Tempered Enthusiasm - Investing In Warcraft

I am very happy this holiday to bring everyone a special report. For well over ten years I have been playing the videogames created by Blizzard Entertainment. I am sure that some of the names will ring a bell even with the non-gamers among you (Starcraft, Warcraft III, Diablo, etc.) Blizzard has been enormously successful, but they are owned by a huge French conglomerate named Vivendi. Vivendi has a market cap of over $36 Billion and over $30 billion in revenues per year. The Vivendi games section of which Blizzard is a part accounts for under $1 billion of Vivendi's total revenues. Previously, the only real way to invest in Blizzard's continued success was an investment in Vivendi - where you would really be buying many other businesses - mainly a Moroccan Telephone company and a French wireless company.

Time are changing however, and there is now a pure play investment in Warcraft available. It has many interesting features - mainly exposure to the Chinese market and an ADR on the Nasdaq. I think the company's valuation is also potentially attractive - but we will need to delve much deeper and I am looking for other reader commentary here as well - as I am pondering putting some big money (for me at least) in this thing later this fall.

Here is a quick profile and chart:


Now some more of the marketing details. What exactly does this company own and why are they a good vehicle to invesmentt in "Warcraft"?

1) First - the company name is "The9 Limited" - symbol (NCTY). They own an exclusive right to operate World of Warcraft (WOW) in China for the four years between 06/07/2005 - 06/07/2009.

2) During this time period they will share revenue with Blizzard as follows... for every $1.00 that they collect from selling software or services they will pay Blizzard $0.22 royalties. In addition there are certain minimum monies committed to Blizzard regardless of The9's operating success. There are also advances made on the royalty payments which may be recouped in the event that the revenue does not materialize (unlikely).

3) At present it looks like The9 is setup to pay Blizzard at a minimum - $54 million dollars over 4 years to operate WOW in China. That breaks down to around $13.5 million per year. If we consider that Blizzard has been promised 22% of all revenues related to game operation and they are being advanced 13.5 million per year - that implies (13.5 million / 0.22 = $61M) that Blizzard and The9 anticipate $61 Million in annual revenus for The9 as a very achievable goal.

4) The due diligence I have read through and reviewed produces most of its estimates by extrapolating the ACU (average concurrent user data) - and then multiplying that times the gross amount per hour - approximately $0.044 USD and then subtracting out the royalty payments and other operating costs. It appears based on some of these assumptions that The9 could do between $25M-$30M in revenues in the Q3 and potentially net around $10-$15M off of those revenues. That would produce some very solid EPS. As follows below I have included a summary of these figures I got off a Yahoo message board:

"I estimated the Q3 revenues and earnings using the numbers available to us. Let me know if any of my assumptions are incorrect.

Revenue = 25.2 Mil
(260,000 * 24 hrs * 92 * .044).
Assumptions: ACU = 260,000 (June level).
ARPU = RMB 0.36 (4.4 cents/hr), same as for Q2.

Total Expenses = 13.7 Mil
(Royalty payments + Operating expenses)

Royalty payments to Blizzard = 6.9 Mil
(260,000 * 24 hrs * 92 * .055 *.22).
Royalties are 22% of the face value (!) of sold WoW pre-paid cards. Prepaid cards sell for 5.5 cents/hr.
Operating expenses = 6.8 M (management sees operating expenses at the same level as for Q2)

Equity Loss = 0.5 M (MU, etc. same loss as for Q2)

Net Profit = 11.0 Mil
(Revenues - Expenses - Equity Loss)

Q3 EPS = 0.45 USD"

I think most of the above assumptions are reasonable. The one thing that I did not see a reflection of here and I have not seen much commentary on - is that The9 does not currently own 100% of C9I, which is the entity that operates and owns the rights to WOW in China. In fact - The9 co-owns C9I with another asian company and their ownership is currently limited to around 68.9%. From an accounting standpoint - I think they will manage to twist the EPS numbers their way as they have been consolidating the C9I revenue/earnings - from IPO, even though they only started with around 54% ownership.

They are expected to purchase the remaining 31% ownership interest in the entity sometime in Q3 for an undisclosed amount - but I think it is safe to assume in the $7-15 million range. Depending on how that purchase is accounted for (re: deducted from operating income or amortized over several years) - may have a major impact on Q3 earnings.

Here are a few different ways to shade the facts re: The9's opportunities:

Negative Scenario: The9 has nothing. They have the "right" to operate WOW for a period of 4 years. They own none of the intellectual property and after the four years is up - even if they were successful - they will have to pay out the eyeballs to get the next Blizzard game or renew the Warcraft license.

Positive Scenario: The9 has everything. They are "exclusive" with WOW in China. This game is hugely popular worldwide and they could potentially garner up to 10M paying customers over the next 2 years on a monthly basis. This would mean huge money for them and an increase in the stock price.

Now, finally - I will get to what I consider to be the biggest risk regarding The9 - which is political. Here are just a few of the regulations adopted by BigBrother (aka Chinese Government) over the past few years regarding internet access. Unforunately this type of regulation appears to be accelerating instead of going away. This is a very troubling trend.

Unfavorable Legislation to Industry and my commentary:

a) Internet Cafe Regulations - much more difficult to open one and many were shut down. Also makes it more difficult for kids under 18 to enter. I see this as a major negative.

b) Limited hours - Big Brother has put limits on how many hours the people can play video games.

c) Classification of games - Big Brother has said that certain games are bad because they have violent content, etc. and for those games - people under a certain age cannot play them and hours are limited, etc. (note: WOW is considered one of these violent games and its playtime is limited accordingly.)

d) Here is a link with more of where Big Brother is headed - http://www.gametab.com/news/352246/

This scares me so much because I am thinking what if one morning I wake up and read a headline that says - Warcraft outlawed in China! When you think about the phenomenon that Starcraft was in Korea, I think you could imagine that it would scare the shit out of the Chinese Authorities that a videogame had that much control over their people and just outlaw it altogether. Or what if they just outlawed all the games that they considered too popular.

I don't know if there are any overlapping requirements here with their 2008 WTO admission - that they will be forced to move closer to an open society instead of closer to a prison, however the developments re: the video games industry over past several years - look headed much more in the prison direction to me. I was shocked to read the political risks that exist - but the more I am seeing them - it is a huge wake up call.

So for the meantime I am not going to buy much of this one. I am thinking of getting my feet wet with 100 shares sometime in next few weeks - but ultimately I would like to own 500-600 shares of this company based on their operating potential.

The problem is that I don't know if I will have the balls to do it based on the political risks. I have not accounted these types of issues much before as I have traditionally purchased companies that operate mainly in the USA, Americas, Europe, etc. - (with the notable exception of the mining companies).

Any comments or feedback is appreciated.

Best Regards and Happy Holiday,

BG