The9 Ltd (NASDAQ: NCTY) - HOLD

Prepared by: Vivian Li

Key Statistics

Trade Time	18 July 2008
Last Trade Price	$26.50
Market Cap	$756.47 M
Share Outstanding	28.763 M
Average Daily Volume	208,230
52-wk High	$52.21
52-wk Low	$15.05
Beta	1.09
EPS	$1.36
P/E	18.36

Data provided by Reuters.com

Business Overview

The9 Limited, incorporated in December 1999, is a leading online game operator in China. As of March 31, 2008, The9 City had close to 38.1 million registered users. The Company’s business is primarily focused on operating massively multiplayer online role-playing games (MMORPGs). Its major products include:

-          Affiliates operating licensed games, e.g. World of Warcraft (WoW), MU, Soul of The Ultimate Nation (SUN) and Granado Espada (GE).

-          The proprietary MMORPG, e.g. Joyful Journey West and Warriors of Fate Online. 

-          Other exclusive licensed MMORPGs and advanced casual games, e.g. Hellgate: London, Ragnarok Online 2, Emil Chronicle Online, Huxley, FIFA Online 2, Audition 2, Field of Honor, Audition and Atlantica. 

-          Other Products and services, include game operating support, website solutions and advertisement services, short message service (SMS), sales of its Pass9 system, and licensing of its games to third parties.

1)      Rising Demand for Asian Online Gaming Market

One of the largest video game publishers in the world - Electronic Arts (EA) Inc. predicted that Asia Pacific’s software market will grow from over $8 billion in 2007 to $12 billion by 2010 with online and mobile games as main drives (Reuters New, June 18^th 2008). EA also expected a substantial rising demand for online gaming in China, which by some estimates has now surpassed the US to become the world’s largest Internet market. Online gaming are particular popular in China as they are less expensive than consoles. In fact, EA has purchased a stake of The9 Ltd in April 2008, and expect China to become one of its three fastest-growing Asian markets in a year or two.

Seeking Alpha (May 15^th, 2008) reported that video game industry is one of the most attractive area to invest right now. It says that the video game industry is still at its very beginning stage, it will grow to be bigger than movies and TV combined as it leverages its key advantages of interactivity, connectivity and non-linearity. It also mentioned the rising popularity of massively multiplayer online (MMO) gaming and casual gaming. There are more than 200 million people who play online casual games every month, both downloadable and browser games. The9 Ltd’s focus on product diversification and casual game (e.g. FIFA Online 2, Audition 2) development is a wise decision and will definitely add value to its shareholders in the long run.

2)      The9’s Transformation to R&D Company

The9, which used to be an agency for large foreign games rather than an independent developer, is paying more and more attention on independent R&D. In April 2008, The9 Ltd announced an investment of USD $38 million in a Korea-based online gaming company G10 Entertainment Inc. (a subsidiary of T3), which is the developer of the popular online game Audition.

The company’s president Ms. Xiaowei Chen also mentioned to Sina.Com that “The9 has set up a 200 people R&D team and has planned to launch at least five self-developed online games soon”.

3)     International Expansion and Integration

Strategic Affiliation and Joint Venture

On July 7^th, The9 Ltd announced that it has entered an agreement with Korean online game developer T3 Entertainment Co. Ltd. to form a joint venture. The joint venture will strengthen the companies’ partnerships in game development and publishing. It will also ensure The9’s involvement in the development of Audition 2, as well as other games in the Audition game series. In fact, The9 Ltd already announced (on July 9^th) that it would soon finish the Beta Test of “Audition 2” to satisfy the eager anticipation of dance game player. Such joint venture may also enhance The9’s brand name and promote its products to international online game market.

Promote Self-Developed Games to Overseas Market

The9 Ltd is expected to explore overseas market with its game products. The company’s president Ms. Chen released to Xinhua New (July 16^th 2008) that the company has already signed agreements with the overseas operators for one of its self-developed games Joyful Journey West.

4)     Promotion and Development of Current Products

Promotion on World of Warcraft

WoW is a full-view, three-dimensional (3D) MMORPG developed by Blizzard Entertainment - the game development studio of VUG, which has developed personal computer (PC) games, including the Warcraft, Diablo and StarCraft series.

The9 is well-known as an online game operator for WoW. The revenue from the game accounted for more than 90% of the company’s total revenue.  As of June 2008, there are approximately 11 million registered player of WoW under The9’s operation and the concurrent user number of WoW has exceeded one million on 22 April 2008.

In order to further promote WoW, The9 Ltd, Blizzard Entertainment and China Merchants Bank announced on 13^th June, 2008 that they will jointly issue credit cards featuring WoW, as part of their cooperation on brand and marketing. The new credit cards also link the credit accounts to the online game accounts, which would provide more convenience for the WoW players. 

Product Diversification and Development

By the end of 2008, The9 Ltd will launch an action game Warriors of Fate Online. Other possible games will include the Audition2, FIFA Online2 and WoW’s expansion set – the Wrath of the Lich King. The9 also invested USD $39 million for a minority stake in G10, a Korean based game developer.  Hopefully all those diversification and development will bring substantial amount of future income to the company.

5)     Company’s Financial Performance

The9 Ltd’s Q1 revenue rose 63% year-over-year to $62.7 million. Fully diluted earnings per share stood at $0.46 compared with $0.36 a year earlier. It attained aggregate peak concurrent users of approximately 1.2 million, and as of March 31^st 2008, it had over 38.1 million total registered users.

Net Revenue 

Net revenue of The9 Ltd attributable to the operation of subscription-based game included revenues from game playing time, merchandise and installation package sales. For Q1 2008, online game services net revenues were USD $62.7 million, representing a 4% increase from USD $60.4 million in Q4 2007 and a 63% increase from USD $38.5 million in Q1 2007.  The results were mainly driven by “resilient growth” in the World of Warcraft game, despite the usual seasonal weakness in the first quarter. Meanwhile, the Soul of The Ultimate Nation and Granado Espada games performed in line with expectation. The net revenue increase is also due to the first full-quarter revenue contribution from GE.

Profit from Operation

Net Income and Diluted Earning Per Share

Cash Balance

The decrease in cash and cash equivalents in Q1 2008 was mainly due to the combined result of transfers of certain cash balances to six-month fixed deposits (which were reflected under short term investments), prepaid royalty payments to game licensors, share repurchase program, and capital expenditures relating to game server sites. The cash outflow is offset partially by cash receipts from sales of prepaid game points.

Direct Competitor Comparison

The9’s major competitors include Shanda Interactive Entertainment Limited, 163.com affiliated with NetEase, Giant Interactive Group, Sohu.com and Perfect World, Co. Ltd. The following table shows that NCTY outperformed its peers and the industry average in terms of Revenue Growth, but substantially below its competitors in terms of Gross Margin and Operating Margin, its EPS is higher than GA but much lower than SNDA. Hence The9’s excellence in financial performance is not obvious.

Direct Competitor Comparison
	NCTY	GA	SNDA	NTES	Industry
Market Cap	731.9 M	2.62 B	1.76 B	2.53 B	102.72 M
Employ­ees:	1,361	1,016	2,564	2,368	462
Qtrly Rev Growth (YoY):	62.7%	N/A	46.5%	20.8%	1.2%
Revenue (ttm):	212.43 M	246.57 M	397.99 M	340.76 M	124.58 M
Gross Margin (ttm):	45.37%	88.29%	74.12%	81.73%	33.01%
EBITDA (ttm):	N/A	N/A	182.45 M	204.72 M	8.22 M
Oper Margins (ttm):	20.46%	68.57%	40.27%	55.82%	1.22%
Net Income (ttm):	38.77 M	179.87 M	181.21 M	180.60 M	-399.45 K
EPS (ttm):	1.366	0.783	2.474	1.384	N/A
P/E (ttm):	19.40	13.93	9.81	15.08	19.41
PEG (5 yr expected):	0.59	0.57	0.57	0.96	2.35
P/S (ttm):	3.49	10.61	4.35	7.41	0.97
GA = Giant Interactive Group, Inc. NTES = Netease.com Inc. SNDA = Shanda Interactive Entertainment Ltd Industry = Gaming Activities

Data provided by Yahoo Finance

Furthermore, The9 Ltd still lags behind its immediate rival Giant Interactive in Q1 2008. NYSE-listed Giant Interactive (GA) is the developer and operator of popular online game ZT Online. It released its first quarter results on May 21^st 2008, the company’s Q1 revenue is $67.3 million, led NCTY by $4.6 million. Therefore Giant maintained the lead it has held since 2007, when it surpassed The9 to become China’s third largest online game company (in terms of revenue).

6)     Other Concerns- Sichuan Earthquake

The9 Ltd said that its gaming operation would be suspended from May 19^th to May 21^st – a national period of mourning for the tens of thousands of victims of Sichuan Earthquake in China. Citigroup Analyst Alicia Yap said the second quarter revenue for all the gaming companies will be hurt from the suspension of game services during the mourning period and the earthquake’s impact on the companies’ operations in Sichuan Province, China.   Specifically, Yap predicts an approximate 1% revenue decline on the day of the earthquake, and another 3% to 5% decline for the three-day shutdown period.