The9 Limited
Q2 2007 Earnings Call Transcript

Published: 11 Sep 2007

[Operator:]

Good day, ladies and gentlemen, and welcome to The9 Limited’s second quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's conference, Ms. Dahlia Wei, Senior IR Manager of The9 Limited. Please proceed, ma'am.

[Dahlia Wei:]

Thank you, operator. Hello, everyone and thank you for joining us today for The9’s second quarter 2007 financial results conference call. The management with me today are Mr. Jun Zhu, Chairman and CEO and Ms. Hannah Lee, Senior Vice President and Chief Financial Officer. Before we start, I would like to read you the Safe Harbor statement. During the course of today’s call, certain projections or forward-looking statements may be made regarding The9’s future financial performance or future events. We wish to caution you that such statements or predictions are based on our current information and expectations, and actual results may differ materially from those projected in the forward-looking statements. We would also like to refer you to documents that the company files with the U.S. Securities and Exchange Commission. Those documents contain additional information concerning factors that could cause actual results to differ materially from those contained in management’s projections or forward-looking statements. Let me now turn the call over to Mr. Zhu, our CEO, who will provide you with an overview of our business for the quarter.

[Jun Zhu:]

[Presentation in Mandarin] [Translation] Good morning and good evening, ladies and gentlemen. I would like to thank you for participating in our discussion of The9's second quarter 2007 results. As I have a sore throat this morning, I will ask our CFO Hannah to present my prepared remarks and I will participate in the Q&A session later on.

[Hannah Lee:]

Thank you, Dahlia. First, I would like to present a quick overview of our key financial highlights for the second quarter 2007. Net revenues for the second quarter were $35.5 million. Net income was $6.6 million, with earnings of $0.25 per ADS. Now let me go through some highlights of our games during the quarter. First of all, World of Warcraft. In the second quarter of 2007, we conducted server upgrades and mergers for the existing World of Warcraft server sites in preparation of the further content upgrades to the game. Although the temporary shutdowns during the upgrade process had some impact on World of Warcraft's revenue in the second quarter, we believe this transitional process is very important and will benefit the game in the long run. In the second quarter 2007, World of Warcraft's peak concurrent users, PCU, was over 665,000 and average concurrent users, ACU, was over 300,000. As of June 30, 2007, approximately 8.3 million accounts have been registered and activated for the World of Warcraft game in Mainland China. On June 7th, we celebrated World of Warcraft's second anniversary in Shanghai, with hundreds of loyal users physically on-site and millions of users nationwide online to share the event. On the same day, we also announced a co-marketing partnership with Intel, a world-leading IT brand to promote World of Warcraft, The Burning Crusade expansion pack in Mainland China. Meanwhile, we also announced that existing World of Warcraft players can access the Burning Crusade expansion pack content without having to purchase another CD key. Players' expectations is high for The Burning Crusade expansion pack and we trust that players will very much enjoy this content, like other World of Warcraft players do in other parts of the world. We finished the server upgrade and merger process in mid-June. In late June 2007 we introduced Before the Storm, the last major content upgrade patch before The Burning Crusade expansion pack and subsequently launched the eight server sites for World of Warcraft. To date, we have opened ten of the 40 realms in these new server sites and have seen satisfactory results. With everything ready now from an infrastructure perspective, we now expect the Burning Crusade expansion pack to be launched in Mainland China in September 2007. Now let's discuss our newly launched game Soul of the Ultimate Nation, SUN. After over one month of open data testing in the second quarter, we commenced commercialization of Soul of the Ultimate Nation on May 24 under the free to play and item sales model. In early June, we announced a strategic co-marketing partnership with Master Kong a well known consumer goods brand to promote SUN throughout Mainland China. The performance SUN achieved post commercialization once again demonstrated The9's operational capabilities. It is an important milestone for The9 as we transition from a one game company to a multi-game company with diversified revenue sources. On July 11 we launched a content upgrade patch for SUN called Fire Dread Valley and we are currently in preparation for server optimization for SUN's existing server sites and opening of additional server realms including an upcoming upgrade patch called Scarlet Tower. Next about Granado Espada, GE, we started to accept application for limited open beta testing account on August 22 and so far we have received over 200,000 applications. We plan to commence limited open beta testing in September this year. We anticipate this game to also adopt a free-to-play and item sales model when it commercializes. GE is currently in commercial operation in Korea, Japan, Thailand and United States with decent performance and in close beta testing in Taiwan and open beta testing in Singapore respectively. Now some updates on our other licensed games in our portfolio. For Hellgate

[Operator:]

Your first question comes from Paul Keung - CIBC World Markets.

[Paul Keung:]

Good morning. My two questions relate to The Burning Crusades. First, what is the exact date of launch? Second, how much marketing are you looking to spend on the game in the second and third quarter?

[Jun Zhu:]

[Response in Mandarin] [Translation] The Burning Crusades is currently under final technical preparation and that will be launched around September 10.

[Hannah Lee:]

With respect to your question about marketing expenses, we spend about $3 million of marketing in Q2, most of that relates to SUN, about half of that. We spent about $700,000 for WoW and the rest goes to Guild Wars. For Q3, we expect because we are launching Burning Crusades in September, we will be spending much more in terms of WoW. The marketing activity started earlier on in the month and will continue on in September. It will likely be in the ballpark of $1.5 million to $2 million. For SUN, we will continue to spend marketing dollars to promote the game but it will not be in the same magnitude as how much we spent in Q2, probably around the $1 million range. We will definitely spend some marketing dollars on the new game that we are starting internal beta testing, Granado Espada, in late Q3.

[Operator:]

And your next question comes from the line of Wallace Cheung from Credit Suisse. Please proceed, sir.

[Wallace Cheung:]

Hi, Jun, Hannah and Dahlia. Just a quick question on the World of Warcraft, the trend in the second quarter and first quarter. What is the level in terms of ACU and how is the performance in the third quarter as well? Thank you.

[Hannah Lee:]

For quarter two, we do not give, as usual, we do not give out month-over-month trends in terms of exact numbers of the month-over-month PCU and ACU numbers, but because of the server shutdown, there is some impact in the -- which goes from -- the dead server upgrade process goes from April until mid-June, so there is some server upgrade impact in terms of the impact to ACU and PCU in quarter two. However, after the server upgrade impact in June, we’ve seen the user level coming back up and also we introduced a new upgrade patch, Before the Storm, which is the upgrade patch before Burning Crusade. And we’ve seen quite satisfactory results. We also launched a quarter of the eighth server site at the end of June in anticipation for the additional demand with Before the Storm, and also we want to build the capacity for Burning Crusade.

[Wallace Cheung:]

Thank you.

[Operator:]

Your next question comes from the line of Alicia Yapp from Citigroup. Please proceed, Madam.

[Alicia Yapp:]

Good morning. Thank you. For the patch 2.1 upgrade, could you help us understand how much additional content is in the patch and how long it will take for average players to burn through the content? Is it three weeks, six weeks, or eight weeks? And I have one follow-up.

[Hannah Lee:]

It is very hard to quantify as to how much content there is in Burning Crusade. What I can tell you is how this game has been, how the players in the overseas market have been responding. In the States, the game has been launched for quite some time and based on our understanding, the players are still very much into the game and the closest market, i.e. the Taiwanese market, the game has been launched for a few months and we believe the game is still going quite strong. And for China, because the players are definitely much more eager in terms of getting into the new content and leveling up from 60 to 70 and also experiencing the new content with the new characters, we expect there will definitely be an increase of usage after the launch of Burning Crusade. As to how much time it would take to burn through the content, to go through the content of Burning Crusade, it is hard to say whether it will be a month, two weeks or three weeks or four months or six months. It really depends on how much time each player spends on a daily basis in getting through the content. But knowing that Blizzard is a very renowned and experienced developer, it is pushing out upgrades on a regular basis, so we believe for China, we will also push out the localized upgrade pack on a regular basis to satisfy the demand from the Chinese gamers.

[Alicia Yapp:]

Yes, but I actually was asking about the patch 2.1 upgrade that was released at the end of June. I was just --

[Hannah Lee:]

You are asking about Before the Storm?

[Alicia Yapp:]

Yes, Before the Storm. How long do you think the average player burns through the content?

[Hannah Lee:]

I would say it would probably be a couple of months, on average.

[Alicia Yapp:]

Okay, and then can I just ask you one follow-up on SUN; how was the monetization trend since commercial launch in terms of the users and how was it trending in July and August compared to June? And in terms of the virtual items sold, if you can give more color. And then one lastly is on -- can you tell us how you book your revenue on the item-based model? Do you recognize all as revenue when the item was purchased or do you have to book it as deferred revenue first and recognize sporadically based on the estimated lifespan of the item? Thank you.

[Hannah Lee:]

For your first question about how the monetization has been for SUN post commercialization, we are quite happy with the results that we have achieved in the 38 days in the second quarter. And post Q2, we have seen quite satisfactory results too. As you know, for item sales-based games, the revenue actually fluctuates quite a bit in proportion to the amount of new content or new items that we put up for sale. So with more upgrades and more expansion packs to come out, which I had mentioned in my presentation, or when I read Zhu Jun’s presentation, we already pushed out an upgrade and we are planning for server realm optimization and launching new server realms which, from an industry perspective, are measures that we can incentify players to spend more time and spend more money in buying items. With respect to your question about revenue recognition, like all the other companies that use the item sales based model, we do not recognize revenue when people buy these items, depending on the type of item. If they are for one-time usage, we do recognize that revenue upon usage. And if these items are on a “more permanent” basis, we amortize the revenue and recognize it over the estimated player life within that particular game. That is consistent with industry standards.

[Alicia Yapp:]

Thank you so much.

[Operator:]

Your next question comes from the line of Dick Wei from J.P. Morgan. Please proceed, sir.

[Dick Wei:]

Thanks for taking my questions. I have a question regarding SUN. It looks like the early commercialization bookings are strong. I wonder how much is the revenue I guess for the installation package, would it contribute a part of the revenue that you recognized? If you can also talk about how much CapEx you spend related to SUN, that would be great. Thanks.

[Hannah Lee:]

The installation package sales for SUN is very immaterial. It is less than $50,000. For the cost of SUN’s server hardware, it costs about $3 million to $3.5 million.

[Dick Wei:]

If I can follow-up on this, for the Warcraft, when do you expect to launch server nine or 10, or half the capacity for server eight?

[Hannah Lee:]

Currently we have eight server sites that would -- 7.25 sites that are up and running. We still have capacity to open three-quarters of the last server site that we launched in late June. We have started preparation or discussion with Blizzard for future plans in response to the Burning Crusades launch where we anticipate there will be added demand. We will of course act very quickly in response to the players’ demands. The earliest we will be able to add the next server site, i.e. the ninth server site, will be in Q4 because we will be launching Burning Crusades in December. The eight server sites in total provide us with a capacity of about 1 million PCU.

[Operator:]

Your next question comes from the line of Ming Zhao – FIG.

[Ming Zhao:]

Good morning. First on SUN, two small questions really.

[Dahlia Wei:]

I'm sorry, Ming, can you speak up?

[Ming Zhao:]

Sure, yes. If I looked at the average revenue per user paying accounts for SUN, because you only have like 36-37 days in the quarter and you just mentioned I believe it was RMB 68 per month. So if I normalize the monthly payment it should be relatively up, it should be RMB 130 per month, right? Do you think that's aggressive or do you think you will continue to see the ramp up in this average revenue per paying account? That's the first question. The second question is if I work back from your 930,000 PCU for the quarter, including every game and subtract that from the 660,000 for the World of Warcraft, I got pretty much 270,000 PCU for SUN, which is lower than the 400,000 PCU you reported initially. Can you just comment on the trend of SUN for the quarter and what's the trend like into the third quarter? Thank you.

[Jun Zhu:]

[Response in Mandarin] [Translation]

[Hannah Lee:]

Ming, can you kindly explain how did you arrive at RMB 130 monthly revenue? Because what I said in my presentation the 68 RMB has already taken into account the 38 days effect, so it's basically $2.1 million of revenue that we pulled in for SUN divided by the 190,000 PCU, prorated for the 38 days. So it's RMB 68 per month already. So if you do a weighted average for the entire quarter you multiply that by 38 divided by 31 days. The contribution for the quarter will be higher than 68, but I wanted to give you an idea of what the monthly spend will be, that's why I say RMB 68 per month.

[Ming Zhao:]

I think I got 129,000 active accounts, so that's wrong. I think I understand now.

[Hannah Lee:]

Yes it is 190,000. For your second question, the 400,000 PCU that we achieved was during the open-beta testing period. We did not take that into account when we calculated the peak concurrent user post-commercialization. The 270,000 relates to the post-commercialization PCU, weighted average PCU. The trend in Q3 so far has been quite stable. We, however, as you know, as a KPI for item-based models, games, we look more into the percentage of active paying users rather than the PCU numbers. The 190,000 active paying accounts is probably what you want to look into and that's what we have been trying to promote, to make an effort to increase that.

[Ming Zhao:]

Do you think that the RMB 68 per month will see a big upside in the future quarters?

[Hannah Lee:]

Because we don't provide financial guidance, I can't really say whether it's a huge upside. But of course internally, our team for SUN is definitely shooting to increase both the paying user ratio, and also the ARPU. That's definitely our goal, is to increase it from RMB 68. But from an industry perspective, I think we are quite satisfied with the results that we achieved in Q2.

[Operator:]

Your next question comes from Wallace Cheung - Credit Suisse.

[Wallace Cheung:]

I also have a question on the SUN. I just want to understand a little bit on the impact from the programs because you mentioned the trend is still stable in the first quarter. Do you mean like paying accounts trend or the ACU trend? Thank you.

[Hannah Lee:]

For item-based games, the relative importance of ACU compared to a subscription-based game is much less, so we do not provide the ACU number for SUN. But in terms of the PCU number for SUN, the last quarter we achieved 270,000. For this quarter, so far we have been experiencing a stable trend. And in the remainder of the quarter it really depends on the amount of content we push out.

[Operator:]

Your next question comes from Ming Zhao - SFG .

[Ming Zhao:]

Just a quick follow-up question on the lawsuit, the Founder font, is there any update on that?

[Hannah Lee:]

As disclosed in the Other Developments section in the Press Release, the comment that we can have right now is because this litigation is still in its early stage we are uncertain what the eventual outcome will be. We will assert all our rights in the court and we believe that even if determined adversely against us this case would not have any material effect on us.

[Operator:]

Your next question comes from the line of Dick Wei - JP Morgan.

[Dick Wei:]

Maybe a longer-term question in terms of the in-game advertising, what is the plan for The9 to take revenue from in-game advertising and are there any plans to include that in FIFA Online or your two games coming up?

[Hannah Lee:]

For in-game item sales, it is definitely more feasible for casual style games, but we are also being very creative and also looking into other ways to monetize. FIFA Online and Audition 2 and Audition 1 are definitely games that we would take into consideration in terms of exploring opportunities in generating revenue from the in-game advertising, and that is definitely an industry trend where everyone else in the industry is also looking into ways to utilize the huge customer database …industries are also looking into ways to also utilize the huge customer database that we have to do more targeted marketing. That is something that we are also exploring.

[Operator:]

Your next question comes from the line of Wallace Cheung from Credit Suisse. Please proceed.

[Wallace Cheung:]

I have a question on Audition 1 and 2 series. Can you explain a little bit on the overall arrangement say next year, when you try to launch Audition 1 after the expiry of the existing contract with the existing operators? Are you going to buy out all the servers, customer data? How can you keep all the gamers after the expiry of the existing contract? Thank you.

[Hannah Lee:]

Audition 2 is a game that is still currently in development. The exact launch plan has not been determined yet for Mainland China. We would likely look at the performance of the game in Korea first before determining what the exact launch timeline will be for mainland China. In terms of your question about Audition 1, like we said in the press release in July and also in our presentation, the license would commence on August 1, 2008 when the current license expires with the current operator. However, if the expiration date is moved up, then we would have the opportunity to move up our commencement date of our exclusive license. The exact arrangement of transition we are discussing with the developers to work out a plan for a very smooth transition when the time comes in 2008, or whenever it is, if it is earlier. Whether we buy out the servers or do other measures, I think the players, the experience of the players not to have significant downtime and other concerns are our utmost concern so we will definitely take that into consideration in terms of our discussion with the developer of the game.

[Wallace Cheung:]

Can I have just a quick update on the -- because we know that there’s a lawsuit between the G10 flash T3, as well as the 9you. Do these lawsuits have any impact on the Audition 1 and Audition 2 launch in China?

[Hannah Lee:]

Because that lawsuit does not concern The9, we do not think that it is appropriate for us to comment on it. Whether it has any effect on Audition 1 and Audition 2, I think it is more a matter between the -- a corporate matter between these two companies. The development effort as far as we know are still going as planned and for Audition 2, we know that the development is still continuing. And for Audition 1, of course, as you can see from the upgrade patch pushed out by the existing operator, is still continuing. So from a development side point of view, while we do not think that has any impact or it will have any impact on the plans for Mainland China.

[Wallace Cheung:]

Thank you.

[Operator:]

Your next question comes from the line of Alicia Yapp from Citigroup. Please proceed.

[Alicia Yapp:]

Yes, thanks for taking my follow-up. Just quickly on SUN; how have you adjusted the pricing of the virtual items? Do you expect to adjust it? And just give us more color in terms of the number of virtual items available in Q2 versus Q3. Thank you.

[Hannah Lee:]

The pricing of the virtual items, once we determine a price for a particular virtual item, we typically do not change the price. However, the other method that we can increase revenue or “adjust price”, will be to offer different versions of an existing version of an item, i.e. pushing out different items and charging different prices for each different item, depending on their functionality and their use. To say what average price we typically charge for SUN, it is hard for me to say an average price because some of the items, if they are one-time usage, of course they would a lot of times cost less than if the items are more on a permanent basis for permanent use. It is hard for me to comment on the average price. In terms of the number of items for sale, I can get back to you on that. I do not have it at this moment. I do not think, however, it is an indicator as to, it is the only indicator as to how much revenue we can pull in because if we push out the right items at the right price, that will give the players more incentive to spend money to buy these items.

[Alicia Yapp:]

And then for the marketing partnership with Master Kong, is it a one-year relationship or is it two years?

[Hannah Lee:]

I believe it is a one-year relationship.

[Alicia Yapp:]

Thank you.

[Operator:]

Your next question comes from the line of Ming Zhao from SFG. Please proceed.

[Ming Zhao:]

I have one more follow-up question; can you just explain to us some of the change on the balance sheet? Some pretty significant changes there -- one line is the prepayment and other current assets, and also the prepaid royalties. And also the advances from customers and deferred revenue also went up. Can you explain these four lines to us, please?

[Hannah Lee:]

Sorry, Ming, can you repeat the four item lines?

[Ming Zhao:]

Yes, it includes the prepayments and other current assets, prepaid royalties, and advances from customers, as well as deferred revenue.

[Hannah Lee:]

For prepayments and other current assets, there has been an increase from the first quarter to the second quarter because of a prepayment of taxes, of which that entity has the ability to enjoy tax-free status for this year and we are waiting for final approval from the Tax Bureau on that. So we are being prudent in terms of paying the tax first and then getting the refund later, and then at that time when we get the refund, we will be reversing the prepayment. The second question about the prepaid royalties was because of the fact that we have started -- the distributors and the Internet cafés have actually already started ordering more prepaid point cards and prepaid game points, in anticipation for Burning Crusade launch and also because Soul of the Ultimate Nation was just launched in May, we have more prepayment for SUN prepaid cards. For advances from customers and deferred revenue, those two line items should be looked into hand-in-hand. There has been an increase mainly because of SUN’s commercialization. We have an additional revenue stream instead of just one from World of Warcraft. Does that answer your question?

[Ming Zhao:]

Yes, but the prepaid royalties should be the royalty you pay to the developers overseas, right? Compared with the previous quarters, this quarter has a big surge. Does that mean you have included the prepaid royalty to Webzen?

[Hannah Lee:]

I might not have made myself clear. The prepaid royalty is because we've gotten more orders from the distributors. We have to order cards from the licensor of World of Warcraft in advance before we can issue these game cards and game points to the downstream distributors and Internet cafes. So we have to prepay the royalties to the licensor first before we issue these cards. That's why there is an increase in prepaid royalties to licensors.

[Operator:]

At this time we have no further questions. Thank you.

[Dahlia Wei:]

Thank you everyone and thank you again for participating in today's call. If you have additional questions please feel free to contact us. Thank you.