Dear Fellow Investor,

There’s been a lot of acquisition talk on Wall Street this week. Aluminum giants Alcoa and Alcan have been front and center in all of the takeover speculation, but the biggest acquisition news came on Monday. China surprised everyone when it said it would purchase a small stake in Blackstone Group, one of the world’s most influential private equity firms.

In today’s Dispatch, I want to talk briefly about the Blackstone deal and what it means for investors. I also want to tell you about some exciting developments with one of the companies that’s making big gains for China Strategy subscribers.

China and Blackstone: A Profitable Team

According to the details that were released on Monday, China is ponying up $3 billion for a 10% stake in Blackstone Group. One of the reasons China wants a piece of the firm is because Blackstone will be taking its management division public in an upcoming IPO, which is expected to raise up to $4 billion. (But so far, no date has been set for the public offering.)

Another reason that China purchased a stake in Blackstone is because it wants to earn higher returns on its foreign reserve. As you know, China has the world’s biggest foreign reserve ($1.2 trillion!), which is currently invested mostly in sluggish U.S. government Treasury bills and bonds.

The U.S. dollar has declined 30% since 2002, and dollar-denominated assets are becoming increasingly cheap for foreign investors.  It’s only natural for countries like China to invest abroad in opportunities that offer attractive returns.

And Blackstone definitely offers attractive profit potential. As one of the top-five private equity firms on the planet, Blackstone operates multibillion-dollar funds, which it uses to buy ailing companies. The firm then turns these companies around and sells them at a substantial profit. Through its Blackstone investment, China will gain access to one of the most sophisticated buyers of corporate assets in the world, and it will indirectly own stakes in the firm’s portfolio of companies.

I view the Blackstone deal as a big step towards positive business relations between the U.S. and China. In a healthy global financial system, money should flow both ways. After all, U.S. financial giants such as Bank of America and Goldman Sachs gained more than $15 billion in profits from their investments in Chinese banks last year.

The Blackstone investment is also a natural step in China’s evolution towards free-market capitalism. When Japan had the world’s largest foreign reserve in the late 1980s, Japanese businesses bought a big chunk of downtown Los Angeles and mid-town Manhattan. So far, China has been far more reserved than Japan in acquiring foreign assets, but the result is the same. If China starts to invest more aggressively in U.S. stocks and real estate, American investors who own these assets -- people like you and I -- will certainly benefit as Chinese money bids up value.

Now let’s switch gears and turn to one of the stocks I’m currently recommending in China Strategy. The company had a fantastic week -- not only did it report strong earnings, but it’s also benefiting from some of the acquisition excitement that’s going around Wall Street.

Knowing How to Play the Game in China

In my China Strategy service, one of the growing Chinese trends we follow is online gaming. China is one of the world's largest online gaming markets, and Chinese players are very serious about gaming. Hardcore gamers often show up at cybercafés with pillows and blankets to prepare for marathon sessions that can last up to 24 hours.

The most popular online game in China is World of Warcraft (or WoW), which allows players to create their own characters and interact with one another online in elaborate virtual worlds. WoW is operated in China by The9 Limited (NASDAQ: NCTY), a young and rapidly growing gaming company. I first introduced The9 to my China Strategy readers early last spring, and since then the stock has nearly doubled, gaining an eye-popping 98%.

One reason the company is so successful is because it has a unique business model. The9 acquires the rights to operate popular online games in China. This is much better than developing its own online games because China lacks the resources and talent to create big-budget blockbuster gaming hits.

I also admire the company’s CEO, Zhu Jun. Last summer when I was visiting China, I made a point of going to meet with Zhu personally at The9’s headquarters in Shanghai. I left very impressed by his energy and business savvy.

Zhu made it clear to me that he understands his company's competitive advantages, and he has been smart about using them to build The9 into the fastest-growing Chinese Internet company in the past two years.

Zhu also follows a simple formula that I think is a great strategy: He puts up as little front money as he can for new games that have already proven themselves in other markets. He then offers significant profit-sharing for game developers. This limits The9's downside risk with minimal cash outlays.

This strategy has been wildly successful with the company’s most popular game, World of Warcraft. After launching WoW in China in June 2004, The9 saw its revenues surge an amazing 2,400% to $26.3 million, and profits jumped 1,145% to $8.5 million in 2005. After nearly two years, World of Warcraft still accounts for over 90% of The9's revenue.

And that’s not all -- soon the company plans to launch a sequel game to WoW called Burning Crusade. If Burning Crusade can replicate just half of World of Warcraft's success, The9 is in store for a very profitable year.

The Best is Yet to Come

The company announced an exciting development this week: U.S.-based video game publisher Electronic Arts (EA) confirmed that it will buy a 15% stake in The9 for $167 million.

This didn’t come as much of a surprise to my China Strategy readers. In the most recent issue of China Strategy, I talked about how EA has been displaying interest in the company for a few months now. Previously, EA had been denying rumors that it would invest in The9, but it finally came clean and revealed the news on Monday. (Click here to learn how you can join us at China Strategy and be among the first to learn about new developments with The9.)

Electronic Arts’ new stake in The9 is its second Asian gaming investment this year. Just two months ago, EA paid $105 million to acquire a 19% stake in Neowiz, a game developer in South Korea. It’s clear from these investments that EA is serious about entering the Asian gaming market.

It’s easy to see why EA wants a piece of such a profitable industry. The Chinese online game market is very hot -- it’s currently worth $1 billion, and revenue growth last year was an impressive 74%. The country has nearly 40 million gamers, 90% of whom play online games like the ones distributed by The9. And this number is predicted to double over the next four years!
The9 already has the rights in China to operate EA’s popular soccer game FIFA Online. With this new deal between the two companies, I believe The9 will gain additional rights to operate even more of EA’s popular online games in China.

And in continuing with the good news, The9 reported strong first-quarter earnings on Monday. Net profit increased 12% year-on-year to $8.6 million. Revenue came in at $35 million, which was up 27%. And revenue from the company’s flagship game World of Warcraft increased 27% to $34.5 million, accounting for 99% of The9’s total revenue. Gross profit margin -- something that I place a lot of emphasis on -- improved to 48% from 45% one year ago.

All of this good news caused shares of NCTY to jump more than 10% on Monday. The9 has a lot going for it right now -- a climbing share price, a smart CEO, an unbeatable business model, a robust pipeline of games and an exciting new partnership. Looking ahead, once Burning Crusade is launched in China, this stock should kick into high gear. To get my specific buy advice on The9 -- and access to my complete China Strategy portfolio -- click here for details.