NCTY Part 2

I wrote about The9 Limited (NASDAQ: NCTY) last week. I'd just thought I'd give you a update on what I've found after more in-depth research.

1. Investment Thesis

The investment thesis for shorting NCTY is this: NCTY's main business is World of Warcraft (WoW) in China. It recently lost its license to run the game in China. It is spending its remaining cash position to develop new games to generate new revenue. I believe that that is unlikely to occur for the following reasons:

A. These games are very very complex and difficult to program. They take years to build. You can't do it on the fly, burning cash and under pressure from the market to deliver revenue. As it is, most computer games are only delivered years past originally promised completion dates and are notoriously buggy. And for them to have the game gain wide acceptance would take years because consumers need to get accustomed to the game, slowly explore it and recommend it to their friends.

B. They simply don't have the technical capability. NCTY's original function was as a server platform for WoW. They didn't add new functions to the game ie they are not game developers. They wouldn't exist if not for the Chinese gov insistence on having a local entity run these computer games. Blizzard sells WoW to the rest of the world directly without a 3rd party intermediary.

2. Financials

WoW's financial position is actually quite good right now. They are sitting on a US$ 315.5M cash pile right now. Plus US$42M in investments in 4 companies, 9Webzen HK, Object Software, Sunmi Rise and Ideas. The Company invested US$ 3.5M in preferred and common shares in Ideas (a Korean online game developer). NCTY wrote down the US$ 2.1M that they invested in the preferred shares to 0. The Company also invested in a college called Shanghai Institute of Visual Arts (SIVA) a sum of US$1.5M. Their total assets stand at US$ 478.3M as of 31 Dec 2008.

3. Pricing & Valuation

Having said all this, I'm waiting for a rally to around $12 to short the stock. At $8, there is not enough of a margin of safety. The stock did rally to $12 around June for some odd reason. (The announcement for the loss of license was in April.) At $8, their market cap is at USD$240M, which is a 24% discount to their cash value. At $12, their market cap is USD$360M. There is no discount to their cash value and gives us the necessary margin of safety to short the stock.

Extra Data
1. WoW China consists of about 5 million subscribers. The total WoW subscriber base is more than 11.5 million. That means China accounts for about 43% of WoW's subscriber base.

2. NCTY's founder Jun Zhu owns 39.6% of the outstanding stock of NCTY either directly or indirectly as of 31 Dec 2008 from his 13G filings. It is uncertain as to whether he has been selling his stock because the SEC does not require foreign issuers to fill in Form 4s.

3. The reason for the move from NCTY to NetEase is because NetEase agreed to better royalty terms with Blizzard. Wedbush Morgan analyst Michael Pachter thinks that the switch from The9 to NetEase was done for primarily financial reasons: While Blizzard has an estimated 22% royalty rate for WoW income in their partnership with The9 (about 50-55 million USD annually), analysts are predicting that the NetEase agreement would come with royalties of at least 55% - resulting in annual revenue of more than $140 million every year. So switching to NetEase puts approximately $90 million more in Blizzard's pockets every year.

4. The WoW swap from NCTY to NetEase has not been smooth. As of June 7, 2009, WoW has been down in China. It continues to be unavailable in China as of today. There has been rumors that a Beta version of it will be available to existing users July 30, 2009. It is estimated that this will cost Blizzard between US$10 to US$15M.

In my opinion, Blizzard swapping to NetEase is a greed call. They should know that moving from one server to another is always a messy process. For an increase in profits, they cut off more than 43% of their subscriber base for more than 2 months! What are they thinking?! Lost profits aside, they could potentially lose subscribers. Unlike the rest of the world, WoW users in China can play WoW through a prepaid card system. So they are not stuck with a useless monthly subscription. They could easily walk away from the whole thing.

Furthermore, since Blizzard constitutes 91% of NCTY's revenue, I'm sure they could ask for an increase in royalties. I don't quite know what occurred in the negotiations between NCTY and Blizzard. All in all, this is a real big mess.

Hopefully, at least some people can benefit out of it!

Death of a Business Model: The9Limited (NASDAQ: NCTY)

Some years back, I was asking my prof at Rutgers what to look for in a short? He said simply the death of its business model. My reaction was how in the world to run a stock screen on that? Today I might have just that stock.

The9Limited (NASDAQ: NCTY) is a computer game company. It held the license to run to the world's most popular online Massive Multi-player Online Role Playing Game (MMORPG) - the World of Warcraft (WoW) by Blizzard Entertainment - in China. In April 2009, the company announced that Blizzard will not be renewing its license and has awarded it to another company. WoW accounts for 91% of NCTY's 2008 revenue (from 2008 20-F, pg 29). The license was terminated on June 7, 2009. NCTY's other game franchises include Hellgate: London, Soul of the Ultimate Nation, EA Sports FIFA Online and Granado Espada. None of which approach the size of WoW.

It will be hard for NCTY to replace the revenue because MMORPG's are subject to the network effect. Simply put, the more people in any given network, the greater the ability to draw new people into the network. Other examples are mobile phone networks. What makes MMORPGs so fun is that you get to explore a large online world with your friends, go on quests and campaigns with them or challenge them to fights online. WoW is the largest MMORPG (11.5M subscribers as of Dec 23, 2008). It is really difficult to create a new MMORPG from scratch, reach the critical mass/ level of popularity such that young people will pay for it. These MMORPGs are notoriously complex and hard to create because they aim to create whole new worlds online. Furthermore, it is hard for the game to gain enough acceptance to reach that critical mass.

The company has in the past (2007 20-F) run into accounting issues, specifically inadequate financial controls in its financial reporting, leading its auditor, PWC Shanghai, to explicitly state in NCTY's 2007 20-F. This is really unusual. Normally, the auditor's letter in the 20-F or 10-K will give the company a clean bill of health. Any deviation/ failings from the standard norms should be rectified before it comes to the auditor reporting it in the 20-F. All in all, this does not reflect well on the management.

The stock is down around 40% to 50% from the first announcement in April 2008. Currently, it is trading at $8.45 as of last Friday's close. The price rallied to $12 in June. So there might be opportunities for profit on the short end of this trade. I'd recommend to wait for a rally, then short the stock.