The9 Limited
Q3 2007 Earnings Call Transcript

Published: 16 Nov 2007

[Operator:]

Good day, ladies and gentlemen, and welcome to the The9Limited’s third quarter earnings conference call. My name is Antoine and I’llbe your coordinator for today. (Operator Instructions) I would now like to turnthe call over to your host for today’s conference, Ms. Dahlia Wei, Senior IRManager of The9 Limited. Please proceed, Madam.

[Dahlia Wei:]

Thank you, Operator. Hello, everyone and thank you forjoining us today for The9's third quarter 2007 financial results conferencecall. The management with me today are Mr. Jun Zhu, Chairman and ChiefExecutive Officer, and Ms. Hannah Lee, Senior Vice President and ChiefFinancial Officer. Before we start, I would like to read you the Safe Harborstatement. During the course of today’s call, certain projections orforward-looking statements may be made regarding The9's future financialperformance or future events. We wish to caution you that such statements orpredictions are based on current information and expectations and actualresults may differ materially from those projected in the forward-lookingstatements. We would also like to refer you to documents that thecompany filed with the U.S. Securities and Exchange Commission. Those documentscontain additional information concerning factors that could cause actualresults to differ materially from those contained in the management’sprojections or forward-looking statements. Let me now turn the call over to Mr. Zhu, our CEO, toprovide you with an overview of our business for the quarter. Jun Zhu (Translation) Good morning and good evening, ladies and gentlemen. I wouldlike to thank you for participating in our discussion of The9's third quarter2007 results. First, I would like to present a quick overview of the keyfinancial highlights for the third quarter of 2007. The9 revenues for the third quarter was $42.2 million. Netincome was $5.1 million, or earnings of $0.17 per ADS. Now let me go over some highlights of our games during thequarter. First of all, World of Warcraft; after a series of detailedpreparations, we launched WoW

[Hannah Lee:]

Thanks,Dahlia. Thanks, Jun. For the third quarter 2007, The9 reported net revenues of$42.2 million, a 17% increase compared to the previous quarter and a 35%increase year over year. The revenue increase was primarily because of higherrevenue from World of Warcraft, especially after the launch of The BurningCrusade expansion pack in early September and full quarter revenue contributionfrom Soul of the Ultimate Nation. Netrevenues attributable to the operations of subscription-based games, whichincluded revenues from game playing time, merchandise, and installation packagesales, increased by 13% quarter over quarter and by 21% year over year to $37.2million. The increase in such revenues was mainly due to higher concurrent userlevel as well as user usage level after the launch of World of Warcraft

[Operator:]

(Operator Instructions) Your first question comesfrom the line of Jason Brueschke with Citigroup. Please proceedwith your question.

[Jason Brueschke -Citigroup:]

Thank you. Good morning, everyone. I actually have twoquestions but I will respect the request and only ask one and get back inqueue. Hannah, can you help us think about the model and the leverage? You’vehad really good growth over the last year. You grew revenues 35% year over yearthis quarter but your earnings declined around 50%. I understand that you arein expansion mode and you are launching new games and what have, but it alsoseems like to me there’s a lot of associated costs with the business model aswe go forward. I’m just wondering, when can we expect the margins to get backto where they were a year ago? The pro forma margins are around 29% versus 19%.Just conceptually, is this a permanent hit to margins or is this something thatover a year or 18 months or whatever that we should see those margins comingback? Thanks.

[Hannah Lee:]

Thanks for your question. Your question about the growth,last year if you looked at 2006, we basically were only operating one game,which has been -- we have taken advantage of the economy of scale and we do nothave any games to be launched. This year, as we said, we are in expansion modeand almost every single quarter, last quarter were launching SUN, this quarterwe were launching GE, and as our CEO has just said in his presentation, we aregoing to start the closed beta testing of FIFA Online by the end of ’07. And coming up in our pipeline, we will have more games to belaunched in the future. If you really dissect our P&L in the operatingcosts, unavoidably there will be product development costs because we areputting more efforts into developing our own games. We are also increasingsales and marketing for future games that we are pushing out to the market. In terms of the general and administrative expense, as Isaid on the call, since the second quarter, since May, because of certainoptions that we granted, the non-cash share-based compensation expense hasincreased and the amount that, the comparable amount in 2006 is actually veryimmaterial. That’s why I encourage everyone to actually look at the last pagewhere we actually disclose all these non-cash expenses. The depreciation charge is also a big expense within cost ofservices, share-based compensation, and foreign exchange loss is also a newitem because of the U.S. dollar deposit that we have received from theinvestment that we have from EA in late Q2. The foreign exchange loss basicallydoubled in Q3 versus Q2. So that also has an impact on the net revenue line. But from a game-by-game perspective, we are still -- if youare still just looking at World of Warcraft by itself, we are still trying tomaintain at least a mid-25% level of margin by itself. But you have to takeinto account adding the additional pieces of other games like SUN, GE, andother pre-launch costs that we need to take into account to in the quarters thatwe are planning to launch these games.

[Jason Brueschke -Citigroup:]

Okay. Thanks, Hannah. I’ll get back in the queue.

[Operator:]

Your next question comes from the line of Paul Keung withCIBC World Markets. Please proceed with your question.

[Paul Keung:]

Just a question on the World of Warcraft; what was thetiming of the -- that you have in your CapEx forecast for the next couple ofservers for the game? And second, related to that, are you in activediscussions with Blizzard to maybe perhaps extend the contract? Or is thissomething you tend to just -- you would partner your discussions later in theyear?

[Hannah Lee:]

I’ll answer the first part of your question regardingcapital expenditure for World of Warcraft and I will leave to for Mr. Zhu toanswer your second question about the attempt to renew the contract. We are planning, already planning to add another new serversite for World of Warcraft because with the anticipated demand we have and weare also aware that there is going to be a new expansion pack, which we areanticipating also, so in Q1 most likely we will be launching a new server sitefor World of Warcraft, i.e. the ninth server site. And a server site for Worldof Warcraft would cost about $7 million. Jun Zhu (Translation) Before Q3, we had been concentrating on the operation anddiscussion with Blizzard regarding the launch of The Burning Crusade, but afterthat was launched, we started discussions with them regarding the renewal ofthe contract, as you mentioned. So far, we don’t have any comment in thatregard. But we are very confident to eventually renew the contract of WoW withBlizzard. As there is a second expansion pack for WoW called Wrath ofthe Lich King, that launch scheduled is not yet announced by Blizzard. If thatwere to be launched before June ’09, according to the contract that is stillentitled to The9. This expansion pack has a lot of features, such as increasedthe maximum level from 70 to 80 and also adding a new career of characters andalso some character customization services, things like that. We think this isvery good content upgrade. Both The9 and Blizzard hope that this expansion packwill be launched globally at the same time.

[Operator:]

Your next question comes from the line of Dick Wei with JPMorgan. Please proceed with your question.

[Dick Wei:]

Thanks for taking my questions. I want to ask more aboutSUN. If you can tell us more about the PCU that you saw in the third quarterand what kind of trend is looking for the fourth quarter, that would be great.Thanks.

[Hannah Lee:]

The PCU for SUN for the third quarter is about 170,000. Thetrend for the fourth quarter because, as we said in the presentation, we areplanning to push out further expansion packs and further new features for SUNand we are working very closely with Webzen on that. We anticipate that the PCUand also the average revenue per paying account will increase.

[Operator:]

Your next question comes from the line of Evan Wilson withPacific Crest Securities. Please proceed with your question.

[Evan Wilson:]

I would also like to ask a little more on SUN. Hannah, wouldit be fair to say that in the quarter, SUN wasn’t profitable on a standalonebasis?

[Hannah Lee:]

I wouldn’t say that. SUN is actually still profitable in thethird quarter on a standalone basis. Of course, the biggest expense that wewill have is the royalty and the royalty is actually calculated as a proportionof the revenue, and the other expenses would be depreciation and the servercosts for SUN is actually much, much smaller compared to World of Warcraft, sothe fixed cost that we need to cover in order to break even for SUN is actuallymuch lower than World of Warcraft. I can say that for Q3, it is still making money for us.

[Evan Wilson:]

And a follow-up to that point then, as you look at thebuild-out of the server infrastructure for SUN and potentially raising the costof that break-even point, now that we have a pretty good gauge of how the gameis trending in terms of popularity, what are your plans on the serverinfrastructure growth for SUN in particular?

[Hannah Lee:]

Currently and for the last month or so, we have alreadystarted merging servers within the existing server infrastructure we have toincrease the utilization of the server. So from one hand, we are increasing theuser, enhancing the user experience where on the other hand, from a capitalexpenditure perspective, we are not incurring any additional costs. So from looking out for Q1 or for the rest of Q4, we do notanticipate we will need to add additional server infrastructure to increase theexisting capacity, whereby we are actually merging the existing server so wecan increase the user experience, where on the other hand, we can free up somehardware so we can open up new realms for new players to go in and for existingplayers to move over to other realms and build new characters that way.

[Evan Wilson:]

Great. Thanks.

[Operator:]

Your next question comes from the line of Ming Zhao withSIG. Please proceed with your question.

[C. Ming Zhao -Susquehanna:]

Thanks for taking my question. Good morning. Just a quickquestion; in the Chinese media, it’s reported that The9 may take some stake inMSN China. Could you comment on that? Jun Zhu (Translation) Sorry, we cannot comment on the rumors.

[C. Ming Zhao -Susquehanna:]

Thank you.

[Operator:]

Your next question comes from the line of Andrey Glukhovwith Brean Murray.

[Andrey Glukhov -Brean Murray:]

Thanks for taking the question. Hannah, it sounds like Worldof Warcraft is bouncing up very nicely and you guys are talking about goodmomentum in Granado Espada. Can you talk us through the near-term dynamic insales and marketing? Do you need to step it up to strike the iron while it’shot?

[Hannah Lee:]

I guess it would be helpful if I give you a breakdown of themarketing expense that we had for Q3, and I can talk about Q4 and give you somecolor on Q4. We incurred about $4.3 million of marketing costs for Q3 and about$2.6 million of that relates to World of Warcraft. We had about $1 million ofthat related to SUN, with the rest of that being spread around Guild Wars,Granado Espada, and Hellgate

[Andrey Glukhov -Brean Murray:]

Okay, that’s helpful. Thank you.

[Operator:]

Your next question is a follow-up question from the line ofJason Brueschke with Citigroup. Please proceed with your question.

[Jason Brueschke -Citigroup:]

Thank you. My question involves Hellgate

[Jason Brueschke -Citigroup:]

And maybe can I have one follow-up, since I’m at the back ofthe queue, can you give us an update on the status of Audition 1? There’s someI think confusion in the market, or at least I’m confused, as to whether youhave the rights to this game or whether [Nineu] has the rights to Audition 1.Thanks. Jun Zhu (Translation) We have actually received notice of termination from theKorean developer. We think their termination is wrongful and we would like toreserve our rights in this matter and may consider commencing legal action. But recently, we have been in talks with the currentdeveloper regarding the long-term operation plans for the Audition series game.We hope that we can announce this series of plans of this game very soon.

[Jason Brueschke -Citigroup:]

Great, and maybe one final question; there’s been somereports in the press that the Chinese Government may limit the number offoreign games, foreign-developed games it allows into China. Could you commenton that? It would also seem to me that given the fact that you have such astrong pipeline now, that if there were any restriction, that you wouldactually be favored because of your existing pipeline and it would hurt otherpeople trying to bring games in. Could you maybe comment if that’s the rightway to look at that, that if in fact the Chinese Government were to limit thenumber of games coming in? Thanks. Jun Zhu (Translation) First of all, we have not received any [inaudible] from thegovernment so far, and second, we haven’t even heard any rumors about this. But you are right in saying that The9 is one of thestrongest and most experienced operators for foreign licensed games. I willtake this opportunity to further elaborate our licensing strategy. With the rebound of WoW and actually, I believe with thelaunch of the second expansion pack, WoW can achieve another very high levelmilestone. But sales and marketing for WoW will keep a relatively stable range. In addition, we also have a very strong pipeline in thecasual games area. The FIFA Online II, based on our understanding from EA, Ithink this game will be very good for the China market. FIFA Online is kind ofsimilar to WoW’s situation in some extent. First of all, it has a very big user base for the PC versionof FIFA games. And second, FIFA Online II has achieved a very huge success inKorea, so that’s why we think there will be a big -- FIFA Online II will bevery successful in China. Second, regarding the Audition series game, we are veryconfident of the games because the existing Audition 1 game has proved to bevery successful and popular in China. Like WoW once The Burning Crusadeexpansion pack was launched, the PCU was immediately boosted to 900,000 fromthe old 500,000, 600,000 level. That’s why we think the Audition series gamewill also have a very big chance to be successful next year. As I mentioned just now, we hope we will announce the seriesof plans for the Audition series of games in Mainland China. Regarding the other MMORPG like SUN and GE, the existingperformance is very good and we are very confident in the future performance ofthis game. So all in all, although we incurred relatively high cost andexpenses for this game in the third quarter, we believe the future outcome ofthese games will prove to be very worthwhile.

[Jason Brueschke -Citigroup:]

Thank you.

[Operator:]

Your next question is a follow-up question from the line ofEvan Wilson from Pacific Crest. Please proceed with your question.

[Evan Wilson:]

Hannah, could you remind us what the up-front license feeyou’ll record on the P&L when Granado Espada is commercialized in Q4? Andthen, now that we’ve seen some of the data on Granado Espada’s beta, could yougive us some sense or direction on your feeling for what the initial success ofthat game will be in Q4? Thanks.

[Hannah Lee:]

For Granado Espada, the total license fee was $2 million intotal, of which $300,000 was paid in 2004 when we signed the game on and$700,000 has to be paid when the game goes open beta testing, and when thegames go commercialization, we have to pay another $500,000. Upon the gamereaching an average concurrent user level of 100,000, we would be obligated topay another $500,000. So that’s how the $2 million is made up. So far, we have opened two server sites for Granado Espadaand these server sites are pretty full. They are currently in open betatesting. Like we just said in the presentation, we will be adding a thirdserver site and we have already started allowing people to register to activatefor an account in the third server site. And the response that we have receivedso far, we are quite happy about that. Like we said, we will be starting commercialization, i.e.starting to sell items for Granado Espada, by the end of this month and theexact date will be announced very soon.

[Evan Wilson:]

Thank you.

[Operator:]

There are no further questions at this time. I would nowlike to turn the call back to Dahlia Wei for a closing remark on behalf of thecompany.

[Dahlia Wei:]

Thank you, everybody, again for participating in today’scall. If you have any additional questions, please feel free to contact us.Thank you.

[Operator:]

Thank you for your participation in today’s conference. Thisconcludes the presentation. You may now disconnect.