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The9 Limited (NASDAQ:NCTY)

Q4 2007 Earnings Call

February 21, 2008 8:00 pm ET

Executives

Dahlia Wei - Senior Manager, Investor Relations

Jun Zhu - Chairman of the Board, Chief Executive Officer

Hannah Lee - Chief Financial Officer, Vice President

Analysts

Wallace Cheung - Credit Suisse

Analyst for Paul Keung - Oppenheimer

Eddie Yeung - Merrill Lynch

Dick Wei - JP Morgan

Alicia Yap – Citigroup

C. Ming Zhao – SIG

Andrey Glukhov - Brean Murray, Carret

Leah Hao - Goldman Sachs

Victor [Fang] - Deutsche Bank

Eric Wen - BNP Paribas

Operator

Good day, ladies and gentlemen, and welcome to the The9 Limited’s fourth quarter and fiscal year 2007 earnings conference call. My name is Antoine and I’ll be your coordinator for today. (Operator Instructions) I would now like to turn the call over to your host for today’s conference, Ms. Dahlia Wei, Senior IR Manager of The9 Limited. Please proceed, ma'am.

Dahlia Wei

Thank you, operator. Hello, everyone and thank you for joining us today for The9's fourth quarter and fiscal year 2007 financial results conference call. The management with me today are Mr. Jun Zhu, Chairman and Chief Executive Officer, and Ms. Hannah Lee, Senior 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 files 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 the management’s projections or forward-looking statements.

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

Jun Zhu (Translation)

Good morning and good evening, ladies and gentlemen. I would like to thank you for participating in our discussion of The9's fourth quarter and fiscal year 2007 results. First, I would like to present a quick overview of the key financial highlights for the fourth quarter and fiscal year 2007.

Net revenues for the fourth quarter 2007 were $58.1 million, representing 34% quarter over quarter growth. Net income was $11.8 million, or earnings of $0.40 per ADS. For fiscal year 2007, net revenues were $175.4 million, representing 30% quarter over quarter growth. Net income for fiscal year 2007 was $33 million, or earnings of $1.19 per ADS.

Now let me go over some highlights of our games during the quarter. First of all, World of Warcraft. After the phenomenal launch of WoW The Burning Crusade expansion pack in late Q3 WoW enjoyed continued strong momentum in the fourth quarter, attaining a record high of peak concurrent users of over 990,000. The average concurrent user level in the fourth quarter was also at a record high of approximately 470,000. As of December 31, 2007 approximately 10.3 million accounts had been registered and activated for the WoW game in Mainland China.

On November 20 we launched WoW v. 2.3 content upgrade, The Gods of Zul'Aman, which was a patch after The Burning Crusade expansion. Once again, we saw WoW’s concurrent user and usage level boosted. With increasing user demand, to-date we have opened 35 server realms in the no. 8 server site and expect to open the remaining realms in the near future. In addition, we are in preparation for the ninth WoW server site which is scheduled to be launched before June ’08 in order to satisfy anticipated player demand.

During the fourth quarter we conducted a series of marketing campaigns for WoW. In mid-November we kicked off a nationwide WoW tournament promoting a new game feature called Arena which attracted broad user attention and boosted game play time. We also held various holiday-related in-game events during the quarter.

Our Member get Member program continued bear fruit, witnessed by strong new activations during the quarter. To address user demand, we also started to offer WoW game capture transfer services on either a free or paid basis. On the other hand, recently together with Blizzard we initiated the offering of [ME.card] and a security token with high level security password protection tools to further protect users rights and benefits of WoW gamers. How this matter has been carried out has further improved the user experience of our gamers all over China.

Now about Soul of the Ultimate Nation, SUN. SUN's performance remain at relatively stable levels compared to the previous quarter. On December 7, we launched our upgrade patch for SUN called Power of 12 and have seen notable effect with increased in-game consumption, demonstrating satisfied results. We are now setting up an increasingly efficient cooperation mechanism with Webzen whereby several key developers from Webzen are working at our office in Shanghai. With such arrangements, the two companies can work together better and quicker to introduce more frequent content upgrades for SUN for the Chinese market.

Next about Granado Espada (NYSE:GE). We officially commercialized GE on November 22 under the free to play/item sales model. Overall, GE's initial performance in the fourth quarter was quite satisfactory.

With respect to EA Sports FIFA Online 2 we commenced technical testing for the game on January 4, 2008. Although the technical testing was on a relatively small scale, we received positive feedback from testers. Compared to the previous version, FIFA Online 2 has a lot of enhancements in terms of richer content, better playability as well as more items for sale.

As you may have noticed, during the recent Neowiz earnings announcement, Neowiz disclosed encouraging data for FIFA Online 2 in Korea. With the game's existing users transitioning smoothly from FIFA Online to FIFA Online 2, Neowiz remains very optimistic about FIFA Online game and has given an upbeat outlook for the next quarter and fiscal '08. Given the game's high quality, China’s growing online game market sites, as well as a large number of football fans among online gamers, we expect FIFA Online 2 to be well-received by Chinese players.

Now let me briefly update you about other licensed games in our pipeline and their latest estimated launch schedules. Audition 2, the development process is moving smoothly by the Korean developer and the game is close to its final stage of development. We expect to kick off the game's closed beta testing in the summer season of 2008, followed by commercialization under the free to play and item sales model.

Hellgate:London was launched in the US and in Europe in late October/early November last year. Recently, the game’s developer, Flagship Studio, introduced the first big upgrade patch, Stonehedge, adding numerous new content to the game and raising the maximum character level to 50. This upgrade patch was well-received by gamers. Hellgate:London is now under open beta testing in Korea and based on our understanding, is enjoying decent popularity. It has been constantly ranked among the top ten spots on Internet cafe rankings in Korea. The game will start in commercial operations on February 22 in Korea under a monthly subscription model. Based on our valuation of the maturity of the game's content, we currently estimate that we will consider to start beta testing of Hellgate:London by the end of this year.

Now I will briefly talk about our game development. The9 is strengthening our efforts in in-house game developments with our R&D headcount almost double in the past two quarters and several games development projects on the way. [inaudible] beta online, also known as MJSG, a 2D action MMORPG is our second in-house developed game and is scheduled to closed beta testing in Q2 2008.

Fantasy Melody Online (FM Online) a three realm action-based MMORPG is a game we are developing through outsourcing arrangements. It is scheduled to be launched for beta testing by the end of 2008.

Looking back at our fiscal year 2007, World of Warcraft continued to enjoyed high popularity and strong growth as we successfully launched The Burning Crusade expansion pack. We commercially launched two new games, SUN and GE, which contributed incremental revenue sources to the line and milestones to the company's transition from a one-game operation to multi-game operations. We continued to obtain exclusive operating licenses for premium quality games worldwide and meanwhile strengthened our efforts in in-house game development, thus further expanding and diversifying our game portfolio.

Overall, fiscal year 2007 has been a fruitful year for The9. With our focused strategy, topnotch game line, strong execution capabilities as well as our vision in the market, we believe The9 is well-positioned for sustainable growth in the future and will deliver long-term value to our shareholders.

Now I would like to turn the call over to Hannah Lee, our CFO, to provide you with a more detailed discussion of our fourth quarter and fiscal year 2007 financial results.

Hannah Lee

Thank you, Jun and hi everyone. I will now take you through an overview of our fourth quarter and fiscal year 2007 financial results. For the fourth quarter 2007, The9 reported net revenues of $58.1 million, a 34% increase compared to the previous quarter and a 50% increase year over year. The increase was primarily due to higher revenue from World of Warcraft, benefiting from the full quarter impact subsequent to the launch of significant content upgrades from The Burning Crusade expansion pack in September 2007, and approximately one month’s revenue contribution from GE which was commercialized under the item sales model in late November 2007.

For fiscal year 2007, total net revenues were $175.4 million, increased by 30% from $135.1 million in fiscal year 20006. The year-over-year increase was mainly due to revenue growth from World of Warcraft as well as revenue from two new games launched in 2007, namely SUN and GE.

In the fourth quarter 2007, net revenues attributable to the operations of subscription-based games, which included revenues from game playing time, merchandise and installation package sales increased by 39% quarter over quarter and by 38% year over year to $53.1 million. The increase in such revenues was primarily due to higher concurrent user levels as well as user usage after the launch of Blizzard’s World of Warcraft: The Burning Crusade expansion pack in early September.

Net revenues attributable to the operation of item sales based games which included revenues from in-game item sales and installation package sales increased by 23% quarter over quarter to $5.4 million in the fourth quarter of 2007, mainly due to the commercialization of Granado Espada in late November '07 which contributed approximately one month revenue in the fourth quarter.

For fiscal year 2007 net revenues attributable to the operations of subscription-based games which included revenues from game playing time, merchandise and installation package sales were $161.6 million, an increase of 21% from $134 million in fiscal year '06. This year-over-year increase was mainly because of continued growth of user popularity for WoW.

Net revenues attributed to the operations of item sales-based games which included revenues from in-game item sales and installation package sales were $12.1 million, whereas such revenue in fiscal year 2006 was negligible.

During the fourth quarter 2007, ARPUH, average revenue per user hour, for World of Warcraft remained stable at RMB 0.39. In the fourth quarter 2007, item sales games, SUN and GE, in aggregate generated net revenues of approximately 5.4 million and have approximately 4.4 million active accounts of which 252,000 were active paying accounts. On average on a monthly basis, each paying account generated revenue of approximately RMB 73.

For the fourth quarter 2007, gross profit increased by 53% quarter over quarter and 50% year over year to 27.8 million. Gross profit margins for the fourth quarter 2007 improved to 48% from 42% in the previous quarter and was at a similar level compared to the same period for 2006. The quarter over quarter improvement of gross margins was primarily because a portion of costs of services, such as server depreciation and Internet data center rentals remained at a stable level compared to the previous quarter while growth in net revenues take into account the full quarter effect from the content upgrade of the World of Warcraft game.

Gross profits for fiscal year 2007 increased by 26% to 79.5 million from 63.3 million in fiscal year 2006. The year-over-year increase of gross profits was mainly due to increased revenues. Gross profit margins for fiscal year 2007 was 45%, slightly lower than the 47% for '06. This is primarily due to higher server depreciation in 2007 related to hardware upgrades in the second quarter to facilitate the launch of World of Warcraft's The Burning Crusade expansion pack.

For the fourth quarter 2007, operating expenses were $16.8 million, representing a 39% increase from $12.1 million in the previous quarter and 124% increase from $7.5 million in the same period of last year. The sequential increase in operating expenses was primarily due to increased product development expenses relating to new games, pre commercialization, increased sales and marketing expenses relating to Granado Espada and FIFA Online 2; increased general and administrative expenses mainly due to year end related professional fees as well as an impairment provision of 2.4 million on intangible assets relating to Guild Wars.

For fiscal year 2007, operating expenses totaled 47.1 million, a 79% increase from 26.3 million for fiscal year 2006. This is primarily due to increased sales and marketing expenses relating to promotion of several games, in particular significant content upgrades, increased product development expenses due to increased efforts in in-house game development and pre-commercialization costs of these games as well as increased general and administrative expenses primarily related to increase in headcount, non-cash share-based compensation expenses and Sarbanes Oxley compliance-related professional fees.

At the operating level, we recorded a profit from operations of 11.0 million, an 82% quarter-over-quarter increase compared to 6 million and remained largely unchanged year over year compared to 11 million for the fourth quarter '06. Operating margin for the fourth quarter of 2007 was 19%, improved from 14% in the previous quarter, but decreased year-over-year from 28% in the fourth quarter '06. For fiscal year 2007 we reported gross profit from operations of 32.3 million, a 13% decrease compared to 37 million in 2006.

Operating margin, excluding share-based compensation expense of 2.1 million was 23% for the fourth quarter '07 compared to 19% for the third quarter '07, excluding share-based compensation expenses of 2.4 million; and 30% for the fourth quarter '06, excluding share-based compensation expense of 0.5 million. Operating margin, excluding share-based compensation expenses of 6.4 million were 22% for fiscal year '07 compared to 29% for fiscal year '06, excluding share-based compensation expense of 2.4 million.

Interest income for the fourth quarter of '07 was 2.6 million compared to 2.5 million in the third quarter of '07 and 0.4 million in the same quarter of '06. This slight quarter over quarter increase of interest income was primarily due to increased cash balance during the fourth quarter '07. For fiscal year 2007, interest income was 6.9 million, compared to interest income of 1.3 million in fiscal year '06. This was mainly due to increases in cash balance from operations and cash receipts of 167 million from Electronic Arts' equity investment in May 2007.

Other expenses for the fourth quarter of '07 were 2.4 million compared to other income of 2.2 million in the third quarter '07, and other income of 2.6 million in the fourth quarter '06. This slight quarter over quarter increase of other expenses was primarily due to increased foreign exchange loss with a US dollar deposit increase after EA’s cash investment largely offset by financial subsidies of 1.3 million we received from the local government in the fourth quarter '07.

Foreign exchange loss for the fourth quarter was 3.6 million compared to 2.2 million in the previous quarter. Despite the fact that our cash denominated in US dollar has decreased compared to last quarter, non-cash foreign exchange loss increased quarter over quarter because of accelerated appreciation of the RMB against the US dollar in the fourth quarter.

For fiscal year '07, our expenses were 4.1 million, compared to other income of 3.9 million in fiscal year '06. This was a combined result of a decrease in financial subsidies received from the local government during '07 compared to '06, and increase in foreign exchange loss in '07 with the appreciation of the RMB. Financial subsidies received amounted to 2.9 million for fiscal year '07 compared to 4.2 million in '06 and foreign exchange loss amounted to 7.0 million in fiscal year '07 compared to only 0.3 million in '06.

Income tax benefit in the fourth quarter of ’07 was 0.9 million compared to income tax expenses of 0.9 million in the third quarter of '07 and income tax benefit of 0.1 million in the fourth quarter of '06. the sequential difference of income tax expense was primary due to deferred tax assets recognized in the quarter based on the recently published Chinese income tax law.

For fiscal year '07, income tax expense was 1.3 million compared to income tax benefit of 0.4 million in fiscal year '06. A wholly-owned subsidiary of the company enjoyed a tax holiday in '06 whereas in fiscal year '07 this entity was subjected to an income tax rate of 15%. This, together with the implementation of tax structuring measures and recognition of deferred tax assets resulted in an effective income tax rate for the company of approximately 11% for 2007.

Net income for the fourth quarter of 2007 was 11.8 million, which increased by 125% from 5.2 million in the third quarter of 2007 but decreased by 18% compared to 14.4 million in the fourth quarter of '06. For fiscal year '07, net income totaled 33 million, a 23% decrease from 42.8 million for fiscal year 2006. Fully diluted earnings per share and per ADS for the fourth quarter of '07 was $0.40 compared to $0.18 in the previous quarter and $0.58 for the fourth quarter '06. Fully diluted earnings per share and per ADS for fiscal year '07 was $1.19 compared to a $1.74 in fiscal year '06.

For the fourth quarter of '07, adjusted EBITDA was $24.3 million compared to adjusted EBITDA of $18.4 million for the previous quarter and $20.7 million for the same period of last year. For fiscal year 2007, adjusted EBITDA totaled $76.8 million compared to adjusted EBITDA of $68.1 million for fiscal year '06.

On a per share basis, fully diluted adjusted EBITDA per share for the fourth quarter of '07 was $0.83 compared to $0.62 for the third quarter of '07 and $0.84 for the fourth quarter of '06. For fiscal year 2007, fully diluted Adjusted EBITDA per share was $2.78 compared to $2.77 for fiscal year '06.

As of December 31, 2007 the company's total cash and cash equivalent balance was 303.7 million compared to 284.6 million as of September 30, 2007 and $128.6 million as of December 31, 2006. The quarter-over-quarter increase in cash and cash equivalents was mainly due to the combined result of cash receipt from sales of prepaid game points offset in part by prepaid loyalty payments to game licensors and share repurchase program.

Before we proceed to the Q&A session, I would like to take this opportunity to thank Jun and colleagues at The9 for their support during the last four years. It has been my pleasure to serve as the CFO of The9. In addition, I would like to thank all of the analysts and investors that have continuously been very supportive of The9 and to my work during the past years.

With this, I would like to thank you again for your attention and we will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Wallace Cheung - Credit Suisse.

Wallace Cheung - Credit Suisse

Good morning Jun, Hannah, and Dahlia. Congratulations on the good results. Hannah, I appreciate your contribution for the last four years. I hope to cooperate with you very soon.

One single quick question about World of Warcraft, can you give us a little more information, data points about the profit level? PCU, ACU, and in particular when you mentioned in the front page of the announcement, did you include 10 million prepaid points for an expiry recognition of the revenue into your revenue level?

Also, can you comment about the first quarter of ’08 trending as well? Thank you.

[Translation]

Translation for Jun Zhu

As Mr. Zhu has said, the PCU level for World of Warcraft for the fourth quarter was over 990,000 and average concurrent user level for the fourth quarter was approximately 170,000. The 10.2 million of expired points that we recognized in the fourth quarter was included in the revenue and is included in the ARPUH calculation. ARPUH was actually about RMB 0.395 for the fourth quarter.

As to your question about the first quarter trend of World of Warcraft users, as you know historically there will be an impact during the February month with respect to winter holidays and Chinese New Year. However, despite taking out that effect the user level has resumed after Chinese New Year and also after school starts.

So for World of Warcraft, we still believe the user is very much liking the game and the user level is continuing to increase after any impact historically during Chinese New Year and during the winter holiday month. Does that answer your questions Wallace?

Wallace Cheung - Credit Suisse

Just a quick follow-up. You know everyone is concerned about the snow storm impact. Can you comment on that as well?

Hannah Lee

I'm sorry, there's concern about?

Wallace Cheung - Credit Suisse

The snow storm.

Translation for Jun Zhu

For World of Warcraft there is minimal impact with respect to the snow storm because traditionally there has been impact regarding the Chinese New Year and winter holidays anyway, so it doesn't affect us as much as it might have on other games.

Operator

Your next question comes from Paul Keung - Oppenheimer.

Analyst for Paul Keung - Oppenheimer

Hi everyone. These results are very good, congratulations. Could you give us some idea on the renewal of licenses with Blizzard on World of Warcraft?

[Translation]

Translation for Jun Zhu

Actually, I remember that about one year ago a lot of people are asking and also are concerned about The Burning Crusade expansion pack. At that time, I already very firmly told everybody that I was very confident that The9 would continue to work with Blizzard regarding The Burning Crusade.

And also back in 2005 when everybody was asking about the possible impact of the [inaudible] system, I said I believe this policy will be a long-term benefit to the overall industry growth and also will not have an impact on WoW. Actually now if you look at the implementation of this system, it has not had any impact on our WoW game, so that proves my promise and my belief is very correct.

So regarding your question on the WoW renewal, what I can say is WoW has been in very strong growth during the past few years and also we are always in very good relationships with Blizzard and we always have a very common, unanimous opinion regarding the operation of WoW in China, so I am very confident that we believe we can renew the contract in '09.

Analyst for Paul Keung - Oppenheimer

Yes, okay. There is another expansion pack for World of Warcraft, right?

Jun Zhu

Yes.

Analyst for Paul Keung - Oppenheimer

Is that coming this year?

[Translation]

Translation for Jun Zhu

We are in discussions with Blizzard regarding the exact timing of the second expansion pack but we don't have an exact date yet. After the first expansion pack, The Burning Crusade, was launched we have experienced over 30% growth in PCU numbers of WoW and we believe after the second expansion pack goes out that we will experience a similar, very significant growth.

Analyst for Paul Keung - Oppenheimer

[Translation not provided] Thank you so much.

Hannah Lee

Thank you.

Operator

Your next question comes from the line of Eddie Yeung - Merrill Lynch.

Eddie Yeung - Merrill Lynch

I have one question about basically the pricing model that you guys are running. Have you learned any lessons from a transition from a time-based game, which is like World of Warcraft to running to item-based games? Could you talk about your experiences? Do you think there is upside for your ARPUH in item-based games? If there is upside, would this be coming from ARPUH or the number of paying accounts or both? Thanks.

[Translation]

Translation for Jun Zhu

We believe the both of the two business models are very suitable for the Chinese market. The time-based model , which was very supported by the WoW performance and also the item-based model was also proven by many games including our own two games. So we believe both items will continue to exist in the market.

Regarding the item-based model we actually adopted this model for our two new games SUN and GE and now we have seen the steady [progression] for the two games. We will continue to adopt to this item-based model for some of our future games, for example The Audition 2. We believe the item-based models games like Audition 2 will continue to contribute incremental growth for the Chinese market.

To summarize, with WoW the time-based game continued to grow and also our new and incremental games come into the market and are the free play item sales model I think The9will continue to deliver very substantial and very good output for the future.

Operator

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

Dick Wei - JP Morgan

Good quarter guys. Question is on marketing expenses. I was wondering if you can break out fourth quarter, roughly how much went to each game and also what is the sales and marketing outlook for the next two quarters given that you believe the next game launch is probably in summertime maybe for closed beta? I don't know if you expect to see pretty low marketing levels for the next two or three quarters.

Hannah Lee

We spent $4.5 million in the fourth quarter with respect to sales and marketing of which about $2 million relating to WoW, about $1 million relates to each of SUN and GE and the rest of that relates to FIFA Online 2 and other games that we have in our pipeline that are in pre-launch and pre-beta testing stage.

With respect to your other questions about the trend in Q1 and Q2, right now we have started beta, the technical testing of FIFA Online 2 of which we are planning to start beta testing sometime before mid '08. With that we will be spending marketing dollars to promote the game.

With respect to games that we are planning to push out in the second or third quarter we will spend marketing dollars accordingly. Right now because we don't give out financial guidance we do not provide any specific outlook on the marketing expense. It really depends on how much content we're pushing out and what games we're pushing out at what time.

Dick Wei - JP Morgan

Great. Thanks Hannah and all the best.

Operator

Your next question comes from Alicia Yap - Citigroup.

Alicia Yap – Citigroup

Good morning. My question is regarding the update on FIFA Online. Can you share with us your preparations in operating the games? How many people have you actually dedicated to the FIFA team and whether they actually came from the WoW operations team? Any brand new team that has experience in operating the casual games, is there any challenge or difference in operating a MMO or casual games? In other words, do you actually have to do anything differently in terms of training your customer service reps and the impact on your sales and marketing strategies?

[Translation]

Translation for Jun Zhu

Last year we appoint a new VP Benjamin Lin, he has over ten years of experience in operating casual games in China. Now there are about 40 to 50 people under his team and that team was based in Beijing. We think these people are all very talented people in the casual games area, so we think the team is very professional.

I would like to emphasize that nobody on our FIFA team is coming from our WoW team; they are all new team members joining The9. All these 40 to 50 people have background in the casual games operation area, so we are very confident in this team.

Alicia Yap – Citigroup

Can I have a follow-up on the breakdown of GE and SUN in your item-based revenue? Can you actually break down the ARPUH and active paying customer for SUN and for GE?

[Translation]

Hannah Lee

Unfortunately, similar to other peer companies we are only breaking down our ACU and PCU and key KPIs for games that are in item based, we group them in subscription-based models and item-based models. As Mr. Zhu has said in his presentation, for SUN and GE, for SUN especially has been remaining at a stable level. For GE, it's achieving satisfactory results. We are working very closely with the Korean developers to push out more content upgrades to try to improve the operating results of these particular games.

Operator

Your next question comes from C. Ming Zhao - SIG.

C. Ming Zhao – SIG

Congratulations on a good quarter. I just have a question about the CapEx that you guys may see in 2008 given the launch scheduled games. What kind of server cost and other CapEx do we need to expect for the new games to be launched as well as for nine or ten server groups of WoW in 2008? Thanks.

[Translation]

Hannah Lee

For fiscal year 2007 we have spent approximately $45 million on capital expenditures, mainly to upgrade the hardware for World of Warcraft in preparation of Burning Crusade expansion pack push out and also for SUN and GE’s launch. For 2008 we will be at least adding another service, as you have said, the ninth World of Warcraft server site, and if necessary we will be adding another server site for World of Warcraft.

As you know, each server site for World of Warcraft costs about $7 million to build, and depending on how many server sites we're building, that will add to our capital expenditure accordingly.

In addition to that, we will at least be pushing out FIFA Online 2 and Audition 2 for 2008 so that will have incremental capital expenditures from those gains.

C. Ming Zhao – SIG

Given the preparation for the FIFA, do you think we're going to see maybe $10 million to $20 million in cutbacks for FIFA? I mean I try to gauge what you guys think about the success of FIFA here.

Hannah Lee

With respect to FIFA Online we just finished technical testing on a very small scale, we will soon be starting open beta testing. As you know, for any games that The9 pushes out, we always start with two or three server sites and with that, additional user demand, we will add server sites then to satisfy additional user demand. So right now I can't tell you, I think we would not be spending $10 million off the bat for initial setup of the game; however, we will be spending a few million dollars as usual as any other game that we launched previously to prepare for open beta testing and initial commercialization. After that with additional demand, we will be adding addition server sites where there will be incremental costs of $2 million to $3 million per server site.

So I can't say specifically how much for the entire year we will be spending, but we will be spending a few million dollars to build initial service sites in the beginning and then adding for additional demand.

Operator

Your next question comes from the line of Andrey Glukhov - Brean Murray, Carret.

Andrey Glukhov - Brean Murray, Carret

Hannah, you suggested that the revenue from SUN was relatively flat sequentially. Is the operating margin, is the game itself getting any more profitable or is all the margin expansion we're getting is purely from the improving profitability of World of Warcraft?

[Translation]

Hannah Lee

For SUN, as I said, the revenue contribution from a revenue perspective is actually very similar to what we experienced in the previous quarter. In terms of the mix between active paying users and ARPUH, ARPUH has actually increased compared to last quarter. If you look at last quarter, we reported RMB 62 for SUN and this quarter for GE and SUN combined each would contribute about RMB 73 of ARPUH for each game. These two games are behaving quite similarly in terms of APRUH behavior so there have been some increase in the ARPUH on an active paying account basis. That is what we are trying to at least maintain. From an active paying account basis we are constantly pushing upgrades to try to pull that number up.

From an operational cost perspective, we have been, as you can see in the cost of sales and marketing expenses line item, we have been implementing cost control measures to check that and to keep that marketing expense very efficiently. So we're able to achieve some benefit in terms of margins. We will continue to do that in 2008 but from the margin perspective, it's quite similar to what we have in the third quarter of '07.

Andrey Glukhov - Brean Murray, Carret

That’s helpful. All right and on the housekeeping side, can you maybe directionally talk about what tax rate you guys anticipate paying in 2008? Thank you.

Hannah Lee

As you can see, we have with the recently published Chinese income tax law, we have some deferred tax benefit recorded in Q4 mainly because we have some temporary differences relating to tax and accounting depreciation charge and also some tax loss carryforwards that were experienced in some of the Chinese subsidiaries we have.

For a current tax rate, I think it will be around 18% to 20% depending on the final implementation and regulations that we anticipate would be announced by the local government sometime in the first half of '08.

Operator

Your next question comes from Leah Hao - Goldman Sachs.

Leah Hao - Goldman Sachs

Good morning, guys. I see that you took a $2.6 million impairment charge on Guild Wars. I just want to confirm, does that clear out all your other obligations related to the game? Also related to that, other than FIFA Online maybe contributing revenue in the first half of '08, and Audition 2 for maybe the second half of '08, are there any additional games that will contribute revenue in 2008 from your pipeline?

[Translation]

Hannah Lee

Leah, can you clarify your question about Guild Wars? Are you asking whether there are additional obligations?

Leah Hao - Goldman Sachs

Right, actually my question was related to Guild Wars specifically after the impairment charge I was just wondering if you have any other obligations monetary-wise or otherwise related to Guild Wars, at all. The second question is related to your pipeline.

Hannah Lee

For Guild Wars, we have paid $2.4 million to NCsoft so far and that is what we have provided for. From this point on, we have not made any accrual with respect to additional obligations based on our understanding of the license agreement that we have.

With respect to future games that we generate revenue for 2008, FIFA Online 2, Audition 2 and Fate of Warriors Online which we developed in-house would also be contributing revenue in fiscal year 2008. In the latter half of 2008, as Mr. Zhu has said in his presentation, we will be starting beta testing on various games. These games will be contributing revenue for 2009.

Operator

Your next question comes from Victor [Fang] - Deutsche Bank.

Victor [Fang] - Deutsche Bank

Can I just have a quick update on some of the other game pipelines, maybe towards 2009 such Huxley and Ragnarok and maybe some of the other games we haven't talked about, can we have an update on their status?

As well, my second question is for GE and SUN we're looking to provide more updates for these games; can you just comment on when do we expect more updates of expansion packs to come for these games, and as well are we going to be putting additional marketing expense to promote these new expansion pack releases? Thank you.

[Translation]

Translation for Jun Zhu

We haven't talked about Huxley and [Dispute of Honor] Online but for 2008 we think FIFA Online, Audition 2, especially Audition 2 will be the important contributor. There's also a possibility that several games that we are now in discussion to license can contribute revenue in 2008. For new games like Hellgate: London or Huxley, as the are currently in beta testing and are going to be launched in Korea, we will keep a close eye on their operation status in Korea so to determine whether the company is mature enough for a proper launch in China.

Regarding SUN and GE they are both in very steady operation centers. For GE actually in Q1 we are excited about a very significant content upgrade which we believe will boost the new users and existing users in game.

SUN has been very steady compared to previous quarter and actually the Webzen’s development team has also been very steady. So we believe a stable team and a stable cooperation between the companies can guarantee a very steady operation of the game in the future.

We noticed that aside from the local and the companies teams actually the leading overseas developers, they are also starting to significantly improve their understanding of the Chinese market. We recently have noticed that their understanding levels of the Chinese market have been improving very quickly so we believe the effort will bring new [inaudible] for the Chinese online game market.

I have to elaborate on the importance of product content, quality to The9. We believe the content is king and we keep looking for good quality games no matter if it's licensed or it's locally developed or self-developed as long as it's very good content, we will try to operate these games in China market.

Operator

Your next question comes from Eric Wen - BNP Paribas.

Eric Wen - BNP Paribas

I have two questions, one is regarding FIFA. Jun, can you elaborate on how you plan to deal with the restrictions from FIFA? Regarding the number of items for sale, can you give us specifics that by the time of FIFA’s launch how many items will be available for sale and how do you see that trending up afterwards?

Translation for Jun Zhu

The reason why we do actually operate FIFA Online 2 instead of FIFA Online 1 I is because the FIFA Online 2 has a lot of improvements compared with the previous version essentially in terms of number of items for sale. Actually, we now think the FIFA Online 2 is technically ready and close to technically ready and also the number of items for sale is satisfactory and also it has experienced a very satisfactory performance in Korea so we think it's close to the right stage to be launched in China but we haven't decided on an exact date for the game's launch.

Based on our operation of the Korean market, we believe the Webzen development is very strong and we believe they will continue to add new content and improve the number of items for sale. So we are very confident in the games operation in China.

Eric Wen - BNP Paribas

I'm not sure if this question has been asked. But can you comment on that the developer of your new game, Ragnarok Online 2, I see Gravity has been acquired by a Japanese company. Will that impact your licensing and the cooperation with Gravity in following year?

Translation for Jun Zhu

Actually we have been in constant communication with Gravity regarding RO2’s development stages. Regarding when to operate RO2 in China, we will keep discussing with them and continue to evaluate their content maturity.

Eric Wen - BNP Paribas

I think what we are seeing is that in the licensed operators, we are seeing some acquisitions made by Shanda, for example, to acquire code back several years ago and it basically can stabilize the game development and ensure a constant stream of attention and support to eliminate the [inaudible] information and behavior that we are seeing between the developer and licensee.

Do you see that you will be focusing on working with a handful of developers on your game or are you still focusing on a content first strategy that whatever is the best for content and you then will go and negotiate, license and operate?

Translation for Jun Zhu

As I said just now, the content quality is a key factor when determining to operate our games. Going forward we will keep looking for very good content games no matter if it's internationally developed or locally developed; no matter if it's licensed or self-developed, we will focus on the game quality as well as long as it's a very good game, we will offer that game in China.

Operator

Your next question comes from Wallace Cheung - Credit Suisse.

Wallace Cheung - Credit Suisse

On the return of the World of Warcraft installation package, it costs net revenue in the top line. How much does it cost and has this issue been resolved already for these results?

[Translation]

Hannah Lee

Thanks for the question. As we said in the press release, there was a return of the World of Warcraft installation package and that relates to the packages which includes the -- these packages allegedly contained fonts that were alleged to infringe on third-party intellectual property rights, of which that relates to the Founder lawsuit that we had discussed a few quarters ago. This lawsuit is still ongoing and we currently have no further updates. As we said before, we do not think there is any material impact on The9 financially and we still consider that view as reasonable.

Wallace Cheung - Credit Suisse

The amount of the package return?

Hannah Lee

The amount of the package return is about RMB 1.2 million.

Operator

Your next question comes from Dick Wei - JP Morgan.

Dick Wei - JP Morgan

I believe you mentioned about the item-based model for the game ARPUH is RMB 73 per month. How do you calculate that? If I try to put the numbers together it doesn't seem to add up. Do you just take the average for the two games, or do you account for just 1.5 months of revenue for GE, for example.

Hannah Lee

For SUN it is basically a weighted average. It's basically an average for the entire quarter because that game has been in full, full commercialization in the entire fourth quarter. For GE because we launched the game in late November, how we arrived at our ARPUH is we pro-rated it to the number of days that is in commercialization in the quarter to take into effect the less than full quarter effect and then we averaged these two games ARPUH out to arrive at the RMB 73 per game. As I said, the two ARPUHs of each of these games are very similar.

Dick Wei - JP Morgan

I think last quarter it was around RMB 62, right? How can it go to RMB 73 then? I thought it would be like 62 plus 82 or something and then you average it to 73?

Hannah Lee

No, as I said earlier when answering other analyst questions, 62 was recorded for SUN only in Q3, whereas we have seen increase in the ARPUH number for SUN to the 70s level and that's why when I said the two games are relatively similar with respect to ARPUH, these two games average out to be 73. So there has been increase in the ARPU for SUN from 60s level to the 70s level.

Dick Wei - JP Morgan

Second question is regarding your points expiration policy for WoW, do we actually expect more to come this quarter or will it be a year-end event?

Hannah Lee

With respect to the expiration points, the policy has always been the same. After 12 months of initial inputting into the system if the points have not been used, then we recognize it into income. It has been consistently applied, but because the expansion pack has been pushed out in September we have temporarily suspended such recognition of expired points for a couple quarters in '07, namely Q2 and Q3, because we anticipated that some of the old users would come back to play the game for prudent purposes.

But with stable trend of usage of expiration points, we have enough history to continue our consistent application of expiration points revenue recognition, so from Q4 we continue to recognize expiration points. We will continue to do that practice from Q1 '08 onwards.

Operator

There are no further questions. I would now like to turn the call over to Dahlia Wei for closing remarks.

Dahlia Wei

Thank you again for participating in today's call. Please feel free to contact us if you have additional questions. Thank you again.

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Source: The9 Limited Q4 2007 Earnings Call Transcript
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