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The9 Limited (NASDAQ:NCTY) is a Chinese online game operator that I have followed in the past. Here is a preview of the company's 2Q06 earnings, which it will be reporting on Wednesday.

NCTY Q2-2006 Projections:

Net Revenues: $28.8 Million (9% increase q/q)
Net Income: $9.8 Million (includes $1.4 Million reimbursements for previously paid taxes) or $8.4 Million (without reimbursements).
EPS: $0.41 (includes reimbursements) or $0.35 (without reimbursements), 35% (15% respectively) q/q increase.
World of Warcraft ACU 308,000 (6% increase q/q). PCU 530,000 (4% increase q/q). ARPU RMB 0.357 (2% increase q/q)
2006 Earnings Estimates: $1.58
2007 Earnings Estimates: $2.40

Average analyst consensus estimates:

Q2 Revenue: $29.03 Million
Q2 EPS: $0.34
2006 EPS: $1.35
2007 EPS: $1.94

Q2 Earnings Preview

The9 (NCTY) Q1 earnings report was generally viewed as disappointing. Three months ago the Chinese operator of the hit online game World of Warcraft reported flat revenues, prompting analysts to wonder if the company’s growth has hit a wall. With the company relying on only one game, and The9’s policy of not providing forward looking guidance, the concern was more than legitimate. The9 reports again on Wednesday, August 9 after the market close. The Q2 earnings report will either confirm or dispel the slowdown concerns.

The Casual Analyst has developed automated data collection software for tracking WOW server usage levels. In our analysis, the ACU and PCU were determined by analyzing the server stats, collected since October 2005, in conjunction with the ACU and PCU reported by The9 in the previous earnings reports and conference calls. Our estimate for ACU is 308,000, a 6% increase quarter over quarter. The PCU estimate is 530,000, a 4% increase vs. Q1.

Revenues Estimates: WOW is responsible for 99% of The9’s revenues. NCTY recognizes revenue based on the actual usage of the game, instead of the value of the sold game cards.
We project net revenues of $28.8 Million, a 9% quarter over quarter increase, driven by a 6% ACU increase and a 2% improvement in the average revenue per unit [ARPU]. Q1 ARPU was negatively impacted by a loss of WOW usage data. We assume this loss was one-time event.

Cost of Services: We project a 7% q/q increase. The increase is driven by a 9% increase in royalty payments to Blizzard.

Operating Expenses: We expect a moderate (5% q/q) increase in operating expenses. We do not expect Sales and Marketing and General and Administrative expenses to increase significantly. However, the Product Development expenses could be significantly higher this quarter, as The9 prepares for the launch of SUN and Guild Wars.

Reimbursement for Previously Paid Taxes: The9 is exempted from paying taxes in 2006. In fact, the company does pay taxes, but the local government refunds these taxes back to NCTY. The9 recognizes tax reimbursements as Other Income. The timing of the tax refunds are difficult to predict. NCTY has reported tax reimbursements during Q4-2005; there were no reimbursements in Q1.

We believe that tax reimbursements are likely this time, and we estimate them to RMB 11 million ($1.4 Million). There is even a remote chance that The9 will get reimbursed for two quarters worth of taxes, which would further elevate The9’s earnings by an additional 6 cents.

Equity in Profit from Affiliated Companies: We conservatively project a small profit, driven by the Taiwan WOW operations, offset by losses from 9Webzen and Object Software.

Net Income and EPS: We project a net income of $9.8 Million and EPS of $0.41, a 35% q/q increase, providing that our assumptions on tax reimbursements realize. Excluding reimbursements, the net income and EPS stands at $8.4 Million and $0.35 respectively, increasing by 15% from Q1.

2006-2007 Estimates

We are confident that World of Warcraft will continue to grow in 2006 and 2007, driven by new content updates and the release of the Burning Crusade expansion pack in 2007.

As the Chinese online gaming sector become more and more competitive, the single most important success factor for game operators will be the quality of the games they operate.

NCTY has the best new game pipeline, with no number two competitor in sight. In a recent survey published on 17173.com, SUN and Guild Wars were ranked number one and number two most anticipated new games in China, Granado Espada was ranked number four, and Hell Gate: London number eight. We expect Guild Wars to bring in revenues starting with the fourth quarter. SUN will probably be released in early 2007. GE is scheduled for mid 2007 and Hell Gate:London for late 2007.

Both SUN and Guild Wars should be solid earners for 2007, although I do not expected them to challenge World of Warcraft in terms of user base and revenues. For this, The9 will have to wait at least one more year. Hell Gate:London is projected to be the next blockbuster game in China; fortunately for The9, they own its exclusive distribution rights for China.

Comprehensive Q2-2006 Earnings Estimates

ncty comp
(1) We project a RMB 11 Million reimbursement for previously paid taxes. If this reimbursement does not materialize during Q2, the net income and EPS will decrease by the appropriate amounts.

NCTY 1-yr chart:

NCTY 1-yr chart

Disclosure: The author owns NCTY stock.

Source: The9 Earnings Preview: Server Stats Show an Expansion of WOW in Q2