The9 Limited
Q4 2007 Earnings Call Transcript

Published: 22 Feb 2008

[Operator:]

Good day, ladies and gentlemen, and welcome to the The9 Limited’s fourth quarter and fiscal year 2007 earnings conference call. My name is Antoine and I’ll be your coordinator for today. (Operator Instructions) I would now like to turn the call 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 fourth quarter and fiscal year 2007 financial results conference call. The management with me today are Mr. Jun Zhu, Chairman and Chief Executive Officer, 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 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 the management’s projections or forward-looking statements. Let me now turn the call over to Mr. Zhu, our CEO, to provide you with an overview of our business for the quarter and fiscal year.

[Jun Zhu (Translation):]

Good morning and good evening, ladies and gentlemen. I would like to thank you for participating in our discussion of The9's fourth quarter and fiscal year 2007 results. First, I would like to present a quick overview of the key financial highlights for the fourth quarter and fiscal year 2007. Net revenues for the fourth quarter 2007 were $58.1 million, representing 34% quarter over quarter growth. Net income was $11.8 million, or earnings of $0.40 per ADS. For fiscal year 2007, net revenues were $175.4 million, representing 30% quarter over quarter growth. Net income for fiscal year 2007 was $33 million, or earnings of $1.19 per ADS. Now let me go over some highlights of our games during the quarter. First of all, World of Warcraft. After the phenomenal launch of WoW The Burning Crusade expansion pack in late Q3 WoW enjoyed continued strong momentum in the fourth quarter, attaining a record high of peak concurrent users of over 990,000. The average concurrent user level in the fourth quarter was also at a record high of approximately 470,000. As of December 31, 2007 approximately 10.3 million accounts had been registered and activated for the WoW game in Mainland China. On November 20 we launched WoW v. 2.3 content upgrade, The Gods of Zul'Aman, which was a patch after The Burning Crusade expansion. Once again, we saw WoW’s concurrent user and usage level boosted. With increasing user demand, to-date we have opened 35 server realms in the no. 8 server site and expect to open the remaining realms in the near future. In addition, we are in preparation for the ninth WoW server site which is scheduled to be launched before June ’08 in order to satisfy anticipated player demand. During the fourth quarter we conducted a series of marketing campaigns for WoW. In mid-November we kicked off a nationwide WoW tournament promoting a new game feature called Arena which attracted broad user attention and boosted game play time. We also held various holiday-related in-game events during the quarter. Our Member get Member program continued bear fruit, witnessed by strong new activations during the quarter. To address user demand, we also started to offer WoW game capture transfer services on either a free or paid basis. On the other hand, recently together with Blizzard we initiated the offering of [ME.card] and a security token with high level security password protection tools to further protect users rights and benefits of WoW gamers. How this matter has been carried out has further improved the user experience of our gamers all over China. Now about Soul of the Ultimate Nation, SUN. SUN's performance remain at relatively stable levels compared to the previous quarter. On December 7, we launched our upgrade patch for SUN called Power of 12 and have seen notable effect with increased in-game consumption, demonstrating satisfied results. We are now setting up an increasingly efficient cooperation mechanism with Webzen whereby several key developers from Webzen are working at our office in Shanghai. With such arrangements, the two companies can work together better and quicker to introduce more frequent content upgrades for SUN for the Chinese market. Next about Granado Espada (NYSE

[Hannah Lee:]

Thank you, Jun and hi everyone. I will now take you through an overview of our fourth quarter and fiscal year 2007 financial results. For the fourth quarter 2007, The9 reported net revenues of $58.1 million, a 34% increase compared to the previous quarter and a 50% increase year over year. The increase was primarily due to higher revenue from World of Warcraft, benefiting from the full quarter impact subsequent to the launch of significant content upgrades from The Burning Crusade expansion pack in September 2007, and approximately one month’s revenue contribution from GE which was commercialized under the item sales model in late November 2007. For fiscal year 2007, total net revenues were $175.4 million, increased by 30% from $135.1 million in fiscal year 20006. The year-over-year increase was mainly due to revenue growth from World of Warcraft as well as revenue from two new games launched in 2007, namely SUN and GE. In the fourth quarter 2007, net revenues attributable to the operations of subscription-based games, which included revenues from game playing time, merchandise and installation package sales increased by 39% quarter over quarter and by 38% year over year to $53.1 million. The increase in such revenues was primarily due to higher concurrent user levels as well as user usage after the launch of Blizzard’s World of Warcraft

[Operator:]

(Operator Instructions) Your first question comes from Wallace Cheung - Credit Suisse.

[Wallace Cheung:]

Good morning Jun, Hannah, and Dahlia. Congratulations on the good results. Hannah, I appreciate your contribution for the last four years. I hope to cooperate with you very soon. One single quick question about World of Warcraft, can you give us a little more information, data points about the profit level? PCU, ACU, and in particular when you mentioned in the front page of the announcement, did you include 10 million prepaid points for an expiry recognition of the revenue into your revenue level? Also, can you comment about the first quarter of ’08 trending as well? Thank you. [Translation]

[Translation for Jun Zhu:]

As Mr. Zhu has said, the PCU level for World of Warcraft for the fourth quarter was over 990,000 and average concurrent user level for the fourth quarter was approximately 170,000. The 10.2 million of expired points that we recognized in the fourth quarter was included in the revenue and is included in the ARPUH calculation. ARPUH was actually about RMB 0.395 for the fourth quarter. As to your question about the first quarter trend of World of Warcraft users, as you know historically there will be an impact during the February month with respect to winter holidays and Chinese New Year. However, despite taking out that effect the user level has resumed after Chinese New Year and also after school starts. So for World of Warcraft, we still believe the user is very much liking the game and the user level is continuing to increase after any impact historically during Chinese New Year and during the winter holiday month. Does that answer your questions Wallace?

[Wallace Cheung:]

Just a quick follow-up. You know everyone is concerned about the snow storm impact. Can you comment on that as well?

[Hannah Lee:]

I'm sorry, there's concern about?

[Wallace Cheung:]

The snow storm.

[Translation for Jun Zhu:]

For World of Warcraft there is minimal impact with respect to the snow storm because traditionally there has been impact regarding the Chinese New Year and winter holidays anyway, so it doesn't affect us as much as it might have on other games.

[Operator:]

Your next question comes from Paul Keung - Oppenheimer.

[Analyst for Paul Keung:]

Hi everyone. These results are very good, congratulations. Could you give us some idea on the renewal of licenses with Blizzard on World of Warcraft? [Translation]

[Translation for Jun Zhu:]

Actually, I remember that about one year ago a lot of people are asking and also are concerned about The Burning Crusade expansion pack. At that time, I already very firmly told everybody that I was very confident that The9 would continue to work with Blizzard regarding The Burning Crusade. And also back in 2005 when everybody was asking about the possible impact of the [inaudible] system, I said I believe this policy will be a long-term benefit to the overall industry growth and also will not have an impact on WoW. Actually now if you look at the implementation of this system, it has not had any impact on our WoW game, so that proves my promise and my belief is very correct. So regarding your question on the WoW renewal, what I can say is WoW has been in very strong growth during the past few years and also we are always in very good relationships with Blizzard and we always have a very common, unanimous opinion regarding the operation of WoW in China, so I am very confident that we believe we can renew the contract in '09.

[Analyst for Paul Keung:]

Yes, okay. There is another expansion pack for World of Warcraft, right?

[Jun Zhu:]

Yes.

[Analyst for Paul Keung:]

Is that coming this year? [Translation]

[Translation for Jun Zhu:]

We are in discussions with Blizzard regarding the exact timing of the second expansion pack but we don't have an exact date yet. After the first expansion pack, The Burning Crusade, was launched we have experienced over 30% growth in PCU numbers of WoW and we believe after the second expansion pack goes out that we will experience a similar, very significant growth.

[Analyst for Paul Keung:]

[Translation not provided] Thank you so much.

[Hannah Lee:]

Thank you.

[Operator:]

Your next question comes from the line of Eddie Yeung - Merrill Lynch.

[Eddie Yeung:]

I have one question about basically the pricing model that you guys are running. Have you learned any lessons from a transition from a time-based game, which is like World of Warcraft to running to item-based games? Could you talk about your experiences? Do you think there is upside for your ARPUH in item-based games? If there is upside, would this be coming from ARPUH or the number of paying accounts or both? Thanks. [Translation]

[Translation for Jun Zhu:]

We believe the both of the two business models are very suitable for the Chinese market. The time-based model , which was very supported by the WoW performance and also the item-based model was also proven by many games including our own two games. So we believe both items will continue to exist in the market. Regarding the item-based model we actually adopted this model for our two new games SUN and GE and now we have seen the steady [progression] for the two games. We will continue to adopt to this item-based model for some of our future games, for example The Audition 2. We believe the item-based models games like Audition 2 will continue to contribute incremental growth for the Chinese market. To summarize, with WoW the time-based game continued to grow and also our new and incremental games come into the market and are the free play item sales model I think The9will continue to deliver very substantial and very good output for the future.

[Operator:]

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

[Dick Wei:]

Good quarter guys. Question is on marketing expenses. I was wondering if you can break out fourth quarter, roughly how much went to each game and also what is the sales and marketing outlook for the next two quarters given that you believe the next game launch is probably in summertime maybe for closed beta? I don't know if you expect to see pretty low marketing levels for the next two or three quarters.

[Hannah Lee:]

We spent $4.5 million in the fourth quarter with respect to sales and marketing of which about $2 million relating to WoW, about $1 million relates to each of SUN and GE and the rest of that relates to FIFA Online 2 and other games that we have in our pipeline that are in pre-launch and pre-beta testing stage. With respect to your other questions about the trend in Q1 and Q2, right now we have started beta, the technical testing of FIFA Online 2 of which we are planning to start beta testing sometime before mid '08. With that we will be spending marketing dollars to promote the game. With respect to games that we are planning to push out in the second or third quarter we will spend marketing dollars accordingly. Right now because we don't give out financial guidance we do not provide any specific outlook on the marketing expense. It really depends on how much content we're pushing out and what games we're pushing out at what time.

[Dick Wei:]

Great. Thanks Hannah and all the best.

[Operator:]

Your next question comes from Alicia Yap - Citigroup.

[Alicia Yap:]

Good morning. My question is regarding the update on FIFA Online. Can you share with us your preparations in operating the games? How many people have you actually dedicated to the FIFA team and whether they actually came from the WoW operations team? Any brand new team that has experience in operating the casual games, is there any challenge or difference in operating a MMO or casual games? In other words, do you actually have to do anything differently in terms of training your customer service reps and the impact on your sales and marketing strategies? [Translation]

[Translation for Jun Zhu:]

Last year we appoint a new VP Benjamin Lin, he has over ten years of experience in operating casual games in China. Now there are about 40 to 50 people under his team and that team was based in Beijing. We think these people are all very talented people in the casual games area, so we think the team is very professional. I would like to emphasize that nobody on our FIFA team is coming from our WoW team; they are all new team members joining The9. All these 40 to 50 people have background in the casual games operation area, so we are very confident in this team.

[Alicia Yap:]

Can I have a follow-up on the breakdown of GE and SUN in your item-based revenue? Can you actually break down the ARPUH and active paying customer for SUN and for GE? [Translation]

[Hannah Lee:]

Unfortunately, similar to other peer companies we are only breaking down our ACU and PCU and key KPIs for games that are in item based, we group them in subscription-based models and item-based models. As Mr. Zhu has said in his presentation, for SUN and GE, for SUN especially has been remaining at a stable level. For GE, it's achieving satisfactory results. We are working very closely with the Korean developers to push out more content upgrades to try to improve the operating results of these particular games.

[Operator:]

Your next question comes from C. Ming Zhao - SIG.

[C. Ming Zhao:]

Congratulations on a good quarter. I just have a question about the CapEx that you guys may see in 2008 given the launch scheduled games. What kind of server cost and other CapEx do we need to expect for the new games to be launched as well as for nine or ten server groups of WoW in 2008? Thanks. [Translation]

[Hannah Lee:]

For fiscal year 2007 we have spent approximately $45 million on capital expenditures, mainly to upgrade the hardware for World of Warcraft in preparation of Burning Crusade expansion pack push out and also for SUN and GE’s launch. For 2008 we will be at least adding another service, as you have said, the ninth World of Warcraft server site, and if necessary we will be adding another server site for World of Warcraft. As you know, each server site for World of Warcraft costs about $7 million to build, and depending on how many server sites we're building, that will add to our capital expenditure accordingly. In addition to that, we will at least be pushing out FIFA Online 2 and Audition 2 for 2008 so that will have incremental capital expenditures from those gains.

[C. Ming Zhao:]

Given the preparation for the FIFA, do you think we're going to see maybe $10 million to $20 million in cutbacks for FIFA? I mean I try to gauge what you guys think about the success of FIFA here.

[Hannah Lee:]

With respect to FIFA Online we just finished technical testing on a very small scale, we will soon be starting open beta testing. As you know, for any games that The9 pushes out, we always start with two or three server sites and with that, additional user demand, we will add server sites then to satisfy additional user demand. So right now I can't tell you, I think we would not be spending $10 million off the bat for initial setup of the game; however, we will be spending a few million dollars as usual as any other game that we launched previously to prepare for open beta testing and initial commercialization. After that with additional demand, we will be adding addition server sites where there will be incremental costs of $2 million to $3 million per server site. So I can't say specifically how much for the entire year we will be spending, but we will be spending a few million dollars to build initial service sites in the beginning and then adding for additional demand.

[Operator:]

Your next question comes from the line of Andrey Glukhov - Brean Murray, Carret.

[Andrey Glukhov:]

Hannah, you suggested that the revenue from SUN was relatively flat sequentially. Is the operating margin, is the game itself getting any more profitable or is all the margin expansion we're getting is purely from the improving profitability of World of Warcraft? [Translation]

[Hannah Lee:]

For SUN, as I said, the revenue contribution from a revenue perspective is actually very similar to what we experienced in the previous quarter. In terms of the mix between active paying users and ARPUH, ARPUH has actually increased compared to last quarter. If you look at last quarter, we reported RMB 62 for SUN and this quarter for GE and SUN combined each would contribute about RMB 73 of ARPUH for each game. These two games are behaving quite similarly in terms of APRUH behavior so there have been some increase in the ARPUH on an active paying account basis. That is what we are trying to at least maintain. From an active paying account basis we are constantly pushing upgrades to try to pull that number up. From an operational cost perspective, we have been, as you can see in the cost of sales and marketing expenses line item, we have been implementing cost control measures to check that and to keep that marketing expense very efficiently. So we're able to achieve some benefit in terms of margins. We will continue to do that in 2008 but from the margin perspective, it's quite similar to what we have in the third quarter of '07.

[Andrey Glukhov:]

That’s helpful. All right and on the housekeeping side, can you maybe directionally talk about what tax rate you guys anticipate paying in 2008? Thank you.

[Hannah Lee:]

As you can see, we have with the recently published Chinese income tax law, we have some deferred tax benefit recorded in Q4 mainly because we have some temporary differences relating to tax and accounting depreciation charge and also some tax loss carryforwards that were experienced in some of the Chinese subsidiaries we have. For a current tax rate, I think it will be around 18% to 20% depending on the final implementation and regulations that we anticipate would be announced by the local government sometime in the first half of '08.

[Operator:]

Your next question comes from Leah Hao - Goldman Sachs.

[Leah Hao:]

Good morning, guys. I see that you took a $2.6 million impairment charge on Guild Wars. I just want to confirm, does that clear out all your other obligations related to the game? Also related to that, other than FIFA Online maybe contributing revenue in the first half of '08, and Audition 2 for maybe the second half of '08, are there any additional games that will contribute revenue in 2008 from your pipeline? [Translation]

[Hannah Lee:]

Leah, can you clarify your question about Guild Wars? Are you asking whether there are additional obligations?

[Leah Hao:]

Right, actually my question was related to Guild Wars specifically after the impairment charge I was just wondering if you have any other obligations monetary-wise or otherwise related to Guild Wars, at all. The second question is related to your pipeline.

[Hannah Lee:]

For Guild Wars, we have paid $2.4 million to NCsoft so far and that is what we have provided for. From this point on, we have not made any accrual with respect to additional obligations based on our understanding of the license agreement that we have. With respect to future games that we generate revenue for 2008, FIFA Online 2, Audition 2 and Fate of Warriors Online which we developed in-house would also be contributing revenue in fiscal year 2008. In the latter half of 2008, as Mr. Zhu has said in his presentation, we will be starting beta testing on various games. These games will be contributing revenue for 2009.

[Operator:]

Your next question comes from Victor [Fang] - Deutsche Bank.

[Victor [Fang]:]

Can I just have a quick update on some of the other game pipelines, maybe towards 2009 such Huxley and Ragnarok and maybe some of the other games we haven't talked about, can we have an update on their status? As well, my second question is for GE and SUN we're looking to provide more updates for these games; can you just comment on when do we expect more updates of expansion packs to come for these games, and as well are we going to be putting additional marketing expense to promote these new expansion pack releases? Thank you. [Translation]

[Translation for Jun Zhu:]

We haven't talked about Huxley and [Dispute of Honor] Online but for 2008 we think FIFA Online, Audition 2, especially Audition 2 will be the important contributor. There's also a possibility that several games that we are now in discussion to license can contribute revenue in 2008. For new games like Hellgate

[Operator:]

Your next question comes from Eric Wen - BNP Paribas.

[Eric Wen:]

I have two questions, one is regarding FIFA. Jun, can you elaborate on how you plan to deal with the restrictions from FIFA? Regarding the number of items for sale, can you give us specifics that by the time of FIFA’s launch how many items will be available for sale and how do you see that trending up afterwards?

[Translation for Jun Zhu:]

The reason why we do actually operate FIFA Online 2 instead of FIFA Online 1 I is because the FIFA Online 2 has a lot of improvements compared with the previous version essentially in terms of number of items for sale. Actually, we now think the FIFA Online 2 is technically ready and close to technically ready and also the number of items for sale is satisfactory and also it has experienced a very satisfactory performance in Korea so we think it's close to the right stage to be launched in China but we haven't decided on an exact date for the game's launch. Based on our operation of the Korean market, we believe the Webzen development is very strong and we believe they will continue to add new content and improve the number of items for sale. So we are very confident in the games operation in China.

[Eric Wen:]

I'm not sure if this question has been asked. But can you comment on that the developer of your new game, Ragnarok Online 2, I see Gravity has been acquired by a Japanese company. Will that impact your licensing and the cooperation with Gravity in following year?

[Translation for Jun Zhu:]

Actually we have been in constant communication with Gravity regarding RO2’s development stages. Regarding when to operate RO2 in China, we will keep discussing with them and continue to evaluate their content maturity.

[Eric Wen:]

I think what we are seeing is that in the licensed operators, we are seeing some acquisitions made by Shanda, for example, to acquire code back several years ago and it basically can stabilize the game development and ensure a constant stream of attention and support to eliminate the [inaudible] information and behavior that we are seeing between the developer and licensee. Do you see that you will be focusing on working with a handful of developers on your game or are you still focusing on a content first strategy that whatever is the best for content and you then will go and negotiate, license and operate?

[Translation for Jun Zhu:]

As I said just now, the content quality is a key factor when determining to operate our games. Going forward we will keep looking for very good content games no matter if it's internationally developed or locally developed; no matter if it's licensed or self-developed, we will focus on the game quality as well as long as it's a very good game, we will offer that game in China.

[Operator:]

Your next question comes from Wallace Cheung - Credit Suisse.

[Wallace Cheung:]

On the return of the World of Warcraft installation package, it costs net revenue in the top line. How much does it cost and has this issue been resolved already for these results? [Translation]

[Hannah Lee:]

Thanks for the question. As we said in the press release, there was a return of the World of Warcraft installation package and that relates to the packages which includes the -- these packages allegedly contained fonts that were alleged to infringe on third-party intellectual property rights, of which that relates to the Founder lawsuit that we had discussed a few quarters ago. This lawsuit is still ongoing and we currently have no further updates. As we said before, we do not think there is any material impact on The9 financially and we still consider that view as reasonable.

[Wallace Cheung:]

The amount of the package return?

[Hannah Lee:]

The amount of the package return is about RMB 1.2 million.

[Operator:]

Your next question comes from Dick Wei - JP Morgan.

[Dick Wei:]

I believe you mentioned about the item-based model for the game ARPUH is RMB 73 per month. How do you calculate that? If I try to put the numbers together it doesn't seem to add up. Do you just take the average for the two games, or do you account for just 1.5 months of revenue for GE, for example.

[Hannah Lee:]

For SUN it is basically a weighted average. It's basically an average for the entire quarter because that game has been in full, full commercialization in the entire fourth quarter. For GE because we launched the game in late November, how we arrived at our ARPUH is we pro-rated it to the number of days that is in commercialization in the quarter to take into effect the less than full quarter effect and then we averaged these two games ARPUH out to arrive at the RMB 73 per game. As I said, the two ARPUHs of each of these games are very similar.

[Dick Wei:]

I think last quarter it was around RMB 62, right? How can it go to RMB 73 then? I thought it would be like 62 plus 82 or something and then you average it to 73?

[Hannah Lee:]

No, as I said earlier when answering other analyst questions, 62 was recorded for SUN only in Q3, whereas we have seen increase in the ARPUH number for SUN to the 70s level and that's why when I said the two games are relatively similar with respect to ARPUH, these two games average out to be 73. So there has been increase in the ARPU for SUN from 60s level to the 70s level.

[Dick Wei:]

Second question is regarding your points expiration policy for WoW, do we actually expect more to come this quarter or will it be a year-end event?

[Hannah Lee:]

With respect to the expiration points, the policy has always been the same. After 12 months of initial inputting into the system if the points have not been used, then we recognize it into income. It has been consistently applied, but because the expansion pack has been pushed out in September we have temporarily suspended such recognition of expired points for a couple quarters in '07, namely Q2 and Q3, because we anticipated that some of the old users would come back to play the game for prudent purposes. But with stable trend of usage of expiration points, we have enough history to continue our consistent application of expiration points revenue recognition, so from Q4 we continue to recognize expiration points. We will continue to do that practice from Q1 '08 onwards.

[Operator:]

There are no further questions. I would now like to turn the call over to Dahlia Wei for closing remarks.

[Dahlia Wei:]

Thank you again for participating in today's call. Please feel free to contact us if you have additional questions. Thank you again.