The9 Limited's Battle Accelerates: Tragic Timing, Gamer Use Declining, Partnership Blunders

by Sonya Colberg, Senior Editor - 12/10/2015 9:34:43 AM

Just when it seemed The9 Limited’s (NCTY) timing of the Cross Fire shooter game couldn’t get much worse – it did just that.

Less than two weeks after the mass shootings in Paris, The9 announced a deal on Nov. 25 to distribute the Cross Fire 2 sequel in China.

Incredibly, Cross Fire 2 is set for release in China today. Though the website provided a countdown to launch of Cross Fire 2 last night, the site states it is under maintenance this morning. But the game was tragically scheduled for release today to Chinese online gamers just a couple of weeks after the Colorado Springs shootings – and just eight days after the San Bernardino massacre.

Though the latest massacres didn’t happen in China, that government is known for cracking down on societal ills.

Indeed, the Chinese government can – and has – shut down websites deemed socially destabilizing. In fact, China’s Ministry of Culture outlawed godfather and mafia games in 2009 because of the potential negative impact on young people.

So the Ministry may look even more critically at shooter games like Cross Fire2 in the aftermath of the recent massacres. See a sample of the graphics below.

(Source: crossfire.z8games.com)

Yet the stock has somehow managed to rocket.

Shares rose after The9 announced it will operate Smilegate Entertainment’s CrossFire 2 sequel in China for five years at a stunning cost of about $500 million -$50 million upfront, $450 million in milestone payments plus more in royalty payments.

Even if investors push aside the unconscionable timing, significant questions still loom.

How will the Shanghai, China-based company - with a nearly $21 million net loss - pay for something so expensive and uncertain?

The deal required a rapid infusion: a ~$50 million agreement - $40 million in notes and $9.95 million in warrants.

But that obligation looks insufficient considering the upcoming distribution costs as the company burns about $10.5 million per quarter while it holds about $28.2 million in cash.

So we wouldn’t be surprised to see a potentially dilutive stock offering to try to keep The9 in the game.

The9’s financial condition – it just reported the lowest annual revenue since 2004 - has made it one of the riskiest stocks that could be placed in a portfolio:

(Source: Nasdaq.com)

With The9 stock trading around a 2-year high on the misplaced enthusiasm, it is perfectly poised to drop off a cliff.

The company has not responded to a request for comment but investors may find other viewpoints here. Meanwhile, here are the highlights of other issues that present significant downside risk:

*Fewer gamers playing The9 games.

* Terrible position in cash, assets, liabilities and margins.

* Nasdaq delisting risk.

* Chinese government’s developing foreign investment law may kill The9’s structure, governance and operations.

* The9’s partnership missteps have drained over 90% of revenue – and made a rival rich.

*No institutional interest.

Let’s look at the issues poised to knock down The9 shares.

*Gamers Abandon The9 Games

The9 revenue comes chiefly from online games played by Chinese teens whose families can afford China’s very expensive Internet access, as opposed to the TV games played by the vast majority of less wealthy teens and elderly people.  

Yet The9’s most valuable customers, PC online gamers, are nodding off – or at least racing off to explore more exciting games.

Consequently, growing gamer apathy has blown revenues apart. See the chart below:

(Source: SEC filings)

Those numbers were slipping before. Now Asian stocks are adding more pressure as they crumble amid heightened concerns about China’s economic struggles.

*Problems As Sticky As Glu Mobile’s

The9 declines remind us of Glu Mobile (GLUU), another overvalued game company.

We told investors about the deteriorating popularity of Glu’s top game, Kim Kardashian: Hollywood. In 2014, Kim’s download ranking fell from 69 to 163 in one month.

And Kim’s download rank has continued to drop this year. Kim’s ranking has fallen to more of a braces-and-glasses-wearing nerds level of 342 to 600.

Check out the ranking here.

Likewise, Glu’s operating income declined dramatically from $5 million in December 2014 – to merely $389,000 recently.

Glu’s $5 stock began collapsing after TheStreetSweeper’s fall 2014 article.  The stock now trades for around $3.

Though The9 is trading around $4, the company is in far worse shape than Glu Mobile.

Take a look at The9’s cash, assets, liabilities and margins, below.

(Source: Nasdaq.com)

Those declines aren’t the only ones threatening The9. Yet another one could impede investors’ efforts to even check on stock in the future…

*Nasdaq Delisting Risk

Indeed, shareholders’ equity has dropped to the point that The9 stock is on the verge of getting delisted.

Shareholders’ equity – the company’s total assets minus its total liabilities – offers a pretty good measure of the company’s net worth.  In 2011, shareholders’ equity was $200 million.  At the end of last year, the equity dropped to just $10.5 million.

But $10 million in shareholders’ equity is required to remain on the Nasdaq.

Company filings mention how things would likely fall apart if it gets delisted:  

"Our ADSs may be delisted from the Nasdaq Global Market as a result of our not meeting the Nasdaq Global Market continued listing requirements."

"Our ADSs are currently listed on the Nasdaq Global Market under the symbol “NCTY.” We must continue to meet the requirements set forth in Nasdaq Listing Rule 5450 to remain listing on the Nasdaq Global Market. For example, under the “Equity Standard” set forth in Nasdaq Listing Rule 5450(b), we are required to, among others things, have stockholders’ equity of at least US$10 million. As of December 31, 2014, our total equity was US$10.5 million. If we fail to satisfy Nasdaq Global Market’s continued listing requirements in the future and fail to regain compliance on a timely basis, our ADSs could be delisted from Nasdaq Global Market, and we may need to transfer the listing or trading of our ADSs to other stock exchange or trading venues.

However, there can be no assurance that our ADSs will be eligible for trading on any such alternative exchanges or markets in the United States. If Nasdaq determines to delist our ordinary shares, or if we fail to list of ADSs on other stock exchanges or find alternative trading venue for our ADSs, the market liquidity and the price of our ADSs and our ability to obtain financing for our operations could be materially and adversely affected."

*Under China’s Control

Control issues rocket investor’s risks, including the potential for conflict of interest due to five factors:

1. The9 is controlled by CEO Jun Zhu and private entity Bosma Limited.

2. The9 was incorporated in the Cayman Islands, where securities laws are notoriously lax.

3. Operations occur under the eyes of Chinese entities and executives whose assets lie outside the United States.

4. China is working on a foreign investment law that “may impact the viability” of The9’s structure, governance and business operations.

“For example, our actual controlling person, Mr. Jun Zhu, is a citizen of Singapore, which could be one of the significant factors for purposes of determining whether we are ultimately controlled by persons that are of PRC (People’s Republic of China) nationality … Moreover, it is uncertain whether the Internet content provision service, online gaming … and other internet-based industries, in which our subsidiaries and affiliated entities operate, will be subject to the foreign investment restrictions or prohibitions …”

5. The9 operates 27 subsidiaries and entities, and has leaned heavily upon complicated licensing agreements over the years. But China stands ready to intervene in the company’s plans, particularly any acquisitions:

“We may not be able to pursue growth through strategic acquisitions in China due to complicated procedures under PRC laws and regulations for foreign investors to acquire PRC companies.”

*Unrecoverable Partnership Missteps

The9 doesn’t always play well with its partners, resulting in devastating consequences.

1. First, what began as a promising 2003 licensing agreement for both parties soon deteriorated into the partner slapping The9 with a trademark lawsuit.

The company signed an agreement with Korea’s second largest online game developer Webzen (OTCPK: WZENY) to distribute “MU Online” to the Chinese market.

But the battle erupted in 2009, when The9 revealed through teaser movies that it was developing a sequel to MU. Webzen quickly initiated a trademark and copyright infringement lawsuit.

With the partnership dead, ZhaoUC snapped up the operating rights in China in 2012.

The9’s missteps with another partner have proven unrecoverable to this day.

2. Second, in 2005, the company nabbed the license to operate “World of Warcraft” in China for Blizzard Entertainment.  The game quickly accounted for 90% of The9’s revenue. Yet at what appeared to be the peak of “World of Warcraft’s” performance, everything fell apart. Blizzard ripped up the licensing agreement and handed a new license to The9 rival, NetEase (NTES).

Rumor had it that the licensing deal had failed because the Chinese government had targeted a WoW update as an example of  “excessive penetration of foreign culture among Chinese youth.”  

But later, industry observers suggested The9’s quiet development of an apparent WoW clone called “World of Flight” had upset Blizzard.

Whether World of Flight was reproduction or revenge, the consequences of its loss were devastating to The9 – and thus far unrecoverable. Net revenue for The9 plummeted by 94% year over year.

“As we mentioned in the previous quarter, we ceased the World of Warcraft, or WoW operation, upon expiration of the license in June and we had cautioned you that our revenue had significantly declined since the cease of WoW operations. In the third quarter of 2009, our net revenue decreased by 91% quarter over quarter and 94% year over year to $3.7 million, due to the cease of WoW operations.”

(Source: SEC filings)

(Source: Morningstar)

How did the new licensee do with World of Warcraft? The green line below indicates the NetEase stock performance since The9 lost WoW. The red line indicates The9’s stock performance since then.

(Source: Yahoo Finance)

*Virtually non-existent institutional interest

If institutions and analysts show no interest in a stock, it’s typically a great idea to find another investment.

The9 has one analyst covering it and one of the lowest levels of institutional interest TheStreetSweeper has ever seen … less than 1 percent.

(Source: Nasdaq)

*Conclusion:

The9 lost the war when it lost the World of Warcraft deal. Ever since, it has tried to scratch out a tiny niche in the difficult online gaming sector. But The9 has everything from no institutional interest to a loss of active online game users clicking away at those attempts. And now the company is showing a serious lack of business acumen as it distributes a shooter game only days after another massacre. Just how it will financially pull off the release is also concerning.

The9 certainly doesn't appear to be a growth company capable of pulling off a turnaround. In fact, we think a very fair near-term valuation for the stock would be $1.40 per share.

* Important Disclosure: The owners of TheStreetSweeper hold a short position in NCTY and stand to profit on any future declines in the stock price.

* Editor's Note: As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in the companies that they cover. To contact Sonya Colberg, the author of this story, please send an email to [email protected].

 

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