The9 Limited (NCTY) Q4 2011 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the The9 Limited Second Half 2011 Financial Results Conference Call. My name is Edwin, and I'll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's conference, Ms. Phyllis Sai, IR Manager of The9 Limited. Please proceed, ma'am.

Thanks, operator. Hello, everyone, and thank you for joining us today for the The9's Second Half Year 2011 Financial Results Conference Call. With me today are Mr. Jun Zhu, Chairman and Chief Executive Officer; Mr. George Lai, CFO; and Chris Shen, our Vice President in Mobile business. Mr. Zhu will lead off by providing overview of our operational reports for the quarter and give perspective outlook for the year 2012. And then, Mr. Lai will have a detailed discussion of our financials. After prepared remarks, we will open the floor to take questions. Before we continue, as always, please allow me to read to you the Safe Harbor statements in connection with today's call. 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, I would like to turn the call over to our Chairman and CEO, Mr. Zhu.

[Chinese] Good day, ladies and gentlemen. Thanks for participating in our discussion of The9 second half of the year 2011 results. [Chinese] In the past 2 years, the traditional online game business in China has encountered unprecedented challenges, which leads to a series of adjustments and a wave of change in the industry. This is the call of the far game. Too many of homogeneous online games rush into the market under the flag of self-development. While at the end of the today, the market's demand determine the results and the direction of the industry. 6 years ago, we brought up the idea that either 1 goes forward or he will be left behind in this industry. And the leading position can only be maintained 2 or 3 years at the most. We do not want to clone these classics. We even do not want to recopy the duplicate. [Chinese] We think the past 2 years, we are smoothly undergoing the strategic transition from a domestic online game operator to an international online game developer and operator with diversified platforms. We are not only integrating our resources to strategically emphasize on the layout in some new business territories so as to keep the pace with new trends of Internet platforms, terminals and the media and readily march to the blue ocean of business according to the market demands. We further strengthened our MMORPG, web games and social game pipeline by following our strategy of quality and innovative games. Among our robust game pipeline, Firefall, a revolutionary next-generation triple-A title MMOFPS game will be presented to the worldwide online gaming enthusiasts very soon. [Chinese] Recently, Firefall is in a limited beta testing in North America. Its R&D team is gathering comments and feedbacks from the testing users and actively improving the configure settings of the game to deliver a faster game play experience to users. Users are able to get the beta testing accounts through registration in the official forum. [Chinese] Firefall will adopt for free-to-play model for the whole -- for the worldwide market. That is to say, the game will generate its revenues through the micro transactions of in-game virtual items. Garena has the exclusive license. To these views, this game in Southeast Asia and Taiwan at the cost of USD $23 million, including licensing fee and minimum guarantees. So European-English speaking area are excited to launch Firefall's operation with the U.S. simultaneously. While a small scale alpha testing is going to be conducted in South Korea as of the end of this year. For China market, the schedule is tentatively set for next year. For the other markets, we are still evaluating and trying to get that for the business development with the other candidate in the other market. [Chinese] In the coming year, we will continue to increase our investment in the marketing for Firefall, aiming at enhancing the popularity of the product gradually. The marketing campaigns will be focused on the crossing over with soccer community and participating various game exhibitions, including Pax Premier, game show and other massive game show activities. [Chinese] Firefall is now on track for its synchronous progress worldwide. Aside from Shen Xian Zhuan, one of our domestic proprietary online games started open beta testing already. To date, its performance is in line with our expectation. Recently, we licensed the game to Webo Digital in Taiwan for 3 years. [Chinese] Another proprietary online game, Era Zero, invested by our company was opened its trial servers to the user on February 10. The open beta testing is expected to be in the third quarter of this year. [Chinese] On the licensing side, PlanetSide 2, developed by Sony Online Entertainment was officially licensed to us in the early January this year. The Chinese name and official website was opened on January 5. The game is now in the preparation of alpha testing in North America. [Chinese] Let's move to web and social games as well as our Mobile business. [Chinese] Among the web games, our sales developer, propriety web game, Winning Goal, has performed well since its commercial launch in June 2010. There are 56 cooperated servers in domestic and that the revenue stream remains stables. So far, it has been successfully licensed to 12 overseas regions in the countries, including Hong Kong, Singapore, Malaysia, Taiwan, North America, Indonesia, Thailand, Vietnam, Korea, Turkey, Arabia and Japan. On top of that, 3 more proprietary web games are now under development. Of which, Shen Xian Zhuan has been well received by tester engineers from game medias and gained its repetition during the testing. The launch stage for the game is expected to be in the second quarter this year. Meanwhile, we have 11 cooperated web games on our nicely.com [ph] platform. [Chinese] Turn to our social games, we now have the Winning Goal series and the Q Jiang San Guo under commercialization. We are now cooperating with totally 14 social network websites worldwide, including such top websites as Facebook, Mixi, Ren Ren, Caixin, Tencent Weibo and Sina Weibo, et cetera. Especially Q Jiang San Guo, our proprietary self-developed social game ranks in 5 -- top 5 apps in Caixin, Ren Ren and Sina Weibo. Moreover, we have other 3 self-developed social games under development and 1 licensed game, [indiscernible] under localization. [Chinese] For the mobile percentage, we are now moving to 3 main areas. [Chinese] First of all, as the social gaming platform for mobile users, The9 Game Zone has been launched for almost one year. As of February this year, the number of its users reach 7.5 million and enabled games increased to 190. Also as the mobile marketing and application promotion platform for advertisers as the mobile ad developers, [indiscernible] SDK has been developing. Our purpose is to gather developers and user basis as many as we can so as to increase the business opportunities. [Chinese] Second area is the product. It can be described as from 2 aspects, the licensed games and the proprietary games. Under one hand, we've partnered with worldwide developers who published their products in China market. Currently, more than 680 mobile games have been licensed to us. On the other hand, we built up a dedicated in-house development team to develop a proprietary online and social mobile games, including Weibo, San Gou and [indiscernible] which are now available in Apple App Store. [Chinese] The third area is publishing. We provide a one-stop publishing services for worldwide developers, which include localization, packaging, distribution, marketing and promotion, monetization, consulting, et cetera. [Chinese] We will keep a close cooperation with major telecom service carriers, device manufacturers and third-party channels to develop the domestic mobile market for the whole year. And the focus on product will be in social and online games. These 2 types of products will be the main focus in our self-development and license. [Chinese] This concludes our business highlights for the second half of 2011 and the outlook for 2012. And I will hand over to George to cover the financials.

Let me briefly review the highlights of our second half and full year 2011 results, and take you through an overview of our quarterly financial results. The full set of earnings release is available on our website. Our net revenues in the second half of 2011 amounted to $8.7 million, representing an increase of 7% from the first half of 2011 and a slight decrease of 1% from the second half of 2010. Net loss attributable to holders of ordinary shares in the second half of 2011 amounted to $34.9 million, representing an increase of 240% from the first half of 2011 and a decrease of 39% from the second half of 2010. For fiscal year 2011, our net revenues amounted to $16.9 million, representing an increase of 3% from the fiscal year 2010. Net loss attributable to holders of ordinary shares for the fiscal year 2011 amounted to $45.2 million, representing a decrease of 43% from the fiscal year 2010. So let's turn to the quarterly results. Our net revenues in the third quarter of 2011 were $4.3 million, representing an increase of 6% from $4.1 million in the second quarter of 2011 and an increase of 2% from $4.2 million in the third quarter of 2010. These increases were primarily due to an increase in net revenues from our TV game platform and overseas licensing operations. Our net revenues in the fourth quarter of 2011 were $4.4 million, representing an increase of 3% from $4.3 million in the third quarter of 2011 and a decrease of 3% from $4.6 million in the fourth quarter of 2010. The increase from the third quarter of 2011 was primarily due to an increase in net revenues from Shen Xian Zhuan. The year-over-year decrease was primarily due to a decrease in net revenues from our then operating MMORPGs. Our gross profit in the third quarter of 2011 was $2.2 million, representing an increase of 8% from $2.0 million in the second quarter of 2011 and an increase by 17x compared to $0.1 million in the third quarter of 2010. Our gross profit in the fourth quarter of 2011 was $2.1 million, representing a decrease of 3% from $2.2 million in the third quarter of 2011 and an increase by 7x from $0.3 million in the fourth quarter of 2010. The significant year-over-year increase in gross profit in both the third and fourth quarter of 2011 was primarily due to a decrease in royalties, as we have more games in our game pipeline -- in our game portfolio developed in-house compared to last year. In the third quarter of 2011, our operating expenses were $22.5 million, representing a 37% increase from $16.5 million in the second quarter of 2011 and a 79% increase from $12.6 million in the third quarter of 2010. The increase in operating expenses was mainly due to an increase in marketing expenses relating to Chinajoy game exhibition and our online game promotion efforts, as well as an increase in R&D expenses, including those incurred by Red5 Studios. In the fourth quarter of 2011, our operating expenses were $22.3 million, representing a 1% decrease from $22.5 million in the third quarter of 2011 and an 18% increase from $18.9 million in the fourth quarter of 2010. The increase from the fourth quarter of 2010 was primarily due to an increase in marketing expenses for Firefall and G-star game exhibition in Korea and an increase in development expenses due to increased R&D headcount and an increase in G&A expenses as a result of our establishment of overseas offices and increased share-based compensation. Interest income in the third quarter of 2011 were $1.4 million compared to $1.2 million in the second quarter of 2011 and $0.9 million in the third quarter of 2010. Such increase was due to an increase in bank interest rate. Interest income in the fourth quarter of 2011 was $1.1 million compared to $1.4 million in the third quarter of 2011 and $0.9 million in the fourth quarter of 2010. Decrease from the third quarter of 2011 was due to a decrease in cash balance and increase from the fourth quarter of 2010 was due to an increase in bank interest rate. Other expenses in the third quarter of 2011 was $0.9 million compared to other income of $1.1 million in the second quarter of 2011 and other expenses of $0.02 million in the third quarter of 2010. Other expenses in the third quarter of 2010 and 2011 primarily represented the exchange -- foreign exchange loss. Other income in the second quarter of 2011 primarily represented the income from one-off settlement fee. Other expenses in the fourth quarter of 2011 was $0.1 million compared to other expenses of $0.9 million in the third quarter of 2011 and other income of $3.6 million in the fourth quarter of 2010. The decrease from the third quarter of 2011 was primarily due to a decrease in foreign exchange loss. Other income in the fourth quarter of 2010 mainly represented a government subsidy of $3.6 million. Net loss attributable to holders of ordinary shares was $14.9 million and $20 million for the third quarter and fourth quarter, respectively. Fully diluted loss per share and per ADS was $0.59 and $0.82 for the third quarter and fourth quarter, respectively. So thank you for listening to our presentation today. At this point, we will take questions. Operator, please.

[Operator Instructions] Your first question comes from the line of Jin Dong Shi [ph] from CLSA.

My question in on Slide 4. And just wondering to the management [indiscernible] games operation in China. Are you going to license again to a local Chinese operator or you will operate the game by yourself? And if you're agreeing to adopt a license model, what are the criteria you will be looking at when you [indiscernible] the local proprietor? [Chinese]

[Chinese] The operational Firefall in China will be tentatively scheduled in next year. We haven't determined the confirmed operation model yet, but we have already had some directions for that. [Chinese] Currently, the weakness of Firefall in China is the lack of the brand awareness in China. [Chinese] Even if it is the lacking of the brand awareness in China, we have actually already started the cross-marketing campaigns with the soccer area to increase its brand awareness and the influence among the Chinese target users. In the future, we are going to conduct a lot of this kind of marketing campaigns in Chinese market. We are quite sure that the influence and brand awareness will be increased in the coming year. [Chinese] The next steps for us, the key marketing purpose will be to choose the partners that can help us to make sure the Firefall can be installed into the gaming terminals in the Chinese market. Those potential partners who can help us to penetrate the Firefall into the PC platforms as well as the market and help us to penetrate the game into more and more gamers will be our key criteria to choose the partnership. We are still under the evaluation with a couple of candidates for that. Either we, we'll do the operation by ourself. We are going to do that as next-stage purpose. [Chinese] I would like to share the global strategy of marketing for Firefall at this moment. [Chinese] There are a lot of global partners around the world have been visit Red5 Studios to further explore and understand the games. The partners have quite high confidence on these games. So there are a lot of potential partners all around the world already. [Chinese] The license has been licensed out to Southeast Asia and to Taiwan as we have disclosed before. For the other markets, there are a lot of partners have been explored the opportunities to partner with us. We actually have been evaluating some partners for their operation capabilities around the world. And recently, we have some progress on the other markets, which we are going to disclose in the very near future. [Chinese] We tend to do the operation by ourselves in those markets we are very familiar with, such as China and Korea, but we are also evaluating those partners that has -- can provide us a very good capability on the operation, as well as the licensing fees to the other market, so that we are actually still evaluating them. And for those markets, we are going to maybe license to them in the future.

That's very helpful. I have a follow-up question on Firefall. We know these games are quite in the beta in terms of gameplay. But to help us understand, could you give us some colors on revenue potential in China market? And also, Chinese game market is quite competitive. Just wondering if there are any competitors in terms of game play through Firefall amongst existing Chinese games? [Chinese]

[Chinese] Mr. Zhu wants to compare the history of when we launched the World of Warcraft in the past 3 years. At that day, when we launched the World of Warcraft, there are a lot of user base in China market which had been played the PC standalone games before. So that increase created a lot of user base as a potential target user for World of Warcraft. That's one of the reasons why we can be successful for the World of Warcraft in that year. Currently, the market, the person shooting XPS is one of the major category for online game in China. There are a couple very good titles in China such as Cross Fire. So it creates a lot of user base as our potential target. So we believe that if we can try to move these targets to the Firefall, it will definitely be successful. Currently, Mr. Zhu mentioned before that Firefall is still lacking of the brand awareness in China, so we are right now focusing on doing the brand awareness as well as the influence through the cross-marketing campaigns with the soccer teams and the soccer and those persons. We believe that it can increase the brand awareness in Chinese market as well as build up the similar market potential of what we have found for World of Warcraft before.

[Chinese]

We cannot disclose the revenue or profits for the Firefall at this moment.

Your next question comes from the line of Dick Wei from JPMorgan.

My first question is on web game strategy. You mentioned that, that you'd be both developer as well as operator of web games. I wonder which is of a higher priority. And then on in house, how do your platforms or your development team differentiate from other competitors in the market as the market is getting more competitive in the web game space?

Excuse me, so you are talking about the web games?

[Chinese] Currently, we believe that there is no many differentiations between -- among all the web game operator and the developers. The reason why we evolved into the web games is that we want to further explore the opportunities in the marketplace. So we are trying to do the operation and the development simultaneous so that we can get more experiences and opportunities in the market. That's what we're doing now.

Okay, great. And then a follow-up with that -- how's that some movements about Firefall will be licensed into Russia. I don't know whether if you can comment on that as well. If so, what is the timeline?

[Chinese]

[Chinese] We cannot disclose too much information about this. But as what I said before that we can choose to license the game to those market that we are not that familiar with. Russia is one of the markets we are under the progressing of the negotiation. We haven't conduct with any signed contract yet. As long as we signed the contract and have the finality, we are going to disclose in the right time. [Chinese] We are very glad that there are a lot of the markets are very interested at Firefall, such as Russia and Brazil, et cetera, et cetera. This kind of confidence to the games also strengthen our sales confidence for the whole Firefall team so that they can have the confidence to develop the games as well as to operate the game in the future. So this is very good for us indeed.

Great. Maybe a last question, is that sort of web game -- is it in the numbers like ARPU or some of the paying user number or data that you'd be able to share with us?

I think the focus on [indiscernible] now is more like into our game pipeline and Firefall. And therefore, same to our previous practice, we do not disclose the operation details like ARPU and TCO number. But once we get back to the number status and public making, then we will continue to disclose all this operating matrix.

And your next question comes from the line of Atul Bagga from Lazard Capital.

I wanted to ask a little bit on Firefall. You guys have been doing beta testing in the western market. What kind of feedback are you getting? Can you elaborate a little bit on that?

[Chinese] The current feedback is under our expectation, as what the core team of Firefall, which is led by Mark Kern. Most of you know that he was the leader for the development of the World of Warcraft. Most of their crack or the feedbacks are similar to the World of Warcraft when it was developed. So he has a great confidence on that. It can be solved and it can be launched in a very successful result. [Chinese] We have conduct some surveys around the world to understand the feedback from the worldwide gamers, what is their feedback for the games. We even have conduct a survey in China market to those Cross Fire gamers to understand what is their comments to the Firefall. The result was quite positive. It seems that they feel it is very excited for them of the Firefall contents. The only one concern from the gamers is about that technical issue, including the infrastructure and the networker in China. However, we are very confident to Mark because Mark has a lot of experience on solving this kind of issues. So we believe that in the future the Firefall will be very successful around the world as well as in China market.

And when you look at the user sort of taking beta testing and in terms of your target market, who do you think will be playing this game? Is it the users in the rest of the world who played MMORPG or are you targeting -- I'm trying to understand your marketing. Is it going to be catered towards people who have played MMORPG in the past, your subscription base, the free-to-play or this is a new set of users who will be playing a game like this?

[Chinese] When Mark designed this game, he was strictly decided to focusing on both FPS and MMORPG with 2 factors of this -- 2 types of games. So we believe that both game users will be attract by this games. [Chinese] Regarding the whole market in around the world of PC online game, the first -- the top one genre of the game is the sports games. And then the second one will be -- should be the FPS. So when Mark designed this game, he decided it to focus on the FPS category and also as what he was familiar with, which is MMORPG, as what he designed for the World of Warcraft. So he determined that to combine these 2 categories together as the new game for Firefall. So that's what he decided to do. And even he has some failure experience during the past, and all of these learnings and the lessons have helped him to build up more, even better games in the future. So both I and Mark has a very good confidence on the game.

Last, just to clarify, what is this slated launch date for this game in the western market?

[Chinese] There won't be any traditional closed beta or open beta space for Firefall in United States. We actually will open the limited testing phase at the end of April. And we are going to conduct a model that gradually open for users to register on the game and gradually open the commercialization of the game and launch the in-game purchase in certain period. So that's a kind of innovative model for the game. We won't have traditional so-called closed beta testing or open beta testing. [Chinese] We believe that the major target of the Firefall will be -- will come from both World of Warcraft and the Cross Fire. [Chinese] There was a question about what will be the estimated performance for Firefall. We would like to have a comparison with the World of Warcraft. When we did this, the IPO for The9 Limited, we have information about what the performance about the World of Warcraft. Actually at that time, the PC standalone game for World of Warcraft has already got 6 million users in China for the CD-ROM publishing. So at that time, we estimated that the World of Warcraft can reach 400,000 PCCU in the market. But the at the end of the day, the highest PCCU for World of Warcraft has been reached 1.2 million. So we believe that the PCCU for Firefall will be kind of bigger than combined the World of Warcraft and the Cross Fire in China market. That's our estimation for that.

That's very helpful. One more question, based on your internal planning, when do you expect to be cash flow positive?

Well, I think when we can be cash flow positive depends a lot on the launch of Firefall. And just how we talked about our plan in the western market and also our plan in, now, Korea and China and other parts of the world. So this is [indiscernible] but we believe that once Firefall is successfully launched in any of these places, then we will be cash flow positive.

[Operator Instructions] The next question comes from the line of Nick Ning from Roth Capital.

So I guess a lot has been said about Firefall. So it also seems that The9 have spent quite some time on the Mobile side. So could you talk about when should we expect some -- when can we expect some significant revenue contribution from your Mobile business?

The industry in China, I think, everyone is kind of like having a kind of consensus that this is a huge market and this will be a very positive market going forward. But right now, I think this market is still under development. And you know the number of smartphone users is still less than 1/10 of the total mobile users in China. And we all know that the profit generated going forward will be coming from smartphones instead of the traditional digital phones. So what we are doing now in the mobile phone market is to invest and then wait for this market to grow up and then we can benefit after the market is much bigger. So in short term, I guess within 1 or 2 years, we are still in the investing period. And we hope that with the growth of the overall market, we can make some significant profit after 2 to 3 years.

And quickly on this operating expenses side, it seems that it went up a lot in the second half of last year. So how should we look at your operating expenses going forward? And how much of the operating expenses in the second half was related to Red 5 or Firefall versus mainland China?

Just now, I explained that the reason why our operating expenses in the second quarter increased compared to the first half is mainly due to the increasing marketing expenses, including Firefall and our other new things and also the increase in R&D expenses, mainly due to increase in our headcount. So I think in the coming year, 2012, we will still continue to invest in these 2 areas, including marketing and also R&D. So the Firefall expense is also going to increase. We also are going to have some additional marketing expenses. But I guess comparing to the revenue that we are expecting to generate from Firefall, this investment will be worthwhile to make it.

Our next question comes from the line of Gary Ng [ph] from UBS.

I had a question regarding Firefall's potential ARPU and monetization. Just want to understand, what do you think, for this kind of game, the psychology of paying for this game? So for example, an MMORPG, one of the main reasons is the tendency or the advance features that kill off people that's why you pay a lot money. And for other games like League of Legends, it's more about unlocking new features. So for Firefall, what do you think is the key paying driver?

[Chinese]

[Chinese] Mr. Zhu mentioned that the Red5 Studios is going to tailor make some features for the Firefall to make its monetization around the world based on different market. Last year, a couple of very innovative monetization points that generate -- the idea generated by Mark. But of this kind of monetization are kind of interesting ideas for our future marketing, so we cannot disclose right now. But Mr. Zhu invites you to visit Red5 Studios in the U.S. You can find there are a lot of interesting ideas in the United States market, and that will be conduct into Firefall.

And our last question comes from the line of Andy Yeung from Oppenheimer.

My question is about the mobile social gaming platform. Now that you no longer a shareholder of OpenFeint, do you still want to maintain your mobile gaming platform? And also, what's your view in term of being a platform operator versus being a game operator in both the mobile and web gaming space?

We actually had licensed OpenFeint in a 5-year license before and we are currently localize the OpenFeint platform and operated that in China as The9 Game Zone in Chinese market. So we will definitely keep operating this platform in Chinese market. But when we do the localization works, we have added a lot of localized features into the platform as well as the SDK, so that match for the local demands of the mobile users. We are going to keep this kind of efforts to The9 Game Zone and keep exploring the possibility of expanding these features in Chinese markets and then try to find the best way for the monetization of this platform. That's what we can disclose now.

Okay. Just one follow-up on that. I think you mentioned that you have a lot of partnership with a lot of social network to promote your games. What's your view on partnering with other social networks to promote your game versus wanting your own platform as an independent platform operator?

Currently, actually, we have already linked with most of the popular social networks in China, such as the Sina Weibo, Tencent Weibo and Ren Ren, et cetera. So we are going to leverage over these networks in the Chinese markets to ensure that the existing networks of the users can be leveraged to the The9 Game Zone networks. That's what we are going to do. So it will be cooperated instead of the competition for us.

And with that, I will now like to hand the conference back to Ms. Phyllis Sai for closing remarks.

We would like to thank you all for participating today's call and look forward to updating you on our progress next time. Please feel free to contact us with any additional questions. Have a good day.

Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.