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The9 Limited (NASDAQ:NCTY)

Q4 2006 Earnings Call

February 14, 2006 8:00 pm ET

Executives:

Dahlia Wei - Senior Manager, Investor Relations

Jun Zhu - Chairman and Chief Executive Officer

Hannah Lee - Vice President and Chief Financial Officer

Analysts:

Catherine Leung - Citigroup

Lin Chi - Lehman Brothers

Antonio Tambunan - Bear Stearns

Dick Wei – JP Morgan

Paul Keung - CIBC World Markets

William Bean – Deutsche Bank

Chang Qiu - Forun Technology

Presentation

Operator

Good day, ladies and gentlemen, and welcome to The9 Ltd's Q4 and FY 2006 earnings conference call. My name is James and I'll be your coordinator for today. Operator instructions. I would now like to turn the presentation over to your host for today's conference, Ms. Dahlia Wei, Senior IR Manager of The9 Ltd. Please proceed, ma'am.

Dahlia Wei - Senior Manager, Investor Relations

Thank you, Operator. Hello, everyone, and thank you for joining us today for The9’s Q4 and FY 2006 financial results conference call. The management with me today are Mr. Jun Zhu, Chairman and CEO, and Ms. Hannah Lee, 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 has filed 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 management’s projections or forward-looking statements.

Let me now turn the call over to Mr. Zhu, our CEO, who will provide you with an overview of our business for the quarter and fiscal year.

Jun Zhu - Chairman and Chief Executive Officer (TRANSLATION)

Happy Valentine's Day, ladies and gentlemen. I would like to thank you for participating in our discussion of The9's Q4 and FY 2006 earnings.

First, I would like to present a quick overview of the key financial highlights for Q4 and FY 2006. Net revenues for Q4 2006 were $36.2 million, representing 21% QoverQ growth. Net income was $13.5 million for earnings of $0.54 per ADS for Q4 2006. For FY 2006, net revenues were $126.3 million, representing 112% YoverY growth. Net income for FY 2006 was $14.0 million, or earnings of $1.63 per ADS.

Now let me discuss in detail our current operations. With respect to our licensed games, currently we have World of Warcraft (WoW) in commercial operation, Guild Wars in limited open beta testing and Soul of the Ultimate Nation - SUN - in closed beta testing. In addition, we have five highly rated games in our pipeline.

For WoW, since we launched the seventh server site at the end of September last year and introduced the crossover battleground function subsequently, we have seen WoW's game resume steady growth momentum throughout Q4.

For Q4 2006, WoW's peak concurrent users was over 680,000 and the average concurrent users was 340,000. As of December 31, 2006, approximately 6.8 million accounts had been registered and activated for the WoW game in mainland China.

As you may know, Blizzard Entertainment launched the highly anticipated expansion pack for WoW, The Burning Crusade, on January 16, 2007 and has broken day one sales records in North America and Europe. We are very encouraged to see the strong DPO[?] of the Burning Crusade in overseas markets and we are very excited to bring this expansion pack to mainland China.

We have started to prepare for the launch of the Burning Crusade in Mainland China, including content localizations, server arrangements and so on. We currently estimate that the Burning Crusade will be launched in Mainland China by the end of Q2 2007.

For Guild Wars, we started limited open beta testing January 19, 2007 and so far the demand is high. We plan to commence full scale open beta testing for Guild Wars by the end of Q1 2007, after the Chinese New Year holiday.

Pepsi Cola is our co-marketing partner for the Guild Wars games. During the limited open beta testing, we distributed Guild Wars game account through Pepsi's nationwide internet testing channels and we will hold Pepsi-sponsored Guild Wars tournaments and other marketing campaigns in the coming months.

Partnering with domestic or international famous brands to conduct marketing and promotion efforts has been proven to be one of our most important marketing methods to promote online games. Many renowned brands of different industries have shown interest in our strong game pack line, and we are currently in discussions with them to explore potential cooperation opportunities.

For SUN, we started closed beta testing on February 2, 2007 and have seen strong demand with a substantial amount of applications. The higher ratio between the number of closed beta testing accounts activated and to the number of accounts we've released is above our expectations. SUN has long been a highly anticipated MMORPG among mainline China gamers with constant top rankings in [Solvez?] [after being treated?] by one of the largest independent game information portals in China.

With several new games being introduced to the China market, we are also continuing to build our game platform. Recently, we have successfully added three new high caliber games. Ragnarok Online 2 also known as RO2, and Emil Chronicle Online, also known as ECO, and Huxley to our games portfolio. Both RO2 and ECO are cartoon-style MMORPGs, licensed from Grabkey[?] and Huxley is a massively multiplayer online FPS MMORPS, licensed from Webzen.

Together with Granado Espada and Hellgate: London, we believe RO2, ECO and Huxley further strengthened our impressive licensed gaming platforms that is unparalleled to those of other game operators in China. Recognized as the panel of choice in China by renowned overseas game developers, we will continue to look at high quality games work-wise so as to further enrich and diversify our strong pipeline and bring additional fantastic games to Chinese online game players.

Now let me update you on our proprietary in-house developed games. Joyful Journey West is generating small but stable revenue streams since we launched the shopping mall function for the game in September 2006. Fantastic Melody Online, also known as FM Online, a 3D zone action-based MMORPG that we developed through outsourcing arrangements, is estimated to launch in the second half of 2007. In addition, we have another two MMORPG titles that are currently under development.

With a [business scanning plan?] for 2007 and beyond it is necessary to further enhance our existing management team. Recently we announced several appointments at VP level. Through internal promotions and additions of industry veterans from leading game companies, our management team is further strengthened. I expect our management team to fully utilize our resources to execute on our corporate strategy, leading to The9's future success.

Taking this opportunity, I would like to briefly review our FY 2006 and reiterate our company strategy going forward.

In FY 2006, we achieved solid operational performance for WoW, rolled out new games, obtained several new MMORPG licenses, took our first step into the CARO[?] Game through a joint venture and expanded our overseas business to South East Asian markets. I am pleased and confident to report that for the year 2006 was a fruitful year for The9.

The9's core strategy is to offer the best quality games to Chinese users. We plan to execute this strategy by continuing to solidify our partner of choice position and focus on licensing top notch games, meanwhile maintaining the rest of our investments in in-house games development. Going forward, we will also diversify into CARO[?] Games and other game types. We believe our focused strategy, our strong execution capabilities, as well as our passion and determination will drive long-term sustainable value for our shareholders.

Now I would like to pass the call to Hannah Lee, our CFO, who will provide you with a detailed discussion of our Q4 and FY 2006 financial results.

Hannah Lee - Chief Financial Officer

Thank you, Jun, and hi, everyone. I would now like to take you through an overview of our Q4 and FY 2006 financial results.

For Q4 2006 The9 reported net revenues of $36.2 million, a increase of 21% from Q3 2006 and a 33% increase compared to Q4 2005. For FY 2006, net revenues increased by 112% to $126.3 million from $59.6 million in FY 2005. The substantial year-over-year increase of revenue was primarily because The9 commenced commercial operation of the World of Warcraft game in Mainland China in June 2005. In FY 2005, approximately seven months of revenues from WoW was recorded. Net revenues attributable to WoW, which included revenues from game playing time, merchandise and installation package sales were $36.1 million and $125.3 million for Q4 and FY 2006 respectively.

This represents a QoverQ increase of 22% and a YoverY increase of 33%. ARPUH - average revenue per user hour, for Q$ remains stable at RMB0.39, compared to the previous quarter's level.

The attainment of stable ARPUH was mainly because we launched the seventh WoW server site in Q4 2006 and the server capacity remained at a high utilization level due to strong user demand.

For Q4 2006, gross profit rose 25% sequentially and 38% YoverY to $17.3 million, mainly due to increased revenues. Gross profit margin increased to 48% from 46% in Q3 2006, mainly because of increased player usage and better utilization of server capacities in Q$ following the completion of planned server merges and opening of a new server site in late Q3.

For fiscal year 2006, gross profit increased by 106% to $59.2 million $28.8 million in FY 2005. This year-over-year increase of gross profit was primarily due to full year revenue contribution from World of Warcraft in 2006 compared to only approximately seven months in 2005.

Operating expenses for Q4 2006 increased 23% to $7 million from $5.7 million in the previous quarter in line with the revenue trend. This sequential increase was a combined result of increased sales and marketing expenses as we commenced pre-launch marketing activities for Guild Wars and the Soul of the Ultimate Nation and increased general and administrative expenses due to higher year-end related professional fees.

For FY 2006, operating expenses totaled $24.6 million, a 16% increase from $21.1 million for FY 2005. This was primarily due to increased general and administrative expenses mainly related to headcount increase, share-based compensation expenses resulting from the adoption of SFAS 123(NYSE:R), share-based payment, effective from January 1, 2006, and higher professional fees.

At the operating level, we recorded a profit from operations of $10.3 million in Q4 2006, a 26% increase from $8.1 million in Q3. Operating margin for Q4 2006 was 28%, which remained relatively stable compared to 27% in Q3 2006 and 25% in Q4 2005.

For FY 2006, we recorded a profit from operations of $34.6 million, increased by 352% from $7.6 million for FY 2005. This significant improvement was primarily due to full year operations of WoW in 2006.

Other income for Q4 2006 was $2.5 million compared to other expenses of $0.1 million in Q3 2006 and $1.6 million in Q4 2005. The QoverQ improvement was primarily due to the receipt of a financial subsidy of $2.5 million from the local government, whereas no similar financial subsidy was received in Q3.

Two items of note in Q4 2006: we recognized a gain of $3.0 million from the sale of our equity interest in a joint venture in Taiwan that operates World of Warcraft in other greater China regions. In addition, we recorded an impairment provision of $2.6 million in connection with our equity investment in Optic Software, a Beijing development house of which we have a 20% equity interest.

Net income for Q4 2006 was $13.5 million, a 63% sequential increase from $8.2 million in the previous quarter and a 54% year-over-year increase compared to Q4 2005. Net income for FY 2006 was $40.0 million, a 331% increase YoverY from $9.3 million in FY 2005. Fully diluted earnings per share for Q4 2006 was RMB4.25 versus $0.54 compared to RMB2.61, i.e. $0.33 in Q3 2006, RMB2.82, i.e. $0.36 in Q$ 2005. Fully diluted EPS and per ADS for FY 2006 were RMB 12.72, i.e. $1.63 compared to RMB2.92, i.e. $0.37 in FY 2005.

Non-GAAP EBITDA for Q4 2006 was $18.8 million compared to EBITDA of $13.5 million in Q3 and $14.0 million for the same period in 2005.

On a per share basis, fully diluted EBITDA per share was $0.76 for Q4 2006, compared to $0.55 for the previous quarter and $0.58 for Q4 2005. For FY 2006, non-GAAP EBITDA was $61 million compared to $19.4 million for 2005. On a per share basis, EBITDA per share was US$2.48 compared to $0.78 in 2005. As at December 31, 2006, The9's total cash and cash equivalents balance was $120.2 million, a 23% increase compared to the balance of $96.4 million as of September 30, 2006 and a 92% increase compared to a balance of $60.5 million at December 31, 2005.

This increase was mainly due to the combined result of increased receipts from prepaid game points, and financial subsidies, offset in part by purchases of servers, prepaid royalty payments to the licensor relating to WoW's China operations, the final payments in early 2006 relating to the purchase of the remaining interest in the entity that operates WoW in China, and payments relating to the license fees for the Guild Wars and Hellgate: London games as well as an equity investment we made during the year.

With this, I would like to thank you again for your attention, and we would like to thank you, everyone, for participating in this call. Operator, we are ready to take questions.

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Questions-and-Answer Session

Operator

Operator instructions. Your first question comes from the line of Catherine Leung - Citigroup.

Q - Catherine Leung - Citigroup

My first question is can you disclose the terms of the Burning Crusade licensing agreement? And probably give us an update on how it's currently doing in North America and Europe? I know that it had a very strong [inaudible] in January.

A - Jun Zhu (Translated)

For the Burning Crusade, as I always said, it's mostly regarding the marketing arrangement and the timetable and also the server configurations and relevant arrangements. You know, I think we saw the very strong build of the Burning Crusade in North America and Europe and we have been very confident for the future performance of Burning Crusade in the Chinese market. As I said in the presentation section, our WoW registered and activated accounts have reached 6.8 million in Mainland China and I believe after the [long preparation?] stage that a lot of users will come back to play the WoW game again.

Operator

Your next question comes from the line of Lin Chi - Lehman Brothers.

Q - Lin Chi - Lehman Brothers

I have a question on your [new projects?] Huxley and Hellgate: London. It seems like these two games are both online FPS games. Can you comment a little bit on the launching pipeline as well as how you see the potential competition between these two games?

A - Jun Zhu (Translated)

I think although Huxley and Hellgate: London have similarities, they also have very different features. Huxley is very focused on the FPS side and Hellgate: London has kind of a balance between MMORPG and the FPS features. Overall I think the two games are very different with their own features. We can't estimate that Hellgate: London will have closed beta testing and open beta testing in Q4 this year. Huxley is now under development so we currently estimate it will be a 2008 game for us. It is not [inaudible] that Hellgate: London in the recent road show in Taiwan received very good feedback from the European market and a lot of industry people have very high expectations for this game.

Operator

Your next question comes from the line of Antonio Tambunan - Bear Stearns.

Q - Antonio Tambunan - Bear Stearns

I have a question on your execution strategy. Can you please comment on your execution strategy going forward as you move basically essentially from a one game to an eight game company in such a relatively short time and then answering this, could you please discuss your views on trends and personnel costs? I know that it is primarily R&D development costs that are skyrocketing irrationally around the world, but are you seeing rising per head count costs as well on the support level? And are you seeing any personnel shortages in China, especially with all these newly funded studios?

A - Jun Zhu (Translated)

As you may know, we recently announced several appointments at a VP level. I believe with the addition of several international and domestic VP-level personnel, our management team has been strengthened. Apparently, looking at our structure, each team will be operating one game but also a different game teams will share synergy according to our experience with the WoW game.

A - Hannah Lee

With respect to your questions about salaries and costs, we have not seen significant increases of head count costs. We projected that our main increase in head count, especially in 2007, with more games to come out as you know, the demand for customer service staff is the greatest. Customer service staff, we have noticed, have not had a significant increase. The only increase that we have found in our areas of personnel we have is in current roles in the production areas in terms of internal R&D teams. Other than that, we believe in terms of The9 itself, we have still a very strong team with additions of several VPs from internal promotions or bringing them in from other companies or from overseas. We have built a very strong management team but from an operational level, I think we have always been known to have a very strong middle management team. From that perspective I think we do not anticipate there would be a significant increase from our personnel perspective.

Q - Antonio Tambunan - Bear Stearns

What about my previous question about shortages? I mean, are we seeing - if you don't see it now, do you see potentially it's going to be harder to recruit more people? Are you seeing shortages or do you expect to see shortages, or are you still going to be able to hire as quickly as you previously had been able to?

A - Hannah Lee

We believe that yes, we will be able to. Our Human Resources department will be able to meet the demand that we see. The significant increase as I said before will come from customer service and those are relatively easy to find. As to talent in terms of R&D departments, as the industry itself grows, more and more people are coming up and have more experience. From that point of view on I think we don't see a significant shortage of talent. There'll always be a shortage of very, very good talent but we just need to get them in and retain them.

Operator

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

Q - Dick Wei – JP Morgan

I wonder if you could throw some color on the Q1 operation for WoW so far and any new peaks you saw? Also, what kind of seasonality effect will you see due to the Chinese New Year?

A - Hannah Lee

As you know, the Chinese New Year from a seasonal perspective, similar to last year, there would be a slight decrease of usage mainly because of the demographics of the players we have. Just like last year. In terms of the overall growth, we so far think that the utilization of the seven server sites that we have right now is still quite poorly utilized. From the going forward basis, we cannot give out specific guidance as to what we think the Q1 numbers would be like, because we don't give out detailed financial projections.

Operator

Your next question comes from the line of Paul Keung - CIBC World Markets.

Q - Paul Keung - CIBC World Markets

Quickly on the R&D decline this quarter, I know Hannah you spoke a little about the trends and that. I was curious as you think about R&D development, is there going to be some seasonality and some [inaudible] next year in terms of the quarters of what you actually spend more than others? Also, give us any sort of [inaudible] as well?

A - Hannah Lee

With respect to R&D, R&D has two parts to it. One relates to pure R&D that we have incurred in which we anticipate there will be an increase in 2007 compared to 2006, mainly because we are currently finishing up one game called Fantastic Melody Online which is scheduled to be pushed out to the market by the end of the year and also we have a couple of projects internally on the go that are still in the planning and the middle development stage. The other parts relating to pre-launch costs of games that we're going to launch similar to a pre-launch of WoW, R&D costs relating to customer service, infrastructure costs, server depreciation, everything will be classified under R&D product development before the game is commercialized. From an absolute dollar perspective, the R&D line item would fluctuate quite a bit, especially within the first half of the year because we are planning to launch a couple of games - Guild Wars and Soul of the Ultimate Nation - before the end of June 2007.

Q - Paul Keung - CIBC World Markets

Great. And the tax rate?

A - Hannah Lee

The tax rate, we anticipate because the WoW PLC entity will be subject to 15% tax, including from a consolidated perspective, we expect our tax rate to be about 15-20% in 2007.

Operator

Your next question comes from the line of William Bean – Deutsche Bank.

Q - William Bean – Deutsche Bank

Just a follow up on the previous question, could you talk a little bit on a quarter by quarter basis on the margin trends as you go through limited open data and closed data to open data? Could you just talk about how you expect marketing and recognition of costs to fluctuate and give us a little guidance as to what we should expect in Q1, 2 and 3? Thanks.

A - Hannah Lee

Because we do not give out detailed financial projections, I cannot tell you or expect what the gross profit would be. All I can say is we expect to spend more in terms of the marketing, mainly because we would have to prepare for launch of two games, Guild Wars and Soul of the Ultimate Nation. Q1 and Q2 the marketing expense will definitely be higher than Q4, because Q4's would mainly be the recurring costs for promoting WoW, plus very little of Soul of the Ultimate Nation and Guild Wars promotion. However in Q1 and especially in Q2 we would also be promoting Burning Crusade, especially in Q2's time. There will be four games in promotion in Q2 and likely be three games in promotion in Q1. With respect to the detailed percentage I don't think we're at liberty to disclose it right now.

Q - William Bean – Deutsche Bank

Could you talk about recognition of costs as you move from I guess closed beta to open beta commercialization? Is anything different in terms of recognition of costs there?

A - Hannah Lee

The recognition itself would not be different, it's just the classification. Other costs such as customer service, depreciation of servers, internet data center rentals - all these costs pre-commercialization would be classified under product development. After the game is commercialized, all these costs would be classified under cost of services, which is above the gross profit line item.

Operator

Your next question comes from the line of Chang Qiu - Forun Technology.

Q - Chang Qiu - Forun Technology

I have a few questions, actually can you elaborate a little more about the current status for the open beta and also the closed beta for Guild Wars and Soul of the Ultimate Nation?

A - Jun Zhu (Translated)

We can talk about them one by one. For Guild Wars, we are currently in limited open beta testing. We have received thousands of applications with very high popularity but we only now offer it to a limited, selected amount of computer users. For SUN, it's in closed beta now. There is a high ratio between the number of accounts activated by our users versus the number of accounts we actually released, it's above our expectations. We have more than 450,000 applications for the closed beta testing account for SUN and we only offered 40,000 of such accounts. So far we have seen 90% of those accounts activated by our users, which is very high. Based on the closed beta testing of performance, our SUN team are very confident in the future open beta performance and commercialization performance for the SUN game. Based on the very good performance of closed beta testing for SUN, Webzen and us have signed some MOUs to further pave the way for the future launch of SUN in China. Overall, our management and our operational teams are very confident in the future SUN open beta testing and commercialization.

Q - Chang Qiu - Forun Technology

That's great. As far as the feedback from the players is concerned, can you tell us, you know, is there any more work or any patch work needed for example for Guild Wars or for SUN?

A - Jun Zhu (Translated)

For all of our games, there is always ongoing development and follow up development work for these games.

Operator

Operator instructions. Your next question comes from the line of Catherine Leung - Citigroup.

Q - Catherine Leung - Citigroup

I just have a follow up question. You mentioned that you stepped into your Casual Games phase in 2006. I was just wondering if you could update us on the strategy for Casual Games going through 2007?

A - Jun Zhu (Translated)

The Casual Game market is actually taking off in the Chinese market. We are talking a similar approach for the Casual Games, which is offering fast, quality games to China, similar to our MMORPG strategy. About two quarters ago we set out a joint venture with our partners and that joint venture license to a group party. That's our first stab into the Casual Games market. Going forward, we plan to work with the leading CARO[?] games in the world, to fully step into the CARO[?] game market.

Q - Catherine Leung - Citigroup

Can I just ask another question on SUN? So given the success that you've seen so far, have you decided on the type of revenue model that you would use? For example, would it be item based or would it be a time based revenue model?

A - Jun Zhu (Translated)

We haven't decided finally on the revenue model but we intend for the free play and action based model for SUN.

Operator

Your next question comes from the line of Lin Chi - Lehman Brothers.

Q - Lin Chi - Lehman Brothers

I have some questions on a strategy level. I notice you disposed of the equity stake of the Taiwan joint venture during the quarter. Can we understand this a bit more - why is that? Also, we know you are have the potential to get into the South East Asian market as well, will this change in Taiwan be a sort of a fact of your overall regional expansion effort? Also another one is The9 has a very diversified talent pool. Looking at your VP level management, you have people from Korea, Taiwan, Hong Kong and Mainland China. It's certainly a very interesting mix. How would you promote a corporate culture to keep the team very integrated and stable?

A - Jun Zhu (Translated)

The acting influence in the Taiwan joint venture will be eventually be sold into our South East Asia joint venture, called IAH. In that joint venture we also own a minority interest. That IAH joint venture already has the exclusive licenses of Granado Espada and Hellgate: London. We have now sold the Taiwan joint venture which is the operator of WoW in the greater China region, so going forward the IAH joint venture will expand their presence in the South East Asian market. The9 will mainly focus on the Mainland China market. The9 have proven to have a very open oriented corporate culture. Every talented person with their unique understanding and interest in the game industry will have their own responsibilities in The9. I think this strategy is very good as a quality game strategy for a multi-game operator and a diversified management team. The9 also provide a very good platform for all kinds of personnel to show their talents.

Q - Lin Chi - Lehman Brothers

A quick follow up if I may. What kind of business models will you be using for Guild Wars so far? Also what do you see as the [high percent for World of Warcraft?] going forward?

A - Jun Zhu (Translated)

For the running model for Guild Wars, we now haven't decided formally on that, but we will be communicating that with you in March.

A - Hannah Lee

Did you ask about the ARPUH for WoW or the ARPUH for Guild Wars?

Q - Lin Chi - Lehman Brothers

The ARPUH for WoW because the last two quarters of APRUH have been pretty high, I just wanted the trend going forward.

A - Hannah Lee

Our objective is to maintain it at the 0.38-0.39 level. To maintain a stable level.

Operator

Our last question comes from the line of Paul Keung - CIBC World Markets.

Q - Paul Keung - CIBC World Markets

I have a follow up question on the free to play model, which has been successful so far. From my research, these games seem to have a very different marketing strategy and a different day-to-day operating structure. I was curious, as you look forward, do you think you still need to invest in up-front fixed costs and 2007 nearly helped ensure long-term success for free to play games that you may have in your pipeline?

A - Jun Zhu (Translated)

I think overall, essentially, there will not be a major difference in marketing for free to play or subscription model games, these are just trying for different things in the game. I think The9 have already accumulated a lot of experience by working with a lot of international famous brands to do co-marketing for games and we are also doing some smaller marketing campaigns for our games, which have been proven to be very successful. I think the key factor of whether a game will be successful or not in China is the content and the quality of it. The vast quality and content of games plus the best marketing will make a success of the game. Our best quality game strategy is based on marketing intelligence.

Dahlia Wei

Thank you. Operator, I think we can cancel the call now.

Operator

Okay. I'd like to turn the call back to Dahlia for closing remarks on behalf of the company.

Dahlia Wei

Okay. Thank you again for participating in today's call. If you have any additional questions, you can feel free to contact us. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Good day.

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