China Stock Research June 2007

We recommend Buy rating on The9. The company is the third largest online game operator in China. Since year 2005, the highly successful MMORPG, World of Warcraft (WoW) has turned The9’s negative operating income -10 million CNY to a positive number 60 million CNY and increased 3.5 times the next year. Currently, the most serious risk faced by The9 arises from its severe dependence on the single revenue generating source WoW. Thus, whether to invest in The9 depends on how well it is able to diversify its game portfolio and revenue base before the agreement for operating WoW expires in 2009. In Q1 2007, the9 obtained several license agreements that give it the exclusive rights to operate new games, although there is uncertainty about whether the highly expected games will achieve desired outcomes, The9 is recommended to invest in due to the following reasons: 1.                 Several new games have track record and thus provide higher certainty of success. l                     The Soul of the Ultimate Nation has delivered 400,000 concurrent open beta users, and online soccer games and Audition have proved high popularity, all of which infer a promising prospect of Soul of Ultimate Nation, EA SPORTS FIFA Online and Audition 2. l                     Additional popular games will diversify the risk of the single revenue source l                     Inclusion of EA SPORTS FIFA Online and Audition 2 signals The9 expands its game portfolio beyond MMORPG to exploit casual game market. 2.                 The Main Product World of Warcraft is still in its prime time of life. l                     WoW has been in the market for two years and not yet reached the end of its life cycle. Thus, expansion pack of WoW is expected to have a large profit potential. 3.                 Injection of Capital by Electronic Arts Enhances Already Strengthening Liquidity. l                     CFO of The9 had increased 199 times to 599 million CNY in 2006 since 2002. l                     EA invested US$167 million in exchange for 15% common shares of The9   The9 will mainly use the fund injection and internally generated funds to expand casual game market share which is increasingly popular in China.   Company Description The9 Limited is a leading online game operator in China. The9's business is primarily focused on operating and developing MMORPGs for the Chinese online game players market. The9 directly or through affiliates operates licensed MMORPGs, consisting of MU, Blizzard Entertainment's World of Warcraft, and its first proprietary MMORPG, Joyful Journey West, in China. It has also obtained exclusive licenses to operate additional MMORPGs in China, including Granado Espada, Soul of The Ultimate Nation, Guild Wars, Hellgate: London, Ragnarok Online 2, Emil Chronicle Online, Huxley, FIFA Online, Auditon2 and Field of Honor.   Summary We recommend a BUY rating on The9. After analyzing the risks of The9’s development and its growth potential, we conclude that before the agreement of the World of Warcraft expires in the 2009, The9 have strong growth potential in spite of some barriers. This report will discuss the two sides of the situation faced by The9 in sequence. Buy Rating Sources of Risks for Development 1.                  Significant reliance on the sole source of revenue: the World of Warcraft (WoW) Since the World of Warcraft is introduced to the market, it has made up of over 90% of The9’s total net income and in Q1 2007, this percentage reached over 98%. Influenced by the 5% quarter-over-quarter decrease in the net revenues attributable to the operations of Blizzard Entertainment’s World of Warcraft (“WoW”)(1), which included revenues from game playing time, merchandise and installation package sales, net revenues and net income for Q1 2007 decreased respectively by 4% and 37% quarter-over-quarter to RMB270.0 million and RMB66.1 million. However, net revenue increased 27% year-over-year and net income rose 12% year-over-year. The management of The9 attributed the decrease in quarter-over-quarter result to the seasonal effect of Chinese New Year on WoW, however, this result just revealed the risk of 9City’s undiversified source of revenue. Its significant reliance on the revenue from World of Warcraft has limited the growth potential. Besides, SNDA, which is the main competitor of 9City reported net revenues of RMB532.3 million, representing a 13.1% increase compared to RMB470.6 million in Q4 2006 due to its new expansion packs for their main game titles and in-game promotions related to the Chinese New Year holiday. Thus, Chinese New Year can be revenue enhancing period. 2.                  Launch of several highly expected games across short-time spans can create substitutive effects The9 is catching time to diversify its revenue sources before the license agreement with Blizzard Entertainment expires in 2009. In May 2007, The9 launched the Soul of Ultimate Nation and it is expected to launch World of Warcraft – Burning Crusade in Q3 2007, Hellgate: London by the end 2007 and Ragnarok Online 2 and Huxley in 2008. The intensive schedule of commencing new MMORPG will detract players’ time from older games. Thus, effective marketing of each game within the time interval to gain enough popularity and recognition is essential to success. Besides, the two additional casual games Audition 2 and EA SPORTS FIFA Online are expected to be introduced within this time frame. However, since they are a different type of games, different set of players can be attracted, and thus the substitutive effects can be reduced. 3.  Introduction of new games does not necessarily guarantee a bright future In spite of expansion of game portfolio, there is a risk that the highly-expected games may not achieve the desired results. The expected success of Hellgate: London is mainly based on the high reputation of the developer, Flagship Studios who developed Diablo II. In addition to the payments of 5 million USD license fees and 21% of revenue to the Korean game company HanbitSoft, less-than-expected popularity of Hellgate: London can generate losses. The outcomes of Ragnarok Online 2, Emil Chronicle Online, Filed of Honor and Huxley are uncertain. The result of the 3D fantasy MMORPG game, Fantasy Melody Online which is currently under development is even harder to predict   Opportunities for Development We have pointed out the risks faced by The9, but the risks are not significant enough to render The9 an invaluable investment opportunity. The followings are the promising side of The9’s future: 1.                  Several Attractive Games With Higher Certainty of Success Can Reduce Risk of Single Revenue Source The Soul of the Ultimate Nation: Launch time is in Q2 2007 9City started open beta testing for Soul of The Ultimate Nation game in China in April and achieved a stabilized peak concurrent user level of over 400,000 users. 9City also has adopted a strategy that offers the game for free but sells weaponry to game players. This is a strategy that has enabled SNDA to increase its net income by 37 times to RMB448.4 million in Q1 2007 from RMB 11.8million in Q1 2006. In end-2005, SNDA removed hourly fees for the games including The Legend of Mir II, The World of Legend, and The Sign. Only The Legend of Mir II was considered at the end of its life cycle. This game was launched commercially on November 28, 2001and was the most popular online game in China in 2002 and 2003. Different from The Legend of Mir II, The World of Legend and The Sign, commenced in October, 2003 and May 2005 respectively were at their prime time of life. The strategy aimed to increase the number of active accounts and profits earned from each account. Similarly, the 3D MMORPG game, Soul of The Ultimate Nation can boost revenue of The9. Audition 2: Launch date is uncertain, but in 2007 or 2008 Audition is an online dancing game and has been in operation by another online game operator 9you for more than two years in mainland China. Currently Audition is enjoys a high popularity with over 780,000 peak concurrent users. The9 has obtained the exclusive license to operate Audition 2 in mainland China. Audition 2, with enhanced features and more community-oriented functions, is also expected to be popular in the mainland China market. EA SPORTS FIFA Online: Launch date is uncertain, but in 2007 or 2008 The9 has obtained a licensing agreement with Electronic Arts that gives it exclusive publishing rights for EA SPORTS FIFA Online in mainland China. The high popularity of online soccer games can be indicated by the beta testing result of the first online soccer game in China, called Extreme Soccer Online, which was operated by 9you.com in November 2006. On the first day of beta testing, the number of concurrent online players for this game exceeded 50000. The 2006 FIFA World Cup partly contributed to this result. Similarly, with the upcoming 2008 Beijing Olympics and the FIFA World Cup in 2010, online sports games in China are expected to be popular.   2.                  The Main Product World of Warcraft is still in its prime time of life. World of Warcraft (WoW) has contributed over 90% of net income of The9 since its implementation in June 2005. In Q1 2007, it represented over 98% of total net income. In Q1 2007, 9City attained peak and average concurrent WoW users in mainland China of approximately 680,000 and 330,000, respectively. As of March 31, 2007, over 7.5 million paid accounts had been activated. Although the net revenues attributable to the operations of WoW decreased by 5% quarter-over-quarter to RMB266.3 million, since WoW is still in the prime time of its life, its major expansion pack: The Burning Crusade is expected to gain popularity. 3.                   Injection of Capital by Electronic Arts Enhances Already Strengthening Liquidity. The operating cash flow increased 199 times from 3 million CNY in 2002 to 599 Million CNY in 2006. Since 2005, the investing needs have been covered by internally generated funds in addition to the cash in hand. In 2007, the improving liquidity position will be enhanced by an equity investment of roughly US$167 million by Electronic Arts Inc., the world's leading developer and publisher of interactive entertainment. Upon completion of the equity investment, EA will own approximately 15 percent of the common shares of The9. The9 will invest these funds to exploit casual game market, in which The9 is currently in a weak position. Different from MMORPGs, casual game market will attract players across wider age group, while the former typically attract people aged between 18 and 30. Besides, in the period of the Chinese New Year, when the World of Warcraft’s performance was adversely affected, some casual game such as Fantasy Westward Journey operated by NetEase gained its record concurrent online players of 1.5 million and Super Dance Online developed and operated by 9you achieved over 120000, increasing 30% compared with one week prior to the Chinese New Year. Therefore, the injection of funds and expansion in casual game will dilute the risk of one-game reliance and diminish the adverse seasonal effect of WoW on revenue generation.   Table 1: The9 City, Inc. - Annual Income Statement, 2002-2006 (CNY, in millions)     Table 2: eLong, Inc.  –  Balance Sheet, 2002-2006 (CNY, in millions)     Table 3: eLong, Inc.  – Cash Flow Statement, 2002-2006 (CNY, in millions) To access latest stock research and other research content, please register!