Reviewing The9's Intriguing Earnings Report (NCTY)

| About: The9 Limited (NCTY)

The9 (Nasdaq: NCTY) reported intriguing earnings on May 24. Although the company’s Q1 revenue was unchanged from last quarter’s revenues, missing expectations of a single digit increase, the company posted earnings of $0.30, beating consensus estimates by 2 cents.

Analysis of The9’s Q1 Earnings Results

The Q1 earnings results are intriguing for the following reasons:

1. According to the recently reported average concurrent users [ACU] and peak concurrent users [PCU] figures, World of Warcraft, the online game responsible for 99% of The9’s revenues, continues to grow. Yet, despite the ACU increase, revenues were unchanged from last quarter.

2. Net income has grown by 22% (excluding special items) compared to the previous quarter, despite the flat revenues. So how fast is WOW growing, and more importantly, what revenue growth should we expect in the near future?

The data paints a mixed picture. In Q1 the PCU grew by an impressive 15%, to 610,000 from last quarter’s 530,000.

However, the ACU has only increased by 7%, from 270,000 to 290,000, vs. my forecast of 315,000. A core assumption in my analysis, that the PCU/ACU ratio will remain stable in Q1 turned out to be incorrect. This ratio has been extremely stable in the past. Had it stayed the same in Q1, the ACU should have increased to 310,000.

Another negative was a reduction in the revenue per hour [ARPU] that negated the increase in average concurrent users.

Based on the information provided by The9 in the conference call that followed the earnings release, we now believe that Q1 can be viewed as an atypical quarter for several reasons. The ACU was adversely impacted by the Chinese New Year holiday. The revenue was further reduced by an unfortunate loss of game usage data, and by the fact that there were 90 days in Q1, vs. 92 days in Q4.

Overall, PCU is a better measure for WOW growth as it is not impacted by special items. Without special items, we should probably expect the ACU/PCU ratio and the ARPU to improve in Q2.

Another hint for WOW growth in Q1: the accumulated deferred revenue for this quarter was $12 million, 26% higher than last quarter. Also, advances from customers have increased to $9 million, 17% higher vs. Q4. Both numbers suggest a strong WOW growth, and they paint an encouraging picture for Q2.

Also, very positive is The9’s ability to control costs. Q1 operating expenses have decreased by 14% quarter-over-quarter. This improved operational efficiency has single-handedly saved the quarter, turning disappointing flat revenue into a 22% increase in net income.

An increased ACU, correlated with an improved ARPU, and an improved ability to control costs should add up to much better Q2 results.

Looking Forward to the Future: The9’s New Games

Super Girl Online

The9 has announced the agreement to operate “Super Girl Online”, a game based on the very popular “Super Girl” TV show, China’s version of “American Idol”. The9 is finally starting to build their casual games portfolio, and they do it in style.

The Super Girl Online game and community-oriented platform should attract a large number of users. The televised final was watched by 400 million Chinese. Last year Linktone reported a third quarter spike in revenue due to the 20 million Super Girl votes sent through their wireless platform.

Although The9 does not make money from subscription fees (the game is free to play) the company is planning to charge for in-game items and also to make money from in-game advertisement. The game is slated for release in July-August of this year.


Confirming industry rumors, The9 has announced a deal to operate Hellgate:London. The deal, announced on May 29, should further boost and diversify The9’s already excellent game pipeline. The game is a highly anticipated first person shooter MMORPG game, expected to be released in 2007.

Disclosure: The author owns NCTY shares and June Call Options.