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The9 Limited (NASDAQ:NCTY)

Q2 2009 Earnings Call

August 27, 2009 9:00 pm ET

Executives

Phyllis Sai - IR

Xiaowei Chen - President

George Lai - CFO

Analysts

Alicia Yap - Citigroup

Andrey Glukhov - Brean Murray

Atul Bagga - Thinkequity

Wallace Cheung - Credit Suisse

Wendy Huang - RBS

Operator

Good day, ladies and gentlemen, and welcome to The9 Limited first and second quarter 2009 financial results conference call. My name is Krista and I will be your coordinator for today. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes. I would now turn the presentation over to your host for today’s conference, Ms. Phyllis Sai, IR Manager of The9. Please proceed, ma’am.

Phyllis Sai

Thanks, operator. Hello, everyone, and thank you for joining us today for The9's first and second quarter year 2009, financial results conference call. The management with me today are Ms. Xiaowei Chen, President, and Mr. George Lai, Chief Financial Officer. As always, I'll start the call with a review of the Safe Harbor Statements before our management begins their prepared remarks.

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 the documents that the company filed with the United States 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 projection or forward-looking statements.

Now, we would like to begin with our President, Ms. Xiaowei Chen, who will give you an overview of our financial results and operational reports for the quarter, followed by our Chief Financial Officer, Mr. George Lai, who will follow with a detailed discussion of our financials. Ms. Xiaowei?

Xiaowei Chen

Thank you, Phyllis. Good day and evening, ladies and gentlemen. Thank you for participating in our discussion of The9’s first and second quarter 2009 results. 2009 is a challenging year for The9. In June, we (ceased) the World of Warcraft operation upon expiration of the license and our revenues have significantly declined.

However, our proven track record clearly demonstrates The9's first class game operations capability and deep insights in bringing the best online games to Chinese players.

Furthermore, our proprietary development capabilities have substantially grown in the last two years. We believed we will have a turnaround in the near future. We will continue to pursue our 4D strategy. We will continue to license high quality online games and develop our own proprietary games.

In addition to Soul of The Ultimate Nation or SUN and Granado Espada or GE, we launched EA SPORTS FIFA Online 2 and Atlantica in Q2 of 2009 to further enhance our portfolio diversification. Together with Audition 2 and our newly licensed game Kingdom Heroes 2 Online and other proprietary games as well, we have a very strong 2010 licensed games pipeline. We’re increasing our investments in research and development for our own proprietary games.

As of the second quarter, our headcounts in TDC or The9 Development Center had a 57% increase to 300, since its establishment in July 2008. Our proprietary games underdevelopments include World of Fighter or (inaudible), Dragon Emperor, or Jiu Zhou Zhan Ji, Miracles: Ultimate X, Monster of War, Tiny Tribe and other advanced casual games and web based games. Among these proprietary games, World of Fighter has already been licensed to Hong Kong, Macau and Taiwan.

In addition, we made equity investments in a number of games studios in the first half of 2009, which further strengthen our propriety game pipeline.

Now, let me go over some highlights of our games operations during the first half of the year. First of fall, World of Warcraft, with our strong game operation capability, World of Warcraft continue to show a stellar performance in the first quarter despite the negative impact of seasonality.

PCCU reached historical high in Q1 of 2009. Affected by the exploration of contract between The9 and Blizzard, World of Warcraft experienced a decline in the second quarter. Net revenue attributable to WoW for the first and second quarter is $59.0 million and $39.5 million respectively.

Now let's move on to SUN and GE. For SUN, we launched the new expansion pack, SUN: World Edition on June 22nd and after the last massive content upgrade of previous expansion pack, survival of [solo quest] on March 4th. We have conducted various in-game campaigns such as offerings double experience points in April for the celebration of the second anniversary of SUN's commercial launch.

For GE, a content upgrade patch called The Legend of The Master was released on June 25th after the last content upgrade patch Revolution on April 14. A testing server was launched on June 18 where players can experience the most updated content synchronized with the version in Korea.

Let me now move on to our first casual game, FIFA Online 2. FIFA Online 2 began its open beta testing on April 22nd and was commercially launched on May 20th. It has been well received by sports game players and soccer fans.

Currently 15 server sites are open for FIFA Online 2. We expect its performance will continue to improve with increasing virtual items being opened to the players. We will continue to launch various marketing promotions for FIFA Online 2.

Also next year is the World Cup year. Based on the experience in Korea, we expect this will bring a significant growth in this game.

Let's turn to Atlantica, a 3D turn-based MMORPG developed by Ndoor's. Atlantica features real world cultures and countries which are mixed with nephrological and fantasy element. We've received positive feedback since its open beta testing on June 10 and we since started the commercial launch on June 17th.

On a combined basis, our commercialized games excluding World of Warcraft has aggregate active users of 1.5 million for the first quarter of which 74,000 were active paying accounts.

In the second quarter, aggregate active users and active paying accounts over 3.2 million and 73,000 respectively. The number of active users is defined as the number of players who log-in and play during that quarter.

The average quarterly ARPU of these games was RMB299 and RMB221 for Q1 and Q2, respectively. These games all have steady number of hardcore players which provide us a steady revenue stream. We are expecting further in both aggregate active users and paying accounts with the launches new expansion pack and marketing campaigns for these games.

Now, let's turn to our proprietary game development. We're proactively strengthening our proprietary game development capability. As of the second quarter we have approximately 300 people in TDC or The9 Development Center.

We expect to enlarge our development team to around 400 people by the end of 2009. Currently we have various proprietary games including World of Fighter, or (inaudible), Jiu Zhou Zhan Ji, Miracles: Ultimate X, Tiny Tribe or (inaudible), Monster of War and other advanced causal games and web based games in our development pipeline.

World of Fighter or (inaudible) is a 2D MMORPG with a historical background of the three kingdom. The game applies real time combat mode with rich set of skills and strict real time combat operations. It has received positive feedback during the two rounds of closed beta testing. The third round closed beta testing was just launched on August 10. World of Fighter has already been licensed to overseas game operators for operations in Hong Kong, Macau and Taiwan markets.

Our first web based game Jiu Zhou Zhan Ji, is now under closed beta testing. In this game, players can act as nobles, merchants and warriors during the period of the spring and autumn warring period in ancient China via card play.

Multiple in-game daily missions which casual games inserted and easily operated match making, bring players interactive entertainment. In addition, players can also manage their own organizations through the leader election system. Currently we have seven server sites on our own and 15 other server sites by partnership.

In our proprietary game pipeline, we also have Miracles: Ultimate X, a 3D MMORPG, and Tiny Tribe 3D online casual games, Monster of War, a real-time strategic online casual games, and other unannounced advanced casual games and web based games under development.

Going forward, we plan to launch at least two to three proprietary games each year. We also have two important licensed games in our pipeline. Firstly, Audition 2, we're working closely with T3, our development partner of Audition 2 on further polishing the game including game features and social networking functions. We have a conducted a 12-day alpha test in June for the preparation of Audition 2 to close beta testing.

We believe Audition 2 will bring very different virtual dancing experience to millions of Chinese casual game players with its featured social networking highly valued by the players in China.

Last but not least, we announced the licensing of Kingdom Heroes 2 Online from the USERJOY on July 23rd. Kingdom Heroes 2 is a 3D Fantasy MMORPG which stresses on the core feature of Kingdom Wars and maintains a strong community in the gaming. It breaks through the original 2.5D side-scrolling restriction and evolves to the 3D characters and scenes.

With all of these new features and the user base of Kingdom Heroes series, Kingdom Heroes 2 Online has strong potential of becoming another major hit title.

Given our strong new games pipeline and our continuous efforts in proprietary game development, we believe The9 will soon recover from the challenging times and continue to leverage the tremendous growth of China online game market.

Now, let me turn the call over to George Lai, our CFO. George will provide you with a more detailed discussion of our first and second quarter financial results. George?

George Lai

Thank you, Xiaowei and hi, everyone. I will now take you through an overview of our first and second quarter 2009 financial results.

For the first quarter of 2009, our total net revenues were $62.4 million which increased by 4% compared to $59.8 million in the fourth quarter of 2008 and decreased by 3% compared to $64.3 million in the same period last year. Despite the negative seasonality factors, we managed to deliver a quarter-over-quarter growth in the revenues through effective marketing campaigns and ground promotions.

In the first quarter, net revenues attributable to the operations of subscription-based games, which included revenues from game playing time, merchandise and installation package sales, increased by 5% quarter-over-quarter and by 3% year-over-year to $59.0 million.

Net revenues attributable to the operations of item-sales based games decreased by 11% quarter-over-quarter and by 47% year-over-year to $3.1 million, the decrease was mainly due to the lower than expected operating performance of GE which caused decline in active paying users.

For the second quarter of 2009, total net revenues were $42.2 million which decreased by 32% compared to $62.4 million in the previous quarter and by 37% compared to $66.6 million in the same period last year. The decrease was primarily due to the decreased revenue from World of Warcraft, which expired on June 7, 2009.

In the second quarter of 2009, net revenues attributable to the operations of subscription-based game, which included revenues from game playing time, merchandise and installation package sales, decreased by 33% quarter-over-quarter and by 35% year-over-year to $39.5 million.

Net revenues attributable to the operations of item-based games decreased by 24% quarter-over-quarter and by 58% year-over-year to $2.3 million. The sequential decrease in such revenues was mainly due to the lower than expected operating performance of GE.

For the first quarter of 2009, gross profit decreased by 57% quarter-over-quarter and by 65% year-over-year to $9.9 million. The decrease is mainly due to write-off of prepaid royalties and withholding tax related to World of Warcraft due to the non-renewal of license amounting to $15.1 million. Gross profit margin for the first quarter of 2009 was 16% compared to 39% of fourth quarter of 2008 and 44% of the first quarter of 2008.

For the second quarter of 2009, gross profit decreased by 5% quarter-over-quarter and decreased by 67% year-over-year to $9.4 million. The sequential decrease of gross profit was mainly due to the decrease in revenue by $19.5 million since expiration of World of Warcraft license on June 7, 2009, which were offset partially by write-off of prepaid royalties and withholding tax related to WoW due to the non-renewal of license.

The year-over-year decrease of gross profit was mainly due to the decrease in WoW revenue by $21.4 million and the additional accruals of $3.2 million settling costs for the refund of WoW point cards resulting from the rebate program announced in the second quarter of 2009.

Gross profit margin in the second quarter of 2009 was 22%, increased from 16% from the previous quarter and decreased compared to 43% in the same period of last year.

For the first quarter of 2009, operating expenses were $18.3 million, representing a 56% decrease from $41.2 million in the previous quarter and a 33% increase from $13.8 million in the same period last year. The sequential decrease was primarily the result of impairment provision of a receivable and prepayment and advance to suppliers; and impairments of the upfront license fees for certain games made in the fourth quarter of 2008, while there was no such impairments in the first quarter. The year-over-year increase was primarily due to the increased headcount in research and development and increased marketing expenses on new games in the first quarter of 2009.

For the first quarter of 2009, share-based compensation was $2.3 million, compared to $2.3 million in the previous quarter and $1.8 million in the same period last year.

For the second quarter of 2009, operating expenses were $22.3 million, representing a 22% increase from $18.3 million in the previous quarter and a 52% increase from $14.7 million in the same period of last year. The increase (sic) in operating expenses was primarily due to increased product development expenses due to the expansion of our research and development team and the increased in general and administrative expenses primarily due to the impairment of goodwill of $4.4 million related to WoW in the second quarter.

For the second quarter of 2009, share-based compensation was $2.2 million, compared to $2.3 million in the first quarter of 2009 and $1.8 million in the second quarter of 2008.

Interest income for the first quarter of 2009 was $1.3 million, compared to $2.0 million in the fourth quarter of 2008 and $1.9 million in the first quarter of 2008. The decrease of interest income was primarily due to a reduction in bank interest rate.

Interest income for the second quarter of 2009 was $1.0 million, compared to $1.3 million in the first quarter of 2009 and $2.1 million in the second quarter of 2008. The sequential decrease of interest income was primarily due to the decrease of cash balance, the year-over-year decrease of interest income was due to a reduction in bank interest rate and the decrease of cash balance.

For the first quarter of 2009, net loss was $6.9 million, which decrease by 70% from net loss of $23.2 million in the fourth quarter of 2008 and compared with $11.1 million in the first quarter of 2008.

Fully diluted loss per share and per ADS for the first quarter of 2009 was $0.26, compared with $0.85 in the fourth quarter of 2008 and with fully diluted earnings per share of $0.40 in the first quarter of 2008.

The first quarter of 2009, non-GAAP adjusted net income was $7.1 million compared with non-GAAP adjusted net loss of $6.3 million for the previous quarter and non-GAAP adjusted net income of $28.3 million for the same period of last year.

Fully diluted non-GAAP adjusted net income per share was $0.27, compared with non-GAAP adjusted net loss per share of $0.23 for the fourth quarter of 2008 and non-GAAP adjusted net income per share of $1.01 in first quarter of 2008.

For the second quarter of 2009, net loss was $11.6 million, which increased by 69% from net loss of $6.9 million in the first quarter of 2009 and compared with net income of $14.5 million in the second quarter of 2008.

Fully diluted loss per share and per ADS for the second quarter of 2009 was $0.46, compared with fully diluted losses per share of $0.26 in the first quarter of 2009 and with fully diluted earnings per share of $0.52 in the second quarter of 2008.

For the second quarter of 2009, non-GAAP adjusted net income was $0.5 million compared with non-GAAP net income of $7.1 million for the previous quarter and $29.2 million for the same period of last year. Fully diluted non-GAAP adjusted net income per share was $0.02, compared with fully diluted non-GAAP adjusted net income of $0.27 for the first quarter of 2009 and $1.05 in the second quarter of 2008.

So, thank you for listening to our presentation today. At this point, we'll take questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Alicia Yap with Citigroup.

Alicia Yap - Citigroup

I have a few questions. First of all, I did not get the active paying customer number for the first quarter and second quarter. I'm not sure you actually disclosed that. If I remember currently in terms of the ARPU, previously I think the ARPU was actually below RMB100 and so what contributes to the increase of ARPU in the first and second quarter to over about like RMB290? How much contribution from FIFA Online 2 and Atlantica during the second quarter? Then I have couple more follow-ups.

Xiaowei Chen

Thanks, Alicia. Let me take the first question. Let me repeat what I mentioned earlier. On a combined basis, our commercialized gain excluding World of Warcraft which means it's a combined basis of SUN, GE, FIFA and Atlantica; of which only SUN and GE were available in Q1 and Atlantica and FIFA were launched in Q2.

Actually, Atlantica was only launched in June and FIFA was launched in April. But on a combined basis, in Q1, which means only between SUN and GE, we had an aggregate asset user of 1.5 million and active paying accounts of 74,000.

With the joining of FIFA Online 2 and Atlantica in Q2, our aggregate accounts were 3.2 million and active paying users is 73,000. So I hope that's clear enough. We don't breakdown game-by-game, hope that's understandable. In terms of why the ARPU has increased before because of the weighted average of World of Warcraft being 90% of our revenue our ARPU and also by then our ARPU was mainly contributed by World of Warcraft and because that's a time-based game and we charge almost strictly by the hour except for some of our paying services like paid transfer of accounts and rolls, so that's marginally around $0.45 R&D per hour.

However, when you are talking about ARPU this time, what I just mentioned ARPU of RMB299 yuan in Q1 and ARPU of RMB221 in Q2, that's all contributed by SUN, GE and FIFA and Atlantica all of which are item-based games.

Operator

Your next question comes from the line of [Hyatt Gau with SIG]. Please proceed.

Unidentified Analyst

I have two questions, the first one is, how much is fixed expenses in this quarter? Also in your second quarter cost of service, how much is fixed cost?

George Lai

I want to clarify your question. You want to know the fixed cost of...?

Unidentified Analyst

Actually, I think my question has two parts. The first one is about in your second quarter cost of service, how much is fixed cost?

George Lai

Actually, I can give you a rough idea about our cost component. It includes our payroll in customer service department, and also depreciation of service, and also our royalty payment and amortization of license fee. All these four components are the major components in our cost of services. So it depends on how you will return fixed cost, I'll say the customer service department payroll is fixed, while for the depreciation of service, because you know the service are kind of rolling forward account. So, I'm not sure whether you want to include it in the fixed cost.

For the royalty and also amortization of license fee it also depends on the gain. So, normally we would not classify our cost of services into fixed or in variable in that way.

Unidentified Analyst

Can I still go back to your cost of service question, because I just try to simply know, how can we model the cost of service in the following quarters given the depreciation has been cut off a lot?

George Lai

Let me give you some percentage. Included in our cost of services royalty accounts for around 42% of our total cost of services, and then the next big item is the IDC rental which accounts for 12% of our cost of services, and then depreciation as I just mentioned is 20% in the cost of services, and amortization it is 8%. Amortization of license fee is 8%, and the last item is fairly of our Customer Service Department. It only accounts 7% of our total cost of services. So if you consider only payroll is variable cost and I guess royalties will be variable as well, so adding these two together account for around 60% of our variable costs.

Unidentified Analyst

My second question is about your expenses line, how much of them going to be fixed [up to the while] tax been cut off?

George Lai

As far as you know we do not provide guidance for our going forward financials, so I can only give you a rough idea for the fee like items, for our R&D expenses, we expect it will increase going forward because we are going to put more of our resources in our R&D. For selling and marketing expenses, we expect and it will decrease by little bit because in the first and second quarter, we put a lot of our resources in marketing campaigns for our new games. For G&A in general it will decrease because we have pursued quite an aggressive cost cutting post (inaudible), and also on the other hand in the past there are some couple of pieces relating to World of Warcraft, included in G&A expenses. Now (inaudible) we do not have this type of (inaudible). So you can expect our G&A expenses will decrease going forward.

Operator: Your next question comes from the [Julie Yap] with Citigroup.

Unidentified Analyst

I actually have to follow-up with Xiaowei's answer on the ARPU question, because if I remember correctly, your ARPU and APA was in the previous disclosure were mainly only for the item-based game and does not include the World of Warcraft. I think previously you have about 70 for the aggregate number and about 90 on [BSR]. So, I just try to understand with the increase of the ARPU and then with your decrease in the APA, is it mainly because the remaining customer actually pay a higher ARPU in your SUN and GE. What's the contribution? Is there anything related to the launch of FIFA and Atlantica that drive the increase in ARPU?

Xiaowei Chen

The ARPU before, yes, you are right. Mainly due to World of Warcraft and that's on time based game, basically it's $0.45 per hour with a few paid transfers and paid services and that's pretty flat.

The ARPU that you saw this time, what I just mentioned in the earlier part of this call RMB299, that's per quarter and RMB221 also for Q2, that's per quarter. So if you wanted to do it in a simple way per month it is roughly a third of that, and that's pretty much in line with other peoples experience of item-based games and on the four games because all of these numbers we mentioned are excluding World of Warcraft, so all of the current games that we have SUN, GE, FIFA ONLINE 2 and Atlantica are item-based games.

Unidentified Analyst

Then I have second question regarding the impairment costs. Just want to make sure we have this clear. So the 15 million write-off in the cost of revenue in the first quarter is related to the prepaid royalties to WoW license, and then the 4.4 million write-off in the second quarter is also related to the goodwill impairment to WoW, and are these write-off is done and should we not expecting any additional write-off going forward?

George Lai

Yes, you are right. We don't expect any more write-off or impairment relating to WoW going forward.

Unidentified Analyst

Okay. And then lastly on the write-off is the 12 million in the fourth quarter '08 and which you said is related to impairment of receivable and prepayment of advance to supplier and the upfront licensing fee of certain games. When you mentioned in terms of your pipeline for your newly licensed game, going forward, you only mentioned about Audition 2 and also the new under license Kingdom Hero in the pipeline. So should we assume that you have written-down on some of the older games you licensed such as RO2, FM, Huxley, Hell Gate?

George Lai

Yes, you are right.

Unidentified Analyst

And lastly will you be able to provide the ACO and [MPCO] on World of Warcraft?

Xiaowei Chen

World of Warcraft reached its record performance in Q1. And I'm reaching for my data, in 2009 Q1, World of Warcraft PCCU reached 1.06 million and I don't believe we have disclosed ACCU before. In 2009 Q2, World of Warcraft PCCU maintained almost as high as in Q1, however it was stopped on June 7th, so these are the numbers that I can give you, but they both reached over 1 million in Q1 and Q2. The news of The9 exploration of license was announced in April, so more of that effected in Q2 than Q1.

Operator

(Operator Instructions) Next question comes from Andrey Glukhov, with Brean Murray, please proceed.

Andrey Glukhov - Brean Murray

Thanks for taking the question. Xiaowei, maybe you can help us kind of understand what was the overall headcount for the company exiting the second quarter? Where would you expect the headcount to end up, exiting the year?

Xiaowei Chen

The headcount exiting the second quarter is around 1200 and we expect to further maximize our efficiency as the company and we currently cannot disclose the target yet and it also depends largely on the launching schedule of our various new games in the pipeline including Audition 2 and also (inaudible) or World of Fighter, which is our proprietary game.

Andrey Glukhov - Brean Murray

If you look at Audition 2, what is your guys' current expectation when the game would be, let's say in open beta?

Xiaowei Chen

The Korean partner has set their closed beta schedule, and that is targeted for later this year and at this point, we’re still in discussions with our Korean partner T3, on how to and when to launch it in China. At this point I regret not being able to share better information.

Andrey Glukhov - Brean Murray

I guess the last question, if I may. On FIFA Online 2 and Altantica the games that you launched in the second quarter. Can you guys give us some sense on what the magnitude of the marketing commitments or the marketing investments for those games are?

George Lai

We have not disclosed the marketing expenses for individual games because it is quite sensitive commercially. So, we apologize we cannot disclose that.

Xiaowei Chen

Let me clarify by saying that for FIFA Online 2, it’s a highly seasonable kind of game because of the Chinese Super League season and World Cup coming up next year. Our marketing campaigns would be largely design to time with those major events because we believe that those major events will bring a major growth to the FIFA Online 2, PCCU and ACCU level.

For Atlantica, we’re currently still working with the Korean partner on some of the technical issues and our marketing campaign will be designed once the technical issues are resolved.

Operator

(Operator Instructions) Your next question comes from the line of Atul Bagga with Thinkequity. Please proceed

Atul Bagga - Thinkequity

Thank you for taking my call. Can you talk a little bit about what cost adjustment you might have made after World of Warcraft contract expiry? Secondly, when do you guys expect to be cash flow positive? Thank you.

George Lai

Can you repeat your first question, I couldn't get you.

Atul Bagga - Thinkequity

My first question was regarding the adjustments you might have made in your cost structure post World of Warcraft contract expiry?

George Lai

If you are talking about the financial impact like all those impairments, we have written off 15 million of prepaid royalty in the first quarter and about 4.4 million of goodwill relating to WoW in the second quarter.

Atul Bagga - Thinkequity

In terms of the headcount, in terms of your other fixed expenses, can we expect to see any reduction in those expenses going into third quarter?

George Lai

You can expect because we do not operate this scheme anymore, so like in the past those depreciation relating to WoW service, our future and financial results and also in terms of the headcount in our customer service department. The headcount relating to WoW have been decreased quite significantly. We can also expect a decrease in the expense.

Atul Bagga - Thinkequity

Can you quantify the impact, how much expenses might be going down because of World of Warcraft from Q2 to Q3?

George Lai

In terms of the headcount, we have around 600 people in the customer service responsible for WoW and so basically we have plan to and transfer some of them to out other games and some of them and actually they leave the company for other reasons. So, you can expect the headcount for that has been decreased by approximately about 30% to 40%.

For the cost sales (inaudible) actually I just provided to another analyst just now, do you need those data again, I believe if you have those data, you can have a better estimation of our future cost.

Xiaowei Chen

I know you are asking for a quantified answer, let me qualify George's answer, by saying that with the cease of operation of World of Warcarft, several items are ceasing. Number one, for our World of Warcraft, we had a marketing commitment and that has ceased. Also with the World of Warcraft some of the fixed costs like the depreciation of servers, you will not see in our P&L coming up in Q3, and also in terms of bandwidth cost and IDC cost, rental cost you will not see in our Q3 P&L either and in terms of headcount adjustments George has just mentioned.

The major items in terms of cost structure that you saw before in our previous P&L, you will no longer see in the coming up P&L. That qualitatively answers your question.

Operator

(Operator Instructions) Your next question comes from the line of Eddie Leung with Bank of America, please proceed.

Eddie Leung – Bank of America

Have questions about your investments in studios, could you share with us what experience as a teams that you guys have been (inaudible) and what type of games that you developed?

Xiaowei Chen

The investments we made in two major studios in first half of this year include one in (inaudible), for competitive reasons we cannot disclose much more details regarding who they are and how much investments we made exactly, however, let me just say that these are very, very experienced game developers with proven track record and each one is developing at least one major MMORPG that we believe should be ready by 2010.

Operator

Your next question comes from the line of Wendy Huang, with RBS, please proceed.

Wendy Huang - RBS

Just want to get some clarification on your APA and active accounts number you provide. I wonder if the 1.5 million, if 3.2 million is for the registered account or active accounts and why are your active paying accounts declined from 74,000 to 73,000 from Q1 to Q2?

Xiaowei Chen

The 1.5 million you mentioned was aggregate active users, so not just registered accounts but active user accounts for Q1 and 3.2 million for active user accounts in Q2. You're right in Q1, the active paying accounts was 74,000 and Q2, it was 73,000 and that’s largely due to the decrease in SUN and GE because of the lack of content upgrades, but we have major content upgrade especially new item upgrades coming up in the third quarter.

Wendy Huang - RBS

(inaudible) seems inconsistent with active accounts growth, should we assume that some people still stay in the game, but they just stop paying?

Xiaowei Chen

You're right. Superficially, it definitely looks inconsistent. The major increase in active account increased from Q1 to Q2 is due to the launch of new game, FIFA Online 2 and also Atlantica. So you can see a major surge in active account registering.

When FIFA Online 2 and also Atlantica are newly launched, especially when they are not commercialized, remember that Atlantica was only commercialized I think in Q3 or at the end of Q2, so that doesn’t contribute to active paying accounts.

And also FIFA Online 2 when it was just commercialized in May 20, it didn’t have many sellable items when it was first commercialized. So they don’t contribute majorly to active paying accounts, the decrease you saw was largely due to the decrease in active paying account from SUN and GE the two order game.

Wendy Huang - RBS

So is it fair to say the decrease in ARPU from Q1 to Q2 is also partly diluted by the new games?

Xiaowei Chen

It’s not partly diluted by the new games. I would rather say that it’s due to the decrease of old games from Q1 to Q2. Remember in Q2, Atlantica only contributed for like 10 days, in terms of paying commercial launch. And FIFA only contributed for a month. Their contribution was very little to offset the larger base as the older game.

Operator

Your next question comes from the line of [Hyatt Gau with SIG].

Unidentified Analyst

A follow-up question about, how are the FIFA Online 2 and Atlantica doing now? We just try to get some near-term revenue picture?

Xiaowei Chen

I really apologize, [Hyatt], I couldn’t get your question at all. The sound was muffled.

Unidentified Analyst

My question is about, can you give us some update about your FIFA Online 2 and Atlantica's current picture?

Xiaowei Chen

What about them. Sorry, I didn't get the last part of your question.

Unidentified Analyst

How those games are doing now.

Xiaowei Chen

How are those games doing now?

Unidentified Analyst

Yes, right.

Xiaowei Chen

FIFA Online 2 was launched on April 22nd and commercialized on May 20th. And right now our operational team is working on, number one, working with potential partners to incorporate new features into the game.

And as I mentioned the China [SuperMeek] we believe, their game has a major impact on local soccer fans. So that's one thing that we're working on. We're also working on new marketing campaigns, including creative ways of bringing marketing campaigns into FIFA Online 2 and for competitive reasons I cannot disclose this at this point.

For Atlantica what we are doing right now is as I mentioned before, working with our Korean partners in solving some of technical issues. We do believe that Atlantica is the game with strong potentials. Its performance was highly valued in North America and Korea and other markets where the internet environment and also hardware of players are somewhat more advanced. Right now, we're working with our Korean partners on reducing the memory size to a manageable size and we believe that could allow more players to join that game.

Operator

Your next question comes from the line of [Thomas Chen with Integral Capital]. Please proceed.

Unidentified Analyst

I have a question about your expenses, could you give us some colors on your margin trend going forward and how should we model your gross margins and your operating margins? Also I remember George mentioned to a previous question that you expect your R&D expenses to increase and your marketing expenses and your G&A expenses to be decreasing going forward. Just to make sure I understand you correctly, do you mean those expenses to be increasing or decreasing in absolute amount or as percentage of your revenue?

George Lai

In absolute amount.

Unidentified Analyst

In absolute amount, so what about the margin trends?

George Lai

Frankly speaking to the margin trend all depends on (inaudible). I think you can easily make your model by picking out WoW revenue from our existing revenue and at new games revenues and then you can develop your model. I apologize; because you know we do not give any guidance. I'm afraid I cannot give you more color on this.

Unidentified Analyst

WoW is a licensed game, so we all know that it is kind of like pressure to your margin. Now with this game [gone] so probably with a lot of your current portfolio, actually consistent of your in-house [stable again]. Can we expect that your margins to be like increasing a little bit going forward?

Xiaowei Chen

I think you are right. Let me qualitatively answer your question. In terms of margin trend, let me clarify that when George said it all depends on revenue, actually revenue and revenue are different. The revenue from licensed games are different from revenue from proprietary games and one of the reasons for developing proprietary games is obviously to increase margin trends. You are absolutely correct that when our proprietary games are launched, we should expect at least gross margin trends to turn very positively.

One other thing that I want to mention also is that now that we have a collection of medium-size games if you will compare to one standard performance game, I think a lot of the management's focus would be on how to create synergy amongst medium-size games and also how to increase our efficiency amongst medium-size games. And these are all the questions that we're working right now and even among licensed games, we also expect our margin trend to turn positively compared to before.

Unidentified Analyst

And also Xiaowei, could you please help actually repeat the launch date for your Audition 2, I didn't get that?

Xiaowei Chen

I didn't say it either.

Unidentified Analyst

I think you mentioned the closed beta testing on Audition 2 seems to be underway?

Xiaowei Chen

Closed beta testing, right. Our Korean partner for Audition 2 has already set a closed beta testing for their own market and we're currently working with them on setting our closed beta test dates for our China market.

Operator

Next question comes from the line of Wallace Cheung - Credit Suisse.

Wallace Cheung - Credit Suisse

Just one simple question; say in the next six to 12 month time, can you just give us a little bit more color on the pipeline in terms of the games and also in terms of the timing?

Xiaowei Chen

Let me answer this question by saying that in the next six to 12 months, the games that to be launched in our pipeline from the licensing side would include Audition 2 and very likely Kingdom Heroes Online 2.

On the proprietary game side, we have two that are already in closed-beta testing, which are (inaudible) or Warriors of Fate and on Jiu Zhou Zhan Ji or Dragon Empire. In 12 months, there may be a chance that our second major MMORPG, MUX or Miracles: Ultimate X would be launched within the 12 month timeline too.

I don't really want to place a deadline on that because as you know good developers shouldn't be rushed. I should have also mentioned that there may be a chance that the two studios that we most recently invested in may have their products ready also in 2010, but again we don't want to rush the developers.

Wallace Cheung - Credit Suisse

So basically we could have around four to around seven games that to be launched in the next six to 12 months times?

Xiaowei Chen

I think you're right. The games that I mentioned, includes both licensing and proprietary.

Wallace Cheung - Credit Suisse

Okay. Just one quick follow-up; I think previously in my model, I think have record quite few other different names, so we simply just removed the names from our modeling?

Xiaowei Chen

As George has mentioned, some of the older license games have been written-off in this half of 2009.

Wallace Cheung - Credit Suisse

Okay.

George Lai

So it's for 2008.

Xiaowei Chen

Yes. In last quarter of 2008.

Wallace Cheung - Credit Suisse

Yes, that's good. Thank you.

Operator

Your next question comes from the line of Alicia Yap with Citigroup. Please proceed.

Alicia Yap – Citigroup

Just have one quick follow-up on in terms of your servers for World of Warcraft. What are you going to do? Are you going to sell them in the future, or are you going to be able to use it for other games? Thank you.

Xiaowei Chen

Thank you, Alicia. The servers for World of Warcraft were ordered according to specifications designated by (inaudible) and they were especially designed for that game. We obviously would try to see if there are other games that we can apply them too, but game servers are very specified and at this point we're not going to try to force them into a game that is not most suitable for those servers. And at the same time if there is buyers who are interested in buying our servers and if they are at the right price then we would certainly be happy to consider them. But as of today they have been written-off.

Alicia Yap – Citigroup

Okay. Thank you.

Operator

Your next question comes from line of Wendy Huang with RBS. Please proceed.

Wendy Huang - RBS

Just one question on the FIFA ONLINE 2, Xiaowei, could you share maybe the trends experience in the last World Cup and how the FIFA Online's number was boosted by the World Cup last time? Could you quantify your expectation for FIFA for 2010, due to the World Cup?

Xiaowei Chen

Thanks. Before I start let me just say that football in China is a very hard item to quantify. I think most Chinese football players and fans would understand what I am talking about. At the same time, I believe in heights of the Korean games during World Cup. It was 100,000 PCCU? Yes, it was somewhere between 100 to 150,000 PCCU in Korea and for a country as Korea I think that's a huge percentage of their online game population.

We believe that World Cup in China would definitely give FIFA Online 2 a boost in this market too. Exactly how much to quantify it's a really hard question to answer. Obviously I have to say that the Korean teams performance in that World Cup was stellar and I am not saying that the Chinese team's performance will not match that, but you know miracles can happen.

Wendy Huang - RBS

Maybe could you give me something what's PCCU percentage increase before Warcraft and post Warcraft in Korea (lifetimes)?

Xiaowei Chen

I do not have that data available with me, but let me again clarify by saying that the Korean market situation although as close as it can get to China is not exactly parallel to the Chinese market situation. The football environment in these countries are very, very different. The Internet environment and the online gaming environment in these two countries are somewhat different too. And so I would be happy to find those data and provide to you offline later on, but I am not sure how much reference value they may have, in terms of quantitative reference value. In terms of qualitative reference value, we're pretty confident that the World Cup would give FIFA a boost in China too.

Operator

At this time there are no further questions.

Phyllis Sai

We would like to thank you all for participating in today's call. Please feel free to contact us with any additional questions. Thank you. Thank you all.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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