The9 will likely post very good earnings this year. However, the first quarter starts with a whimper. I expect the company to report a significant quarter over quarter decrease in earnings, largely as a result of four factors: lower World of Warcraft revenues, higher product development costs, higher tax expenses, and the likely absence of financial subsidies that were reported during the fourth quarter.

My Q1 estimates (not including extraordinary items) are: $34.5 million net revenues and EPS of $0.28-$0.32, down from revenues of $36.2 million and EPS of $0.54 ($0.43 excluding extraordinary items) in the fourth quarter. For comparison, current consensus analyst estimates call for revenues of $36 million and EPS of $0.32.

Lack of new content and the Chinese New Year holiday sent WOW Q1 revenues lower

A quarter over quarter decrease in revenues should not be a surprise in Q1, considering that WOW did not get a content update since early October. The9 has decided to skip the WOW v2.0 content pack and focus on the release of the Burning Crusade expansion instead.

My measurements of the server utilization levels during the first quarter lead to an average concurrent users (ACU) estimate of 315,000, down from the ACU of 340,000 recorded during the fourth quarter. As expected, lower server utilization levels were observed during the Chinese New Year holiday.

The PCU is actually projected to inch higher in Q1, to 690,000, from 680,000 in the previous quarter The game still attracts record number of players, but the average time each gamer spends playing WOW is a little bit lower this quarter, compared to Q4, when the battlegrounds upgrade and the opening of the 7^th server site kept players around longer.

The9 charges WOW players a relatively stable hourly fee, and the revenues can be easily estimated from the ACU number. My revenue estimate of $34.5 million also factors in some sales of the Guild Wars open beta installation packages.

I expect The9 to spend a little bit more money on product development and marketing in preparation for the launch of SUN and Guild Wars. But the biggest impact to the bottom line should be felt from a large increase in tax expenses. Until now, the company's entity that runs WOW was exempted from paying income taxes. Starting with Q1, the WOW operations are subject to a 15% tax rate.

The first quarter earnings are not going to be spectacular, but I expect investors to brush the bad news aside and set their sight on the updates provided by The9 on SUN and Burning Crusade.

SUN shines

On April 18^th The9 launched open beta testing for SUN (Soul of The Ultimate Nation), a highly anticipated game in China. Within a week of the initial launch, The9 reported that SUN has attained a PCU of over 400,000 users. Since then The9 has added additional servers to meet the growing demand for the game. Based on the scale of the current server deployments, I estimate the current PCU for SUN to be about 500,000. In terms of user base and popularity, The9 just got itself another WOW.

It remains to be seen how successful The9 will be in monetizing the game's popularity. The game relies on the free-to-play pay-for-services revenue model, pioneered by Shanda with great pain last year. The9 is lucky to launch SUN at the right time, when the Chinese gamers have finally started to embrace the new revenue model (and started to shed good money on game services, too).

SUN, with its stunning 3D graphics and advances features should not have a problem attracting a large horde of free-to-play gamers, many of them currently playing lower quality 2D games. The9 should also find it easier to charge higher fees for SUN's in game services.

I expect SUN to materially contribute towards the second quarter earnings while the game is still in open beta testing.

SUN Update: Shortly after the release of this report, The9 confirmed that SUN will be a launched as a free to play game. The9 will start commercialization of SUN game points on May 18. An in-game shopping mall will allow players to purchase virtual items; the mall will open on May 24.

Waiting for the Burning Crusade

The9 is currently in process of upgrading the WOW server hardware in preparation for the Burning Crusade expansion, expected to hit the Chinese market by the end of the second quarter. Burning Crusade was proven to be very successful in North America and Europe, it should do very well in China, too.

Guild Wars

Guild Wars open beta testing was launched on March 7. The9 has teamed up with Pepsi to promote Guild Wars trough tournaments and internet café events. The initial demand for the game was high, but clearly the game was not as well received as SUN.

Electronic Arts rumors

The9 is rumored to have reached a deal to license Electronic Arts' FIFA online. If confirmed, the deal should be a positive development for The9. FIFA online has the ingredients to be a very successful game in China, and it could pave The9's entry into the casual game market.

In another rumor, The9's CEO Zhu Jun turned down Electronic Arts' offer to acquire a 19% stake in The9 for $200 million.

Valuation

The9 trades at a forward P/E of 15, a good value considering its growth potential. Short term investors should expect some volatility following the release of the first quarter earnings.

About the Author

The Casual Analyst editor Daniel Vlad has an MBA in Finance and a PhD in Physics. He works in the IT industry and he is very interested in Chinese stocks.

He welcomes your feedback at dhvlad@CasualAnalyst.com This email address is being protected from spam bots, you need Javascript enabled to view it .

Disclosure

Daniel Vlad is a long term investor in The9. He owns NCTY stock since 2005.