth

The9 has several titles that it has license to or is developing, but has not yet released to the Mainland Chinese market. Each one of these presents a risk for execution, both in terms of marketing and distribution challenges across a large region, as well as technical challenges. More titles will continue to stretch management's resources. However, its proven track record with World of Warcraft aided the company in securing titles expected to do well in China, given its experience in launching blockbuster titles.

Government intervention is a potential risk

The Chinese government's behavior in response to the internet has been erratic, at times banning various websites, such as Wikipedia.^[24] The government has imposed restrictions on gaming cafes, responding to incidences of gamer addiction.^[25] Should the issue of game addition get worse, there is a possibility that the government will step in again. Such action would curb potential play-time hours, thus effectively putting a ceiling on The9's revenues.

Competition

Chinese MMO Players

• Shanda Interactive Entertainment (SNDA) - The top competitor in the Chinese online-gaming market, with diversified game operations ranging from MMOs, to casual online games.
• Perfect World (PWRD) - Another developer and operator of online games in Mainland China, using its own technologies. Its main product is self-titled Perfect World.
• Netease.com (NTES) - the second largest company. However, concerns in 2008 surrounding the company indicate that its development pipeline is weak.

Market Share

In 2007, the Chinese MMO market size was estimated at $1.66 BN.^[26] The major players in this market were Shanda, Netease, Giant Interact, The9, and Perfect World. The9's Market share was approximately 10% by revenue generation.

References

1. ↑ The9 Limited FY 2006 20-F "Revenue Composition and Sources of Revenue Growth" pg.50
2. ↑ The9 Limited FY 2006 20-F "Overview" pg.49
3. ↑ The 9 Limited Press Release, April 28, 2008
4. ↑ The9 Limited Press Release, April 14, 2008
5. ↑ The9 Limited Press Release, April 11, 2008
6. ↑ Seeking Alpha, The9 Earnings Call Transcript FY 2007 Q-4 February 22, 2008
7. ↑ Blizzard Games Press Release, January 11, 2007
8. ↑ Seeking Alpha, The9 Earnings Call Transcript FY 2007 Q-4 February 22, 2008. page 3
9. ↑ Seeking Alpha, The9 Earnings Call Transcript FY 2007 Q-4 February 22, 2008. page 3
10. ↑ Seeking Alpha, The9 Earnings Call Transcript FY 2007 Q-4 February 22, 2008
11. ↑ Seeking Alpha, The9 Earnings Call Transcript FY 2007 Q-4 February 22, 2008. page 2
12. ↑ The9 FY 2007 20-F "CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME" pg.F-2
13. ↑ The9 Press Release, FY 2007 Financial Results "CONSOLIDATED STATEMENTS OF INCOME" pg.17
14. ↑ SeekingAlpha The9 limited Earnigns Call Transcript Q42007 February 22nd, 2008. page 3
15. ↑ SeekingAlpha The9 limited Earnigns Call Transcript Q42007 February 22nd, 2008. page 3
16. ↑ The9 FY 2007 20-F "CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME" pg.F-2
17. ↑ The9 Press Release, FY 2007 Financial Results "CONSOLIDATED STATEMENTS OF INCOME" pg.17
18. ↑ The9 FY 2007 20-F "CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME" pg.F-2
19. ↑ The9 Press Release, FY 2007 Financial Results "CONSOLIDATED STATEMENTS OF INCOME" pg.17
20. ↑ Kotaku "Xbox live downtime due to service attack"
21. ↑ Microsoft (Associated Press) "The9 up with 'Warcraft' deal expansion" April 14, 2008
22. ↑ China Net Investor " The9 commits $74m for WoW; World of Warcraft, The9, Vivendi Universal " The9 commits $74m for WoW; World of Warcraft, The9, Vivendi Universal " Novermber 30, 2004
23. ↑ The9 FY 2007 20-F "KEY INFORMATION" pg.6
24. ↑ New York Times "Chinese Government Relaxes Its Total Ban on Wikipedia" October 16, 2006
25. ↑ BBC "China imposes online gaming curbs" August 24, 2005
26. ↑ SeekingAlpha "It's a Perfect World for Chinese Gaming Developers" October 3, 2007