KongZhong Corporation (KONG) Q3 2012 Earnings Call November 14, 2012 7:30 PM ET
Jay Chang - CFO
Leilei Wang - Chairman & CEO
Adam Krejcik - ROTH Capital Partners
Ladies and gentlemen, thank you for standing by and welcome to the Q3 2012 KongZhong Corp. Earnings Conference Call. At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session (Operator Instructions). I must advise you that this conference is being recorded today Thursday, November 15, 2012.
I would now like to turn the conference over to your first speaker today, Mr. Jay Chang. Thank you, sir. Please go ahead.
Thank you, operator. This conference call may contain forward-looking statements. Although such statements are based on our own information and information from other sources we believe to be reliable, you should not place undue reliance upon them. For additional discussions of risks and uncertainties relating to forward-looking statements and other factors, please see the documents we file from time-to-time with Securities and Exchange Commission. We assume no obligation to update any forward-looking statements which apply only as of the date of this conference call.
Thank you for your continued interest in KongZhong. I will first go over our 3Q results before handing over the call to our CEO, Mr. Wang Leilei.
Total revenues for the third quarter of 2012 were $49.91 million compared to guidance of $50 million to $51 million. As we continue to transition our business to become a cross-platform digital entertainment company, mobile games made up 10.5% of total revenues and internet games contributed 43.2% of total revenues with overall gaming revenues making up 54%.
Total gross profit was $19.1 million compared to our guidance of $21.5 million to $22.5 million, however, 3Q cost of sales included a $1.3 million non-cash amortization expenses related to warrants issued to Wargaming for World of Tanks and other Wargaming games in perpetuity in May of 2012.
Net income was $6.22 million compared to a $17.26 million net loss in the same period of last year. And basic net income per ADS was $0.15. Non-GAAP net income was $9.42 million while non-GAAP diluted net income per ADS was $0.21 compared to non-GAAP net income of $4.72 million in the same period last year and guidance of $10 million to $11 million.
In addition, the Board of Directors has authorized the company to repurchase up to $20 million worth of the company's ADS. The share repurchase plan calls for the ADS’ to be acquired in the open market from time-to-time depending on market conditions, the market price of the company's ADS and the management’s assessment of the company's liquidity and cash flow need. As of September 30th, the company had a $181 million in cash and cash equivalents held to maturity securities, trading securities and restricted cash or $4.37 per ADS.
Turning to each business line units, first, internet game. Internet game revenues were $21.56 million in our third quarter, a 144.6% increase from the same period last year. Revenues from the World of Tanks continued to grow in 3Q compared to the second quarter while revenues from our self developed games and overseas game revenues declined as the company has refocused our efforts on domestic game development towards more differentiated internet games genres and smartphone phone games.
Domestic internet game revenues were $20.32 million, a 161.3% increase for the same period last year, but a slight decrease from 2Q. We think the sequential decrease in domestic revenues was mainly due to the revenue decrease of our solely self developed games including Kung Fu Hero.
Overseas net game revenues were $1.24 million, a 37% decrease from the second quarter. Total overseas revenues as a percentage of total internet game revenues in 3Q was 5.7 compared to 8.5 in the second quarter.
For the three month period in the third quarter, Mainland Chinese online game operations achieved average concurrent users of 286,000, aggregated paying accounts of 781,000, a quarterly average revenue per user of a RMB 165. ACUs in 3Q were up 82% from the same period last year. However, the sequential decline in ACUs and APAs was driven by the decline of the user base of Kung Fu Hero and our other self-develop games while World of Tanks users remained stable.
Internet game gross profit in the third quarter was $9.56 million. The decrease sequentially was mainly due to the increase of warrant expenses amortization in the third quarter of $1.36 million, associated with warrants issued to Wargaming for World of Tanks and other Wargaming games in perpetuity in May of 2012. In addition, gross profits were negatively impacted with the decline in gross profits of Kung Fu Hero and other self-developed domestic games in overseas revenue. Internet game gross margin was 44.4%.
Now turning to mobile games, total mobile game revenues in the third quarter were $5.26 million. Feature-phone mobile games in the third quarter were $3.48 million compared to $4.86 million in 2Q or 28% quarter-over-quarter decrease. Our mobile operator partners continued to implement strict operating policies again to deemphasize our marketing feature-phone mobile games. We see these difficulties continue in 4Q by our legacy feature-phone mobile game business.
Our smartphone mobile game revenues in the third quarter were $1.78 million, a 33% increase from the second quarter, representing 34% of total mobile game revenues. Up to the end of third quarter, our smartphone mobile games have been downloaded over 25 million times cumulatively and during the third quarter period we averaged over 1.5 million monthly active users to our smartphone games.
Mobile game gross profit in the third quarter was $2.53 million, a 8.4% decrease from the second quarter as policies from our mobile operator partners in the mobile game monthly subscription business continue to lead to higher churn. However, this was offset by sequential growth in gross profits from smartphone games. Third quarter mobile game gross margin improved overall to 48% from 45% in the second quarter.
Turning to WVAS; WVAS in the third quarter, revenues were $23.1 million, a 10% increase from the second quarter. Third quarter WVAS revenues saw a sequential uptick in lower margin 2G services and while WVAS revenues were relatively stable compared to prior periods, the WVAS operating environment remains difficult. WVAS gross profit in the third quarter was $7 million, a 3% increase from 2Q. However, gross margin was 30% compared to 32% in third quarter compared to the second quarter.
Turning to our operating line, OpEx, total OpEx in the third quarter was $13.23 million compared to $14.3 in 2Q. Product development expenses in the third quarter were $4.55 million compared to $4.42 in the second quarter and sales and marketing expenses were $5.8 million in 3Q compared to $7.15 million in 2Q, as 2Q marketing expenses included cost for the open beta test of Kung Fu Hero. Going forward, we plan to deemphasize marketing activities for Kung Fu Hero, but we will continue marketing activities around World of Tanks in preparation for future 4Q and through 2013 content update.
G&A expenses in the third quarter were $2.9 million compared to $2.7 million in the second quarter and the company's total headcount increased in the third quarter to 1,035 staff compared to 985 at the end of 2Q. The increase in headcount is associated with our recruitment of new talent for 2013 internet game pipeline.
Operating income in the third quarter was $5.84 million compared to an $18.22 million operating loss in the same period of last year. Third quarter operating margin was 12% compared to 15% in the second quarter.
Now turning to our balance sheet and fourth quarter guidance. At the end of 3Q, the intangible assets of the company increased as well as related liabilities by $64 million compared to the second quarter. This increase was due to the company's newly signed internet game license agreements, which includes license fees and minimum revenue share commitments over the next five years for Guild Wars 2, World of Tanks, World of Warplanes, World of Warships, World of Tank Generals, Hawken, Dragon's Inn and Offensive Combat. The combined total license fee, annual minimum payment guarantees and additional payments in the form of warrants were all recorded as intangible assets on the contract date.
In addition, in September 2012, as part of our license agreement with the ArenaNet, for the exclusive rights for Guild Wars 2 in Mainland China, the company issued a standby letter of (inaudible) to ArenaNet. The purpose of the letter of credit is to backstop our future minimum revenue share as well as license fee commitments to Guild Wars 2 over the next four to five years.
The company pledged RMB 225 million or equivalent to roughly $35 million for five years at the company's bank account as part of this letter of credit. The pledged deposit was recorded as restricted cash, non-recurring restricted cash on the balance sheet.
Now turning to our 4Q guidance, we expect total revenues for the fourth quarter to be within the range of $43 million to $44 million, with business unit revenues at the midpoint expected to roughly consist of WVAS revenues of $16.5 million, mobile game revenues of $5 million and internet game revenues of $22 million.
We expect total gross profit to be within the range of $17 million to $18 million. Total operating profit and net profit of $3 million to $4 million and non-GAAP net profit to be between $6 million to $7 million. Within internet games we continue to see, expect sequential growth from World of Tanks offset by further weakness in our domestic and overseas revenues from self developed games.
Within mobile games, we expect lower double-digit sequential growth in Smartphone games but again continued decline in future phone mobile game revenues. In addition, our outlook for 4Q non-GAAP net profit includes an additional $1 million in quarterly operating expenses associated with the headcount and infrastructure of our newly licensed games including Guild Wars 2, World of Warplanes, Offensive Combat and HAWKEN.
Fourth quarter non-GAAP net profit outlook also includes another roughly $150,000 in expenses associated with the imputed interest on long-term payables, combined our 4Q non-GAAP net profit outlook assumes roughly $1.15 million in additional expenses associated with early build out of our newly licensed games.
Now I would like to turn the call over to our CEO Mr. Wang Leilei.
Thanks Jay. Good morning and good night everyone. Thank you for your continued interest about KongZhong Corporation. Now, let me talk about KongZhong’s major business divisions for internet gaming, Smartphone business and WVAS.
Firstly, I want to say for internet gaming, we have two good things, one good thing we see the World of Tanks continue growth in terms of revenue and the user base. This is for almost two years operations for World of Tanks in China and we believe World of Tanks in the future will continue to have to stabilize the user base and the revenue growth because this game shows strong life cycle and we have a good partnership with our producers and the producer will continue to provide the more localized contents for China market, especially for some Chinese Tank series and the many operative new game play will come out in the next few quarters.
The second thing we just for this year 2012, we view to have a very strong pipeline for next two years. This includes some World of Tanks related series for World of Warplanes and other warfare these type of games and also with agreement with many of famous American producers that Offensive Combat, HAWKEN and Guild Wars 2.
These games we get very positive feedbacks from overseas markets from their good performance for PCU and some third-party comments and also we see these games was very unique and very differentiated type games compared with some in Chinese markets and also what my thinking is for one successful online game in China have the two parts very important.
One is screenplay, the second is valuable [monetization]. Our partners, producers overseas, they have a wide rich game play and we're working closely with these partners to build out good monetization for these unique games in China and we believe we're working closely with our producers, overseas producers to prepare many localize contents and the localized monetization for these new games for the next year and essentially for the next quarter, for this quarter for Q4 this year and this five new products will enter into the government approval process in time to prepare for the next year’s official launching.
And the other negative things for KongZhong for this quarter is the first is our (inaudible) workshop developed the game like Kung Fu Hero is not very successful in China but I believe these are the same problems with Chinese online game producers because of lack of innovation, competitive environment and the user lose interest for the traditional MMOs and we decided to stop to continue to develop the old type MMORPG game and we will hire more console game teams and for our next new in-house self developed games, we have a Chinese name we call the (inaudible).
We focus on develop the [East] War types and the console game quality and we believe this game is very unique just like the other overseas partners of our productive games and we will launch our new game for the second half of next year. So second negative thing is our weak financial numbers and also some lower guidance for the fourth quarter financial numbers.
We believe we will hire more people, more team to prepare and operate our next year’s games and also we will invest more money on the preparations for some new projects especially for Smartphones and also the Guild Wars 2 games and we will invest the money on it.
Let’s talk about Smartphone business, the first thing is very important for KongZhong, we insist to make our mobile gaming business profitable even we invest more money and more resources on this new business lines. The second thing is even we see some our internet gaming team is outdated for the very competitive environment gaming market in China but we believe this is more value for the new market for Smartphone business. We have shipped many of our internet gaming developing [teams] to Smartphone developing and operations and we will focus on develop our sales, develop strategy type game and MMORPG type game for free to play model for Smartphone area in China.
So this is our two major gaming sections for summary and for WVAS, we see some decline for our forecast in Q4 number. This is seasonal reason because our partners for Chinese carriers they always have strict policies for the first quarter because they are on to make short reduction for the user complaints in this quarter.
So we too are very conservative WVAS budget for first quarter and we believe after the first quarter WVAS will recover for the financial numbers. As we mentioned this division for KongZhong is stable life and if the cash (inaudible) for KongZhong.
So that's all for the summary of Q3 and operator open the call for questions.
(Operator Instructions) Your first question comes from the line of Adam Krejcik from Roth Capital Partners. Please ask your question.
Adam Krejcik - ROTH Capital Partners
Couple of questions for you first, for the new content update for World of Tanks. I think you initially said Q4 and now you are saying kind of later Q4, Q1 just wondering what the hold up is, is it on their end or is it getting approval and how big of an impact do you think the next content updates is going to have on World of Tanks.
For World of Tanks only for OB version, they get approval from government for mostly KongZhong [packed cash], when we don't get any approval from government for (inaudible) just update our new content of packs for World of Tanks like English Tanks series but we needn’t get an approval from government and also for the next new comers like the Chinese Tank series we are just you know update ourselves.
Adam Krejcik - ROTH Capital Partners
Okay, and in terms of the gross margin for the internet online game business, you've obviously given some guidance for Q4, but what's kind of the longer term expectation there, should that get back to above 50% next year or can you kind of walk us through how you are thinking about gross margin for that business.
Hi Adam, so going back to the first question for the Chinese tank series that is where we're developing that in conjunction with war gaming. We hope to launch it some time towards the end of 4Q, but we obviously want to get it right. So it may slip by a few weeks or a month or so, but really the impact anyways would come in probably the first quarter of next year regardless given they will be coming towards the end of 4Q for the Chinese Tank series. And that's Version 8.2 and we are launching 8.1 today actually. In terms of gross margins our target should be around roughly the 50% level as the games scale.
The war gaming amortization that dragged down margins in 3Q and in 4Q, it is related to a framework agreement, not just World of Tanks but also we also acquired the rights to a game called World of Tank Generals and any other future potential war gaming properties we would have right of first refusal from. But that would be the amortization is at (inaudible). But I think as we see our new game launched some time in 2013, our target is something around the 50% gross margin level all in as the games scale commercially.
Adam Krejcik - ROTH Capital Partners
With regards to your pipeline, I know it’s difficult to predict, but can you kind of walk us through at least in order of what are the next games we are going to see and your best guess at this stage in terms of when they might start to contribute to revenues.
We do plan to launch Dragons Inn towards the end of this year, early next year. But I think expectations right now where we are keeping those kind of, rather keep it relatively muted. We think it’s a very quality game but we want to do it right. So anything we do in the open beta in the next few months will be very small scale.
The next three games we are working on a lot of its really dependent on two things, one is localization from our development partners and that's something we do very close jointly with and as well as government approvals. Assuming that a government approval takes six to nine months and we start a government approval process for the Combat, Hawken and World of Warplanes in the next few months we are looking towards probably the second quarter 3Q for those properties.
For gaming designs and quality of Guild Wars 2; we want to take a little bit more time as well as government approval process will take more time. That’s probably hopefully back ended toward 2013, and then there is also World of Warships but that is still even (inaudible) I believe in the Russian market today.
For World of Tanks, we've got almost 15 million World of Tanks registered users with just leverage user base who promote other related warfare games like World of Warplanes and the World of Warships. They will be very successful in China too.
Adam Krejcik - ROTH Capital Partners
And what about this World of Generals; is that planned for sometime next year and since it's a browser based game, do you still need approval or what's the idea there?
I think we just traded the expansion pack for World of Tanks and it’s a card collecting, browser based game. We will launch it in the middle of 2013 and it needn’t get any approval from government because this expansion pack is from the World of Tanks.
Adam Krejcik - ROTH Capital Partners
Going back to the balance sheets so that the increase in intangible assets; when do you start to amortize or when do those run through the P&L once the games are actually launched and up and running?
Correct, they are based on when we [personally] launch the games.
Adam Krejcik - ROTH Capital Partners
And then you gave some guidance for OpEx, R&D to pickup, G&A a little bit as you increase your headcount in Q4. How much incremental expenses should we expect next year of that after that fourth quarter levels, are they going to be significant or is that kind of the run rate you are looking at for now.
It’s not going to be significant any more than the 4Q kind of run rate. The variable there is obviously when we get close to commercializing games; we will do marketing which is going to be based on the marketing of new titles. But in terms of infrastructure OpEx, they won’t be significantly higher than the amount that we guided for in 4Q. It will increase, but it’s not significantly higher.
(Operator Instructions) There are no further questions at this time please continue.
Okay. Thank you for your interest in KongZhong, we look forward to speaking to you in the next few weeks and months. Take care.
Ladies and gentlemen that does conclude our conference for today. Thank you for participating. You may all disconnect.
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