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Interpreting The9’s Discount: Good Deal or Hidden Troubles

The9 Limited (NCTY) is trading at a discount relative to peers like Giant Interactive Group Inc. (GA), Perfect World Co., Ltd. (PWRD) and Shanda Interactive Entertainment (SNDA), but is this an opportunity or a warning sign for investors?

The9 Limited [[NCTY]], an online game operator in China, is trading at just 5.8x earnings which makes it one of the cheapest Chinese online gaming stocks. In comparison, the industry as a whole trades at around 14x earnings with average growth rates of 9 percent and average gross margins of 36.81 percent. So, does The9 represent a compelling value or is there a reason for the steep discount relative to its peers?

On April 16, 2009, The9 suffered a major setback when Blizzard Entertainment decided to license its World of Warcraft game to Netease [[NTES]] following the expiration of its current license agreement with The9. The percentage of revenues derived from this contract is uncertain, but as of 2007 the company “derived substantially all of its revenues from WoW.” (Source: 20-F Filing)

During the fourth quarter of 2008, The9 reported revenues of $62.7 million which was down marginally from the comparable quarter a year ago. However, net income dropped 55 percent to $6.5 million as development expenses on its proprietary games consumed a large amount of cash. Unfortunately, there have been no quarterly or annual financial results reported since the contract was lost in April of this year.

Fortunately, The9 has several other games under contract from other companies like Electronic Arts [[ERTS]]. These games includes everything from sports games like FIFA Online to its own proprietary fantasy games like Dragon Empire. Whether or not these games provide enough revenues to cover the loss of its WoW contract remains to be seen, but some investors believe the worst may be over.

In the end, the current discount can be explained by the loss of its license to the popular World of Warcraft game from Blizzard Entertainment. Meanwhile, the success of The9 going forward will largely be the result of its proprietary games in development, which include The9 City, Dragon Empire, Warriors of Fate Online, and its ability to continue in other partnerships with companies like Electronic Arts.

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