TOM Online Inc. Q1 2006 Earnings Conference Call Transcript (TOMO)

TOM Online Inc. (TOMO)
Q1 2006 Earnings Conference Call
May 10, 2006 8:00 a.m. EST

Executives

Rico Ngai - Senior Manager Corporate Communications
Wang Lei Lei - CEO
Jay Chang - CFO

Analysts

Michael Jung - SG Cowen
Nat Schindler - Piper Jaffray
Tian Hou - CE Unterberg Towbin
Richard Ji - Morgan Stanley
James Lee - DE Investment Research
Lu Sun - Lehman Brothers
Jay Ji
Ming Cheng - Calyon Securities
Kip Lu - Goldman Sachs
Andrew Collier - Bear Stearns

Presentation

Operator

Good day, everyone and welcome to the 2006 first quarter results briefing for the TOM Online conference call. (Operator instructions) I would like to hand the call over to Mr. Rico Ngai and I will be standing by for the Q&A session. Please go ahead. Thank you.

Rico Ngai

Good morning and good evening, ladies and gentlemen. Welcome to TOM Online 2006 first quarter results investor conference call. For your information, we have uploaded a slide presentation at our IR website, ir.tom.com. Hosting the call today are our Chief Executive Officer, Mr. Wang Lei Lei; and Chief Financial Officer Mr. Jay Chang.

Mr. Wang will give you an overview of the Company’s business in the first quarter of 2006. Mr. Chang will provide you with financial analysis of the corresponding period. The presentation will be followed by a Q&A session.

Before we proceed, I would like to bring your attention to the fact that the following presentation contains statements that may be viewed as forward-looking statements within the meaning of the Securities Act of the United States. For details, please consult page 2 of the PPT presentation on your computer screen.

Now, ladies and gentlemen, please welcome Mr. Wang.

Wang Lei Lei

Thank you. Good morning all, and good evening. Thank you for your continued interest in TOM Online. I am very pleased to report another solid quarter of performance from TOM Online. Let's turn to page 4.

Our first quarter revenue, as you see, is at the top end of our guidance range, reaching $48.6 million. This represented year-over-year growth of nearly 40% and roughly 1% increase from the fourth quarter. We believe this continues to position TOM Online as the leading wireless Internet company in Mainland China.

More importantly, the first quarter non-GAAP net profit was $12.9 million representing over 40% growth from the same period last year and 1.5% increase quarter on quarter.

Before we go into more details of our first quarter financials, I would once again like to highlight our target to be the leading wireless Internet company in China. We continue to believe the primary media outlet for Chinese consumers to access information on the Internet will be the mobile phone, and we have based our Company around this.

To date the majority of our services are related to the delivery of content to our wireless distribution platforms, but in the future we believe that this same distribution platform will provide TOM Online a competitive edge for the delivery of services such as portal, email, community and other portal services like mobile payment. You can expect TOM Online to be very active in these new areas over the next 18 months.

I continue to be proud of our operations team, their operational ability and also I am very excited about the opportunities which will come when 3G comes to China over the next few years, and believe we are well-positioned to take advantage of these opportunities.

I will just stop here, and ask Jay to give you more detail on TOM Online's financial results. Jay.

Jay Chang

Thanks, Lei Lei. If you turn to page 7 of the presentation, if you have that open. For the first quarter of 2006 our total revenues exceeded the top end of our previous guidance range, reaching $48.6 million. As Lei Lei mentioned, that was about 40% year-over-year growth, at about 1% from the previous quarter.

As we discussed previously, the first quarter is generally a slower operating period for us due to the Chinese New Year period as well as the period having less days. More importantly, focusing on the gross margins, gross profit was around $20 million and a stark sequential decline due to gross margins coming from 44.4% in the fourth quarter down to 41.1%.

Two key explanations for those declines, which we discussed on a previous conference call. One is, obviously our online advertising business has a higher gross margin structure than our wireless business, and as the contribution from that business comes down our margins are offset by the lower wireless Internet margin.

On top of that, we have good performance from the IVR business, and our IVR business has the larger component of revenue share with CRBT partners. All of these are variable costs.

However, I would just like to point out relative to the first quarter of 2005, gross margins were 39.4% so in the first quarter of '06, our margins improved as we benefited from the size of our scale and our distribution platforms in the wireless Internet area.

On a non-GAAP net profit basis, excluding share-based compensation expenses of roughly $778,000 net profit was $12.9 million representing a roughly 1.5% increase from the fourth quarter and a 41% increase from the same period last year.

In addition, our first quarter net profit does include a gain of roughly $920,000 relative to the RMB appreciation.

In terms of non-GAAP fully diluted earnings, excluding stock-based compensation, earnings per ADS were roughly $0.24 per ADS. Turn to our next slide, please.

On page 8 I just describe each of our different revenues and business lines. Due to the Chinese New Year during the period, we were solely impacted relative to quarter on quarter growth. For example, on SMS revenues were down roughly 2% quarter on quarter, however they were still up roughly 40% year-over-year as the market continues to show good growth for the basic services as well as we continue to penetrate and broaden our distribution channel.

Our 2.5G services, was a relatively more mixed performance. WAP was down sequentially roughly 3% quarter on quarter, due to a number of factors including: continued impact from CDMA subscriber trends; increasing competition for deck positioning and an ongoing silent user clean-up.

MMS was down roughly 7% quarter on quarter, but still up over 100% over the same year period, due to the MMS billing platform migration in 1Q05. However, in addition to Chinese New Year seasonality for MMS in the first quarter, there was also some slight MMS billing system changes. However, we are past most of those going into the second quarter.

IVR was a key driver for us in the first quarter, with roughly 13% sequential growth and close to 50% year-over-year growth as IVR continues to be a service that delivers mobile music as well as other interactive programming with our TV channel partners.

Caller ringback tones [CRBT] were up sequentially, however they were still down year-over-year roughly 8%, as we continue to work with mobile operators to promote subscriber usage by giving away free songs. However, we are also seeing many small players increasing competition for deck position on CRBT by using self-promotions.

More importantly though, as a key differentiator from some of our more pure play wireless service competitors, online advertising was down roughly 16% quarter on quarter but was up 70% year-over-year. As traffic to our portal continues to attract both users and advertisers, and more focused sales activities take advantage of it.

Other Internet revenues were up roughly 20% quarter on quarter, and up over 200% year-over-year as a result of consolidation of video games in the last part of the first quarter of '05.

Turning to the operating profit and OpEx. In the first quarter, total operating expenses were roughly $9.32 million, which was roughly flat from the fourth quarter. This does include the $780,000 in stock-based compensation expense. The key variable in our first quarter OpEx was the decline in sales and marketing from the peak seasonality of roughly $3 million in the fourth quarter to roughly $1.5 million in the first quarter of '06. So we've been able to maintain our seasonal spending. You can expect us in the fourth quarter of '06 to maintain spending, but going forward in the second quarter and third quarter we won't be spending anywhere near the fourth quarter of '05.

Lastly before I turn the presentation back to Lei Lei, just from a housekeeping perspective, at the end of the first quarter of '06 we had a total of roughly $122 million of net cash on our balance sheet. With that, I will turn it back to Lei Lei.

Wang Lei Lei

[inaudible] in the mobile entertainment has been mobile music. Mobile music is a key driver for TOM Online's business today and in the future; and as of 1Qmakes up roughly (15%) of overall wireless Internet revenues, driven in part by wireless activities we are building around our Wanleba brand, which is the creative content functions in our Internet portal and drives more community and the user-generated content.

A key reason for our overall success in mobile music was due to our early market entry into this mobile entertainment segment, integration with our online strategy and a strong relationship with our distribution partners.

For 2006 and going forward, we intend to do the same with sports as what we have done with mobile music. We have TOM Online building share in our portal. For our channel, we have partnered exclusively with CCTV 5 which is a leading TV broadcaster, and Titan Sports, China's leading sports print publication, to help enable sports content on our services to Chinese consumers.

[inaudible] our success in mobile music, we believe the second quarter is an important period for TOM Online to promote our brand and our services with mobile sports, especially around the World Cup in June.

Regarding TOM-Skype, we have over 12 million registered users with growth continuing to accelerate, assisted by the promotion of TOM-Skype on eBay China. More importantly, we are seeing good usage on the TOM tab with significant page views being generated through our portal and our recently acquired Huanjian Shumeng which is our online vertical channel.

I am also pleased to report after the integration of Huanjian Shumeng into TOM Online we have seen strong growth in page views and the registered user base. After acquisition, we have seen page views grow roughly to 15 million to 20 million per day, which is roughly 30% higher than in 2005 and the new user base grows about 180,000 with over 2 million registered users on Huanjian Shumeng at the end of March.

This positive change has led TOM Online to begin talking to advisors who would like access to this growing user base and we plan to start better advertising on the TOM tab of Skype and Huanjian Shumeng over the next two or three quarters.

We continue to see this joint venture as a new revenue with a focus on continuing to drive user growth in the near-term; but over the long term and more importantly, the potential for VoIP and the communications services business model as we enter the environment in Mainland China.

Regarding UMPay, at the end of April UMPay had grown to over 10 million users as UMPay leveraged our China Mobile strong distribution channels. This results to TOM Online, we are working with UMPay to be what we hope are [inaudible] to get mass market adoption of the mobile phone as a payment tool with TOM Online, with UMPay as the portal.

As discussed briefly on our last conference call, we are working on a micro payment service for payments under RMB 30 where users can bill goods and services directly to their mobile phone bill with IVR. We are currently developing this portal.

In addition, we are also working with UMPay and China Mobile to develop the prepaid card subscribers over the air recharge services. [Inaudible] subscribers make up the majority of China Mobile subscribers, to recharge their prepaid cards using their banking debit card and cash. According to our estimates in 2005, the total recharge market of China Mobile is for over RMB 120 billion. This is a huge market. We continue to see our alliance with UMPay as a long-term, significant revenue opportunity for TOM Online. We are encouraged by the early feedback from this. To help drive mass market adoption of mobile payments over the coming few years.

Lastly, before we get into the Q&A session, I would like to briefly discuss a topic which many brought up to us over the past few months, which related to how we are provisioned for 3G. We believe that the combination of strong wireless and online platforms will be the key to success in 3G. Mobile companies will continue to partner with key strategic service providers to help them develop new mobile entertainment services in the 3G platform.

To prepare for this, we have begun to mobilize our wireless team to develop a full web portal to complement and leverage on our existing WAP and portal services in the channels.

We expect to be very active in building alliances and acquisitions over the next 18 months to maintain our leadership in the wireless Internet with existing wireless distribution platforms, online communities and the new mobile services such as mobile payments, mobile advertising, mobile search and the others.

I will stop here, and Jay will give some outlook about Q2.

Jay Chang

For the second quarter of 2006 we expect total revenues to be roughly between $50 million and $51.5 million. This implies roughly 3% to 6% quarter on quarter growth and roughly at the top end, 20% year-over-year growth. Online advertising within this guidance will be roughly in the 25% to 30% with wireless internet making up the remainder of that.

In addition, in the second quarter we will continue to expense stock-based compensation roughly in the range of $700,000 to $900,000. On that, I will open the call to questions. Operator.

Question-and-Answer Session

(Operator Instructions) Our first question will be coming from Michael Jung - SG Cowen.

Michael Jung - SG Cowen

Good morning.

Wang Lei Lei

Good morning.

Michael Jung - SG Cowen

Good evening. Congratulations on a solid quarter. I think the Skype opportunity is really exciting. You mentioned the near-term advertising business opportunity, and also the co-development of local features. Does that include the ringtones with those? Just give us a little more color on this opportunity.

Wang Lei Lei

As we mentioned, given that our registered user base is over [2] million, compared with our major competitor, it is a small number. So our plan is to develop the user base traffic and the user penetration in China. We have [inaudible] going forward to put some other type of experience into the Skype plans, because Skype has a strong product to complement our customers, and also our advertising customers like to put their banner ads into the key function page of Skype. So we focus on the advertising business for Skype.

Jay Chang

Michael, to add on to that I think one of the things that we are trying to do with Skype which may be different than what [Q2] are doing is just because (a) they have a much larger user base than us, but (b) a lot of people are using Skype for voice calls first, as a communication tool for voice versus instant messaging.

So we are looking at applications which play on that more, as a complement to the phone as opposed to a replacement for [Q2]. So we can't talk to specifics about that right now, but those are the types of things, in addition to the generic, other premium services we can do on a large instant messaging user base.

Michael Jung - SG Cowen

Thank you. My second question is, in the past we know TOM was invited to China Mobile's music conference in April. Because other attendees are mostly the music labels, that indicates that you do play an important role, even if the central music platform is set up.

So could you give us some color on what you took away from the conference, and how will it change the industry value chain?

Wang Lei Lei

I attended the meeting in April to discuss the mobile strategy with China Mobile and also several music labels. The carriers like to discuss, have a meeting with all partners -- music labels and SPs -- but the carriers want to add this service as a promotional channel. Just as one year ago, China Mobile launched Mobile Music service, they just want to have more service providers. Some key service providers like TOM Online, Sina, Tencent. To get more content to leverage their powerful distribution platform.

We believe China Mobile went out to get more growth. They want us to give them proposals on how to combine this content with the existing user base, and the 3G platform. This is very healthy for us to develop the mobile music in China. Also, it is very healthy for us to maintain the relationship with music labels as a revenue sharing model.

Michael Jung - SG Cowen

That is very helpful. My last question is in China Mobile on April 21, you said they [inaudible] on the clean up of silent MMS users. How does this impact your MMS business in the second quarter and beyond?

Wang Lei Lei

China Mobile just gave notice about the cleanup action for inactive the WAP users. As I mentioned two quarters ago, China Mobile already had a plan to clean up the inactive users that didn't log in to the WAP portal China Mobile in about eight months. This just happened in Q2.

It was delayed some quarters. This is reasonable and a slight impact, I think for the future WAP business. MMS does not have any clean up action because most of the MMS services is message-push services. The user, if he is an MMS subscriber, he will receive the daily MMS push message services. This is not an inactive user at all.

Michael Jung - SG Cowen

Okay, thank you.

Operator

Our next question comes from Safa Rashtchy.

Nat Schindler - Piper Jaffray

Yes. This is Nat Schindler calling in for Safa Rashtchy. If China Mobile does move more into the direction of talking directly to the content providers as that conference seems to suggest, what specific points of value can you provide that China Mobile will have a difficult time doing on their own?

Wang Lei Lei

It's a good question and also I have a good answer. Look at our distribution channels. For the music revenues, just as the other wireless revenues, is only 20% coming from the carrier-related channel like the China Mobile's portal and some local carriers service channel. Most of the revenue is still coming from the internet self-owned or partner channel. We just leveraged our free WAP portal and our internet portal to sell mobile music.

Also, we just had the strong coverage have a partnership with a handset manufacturer to link up the mobile music menu and services into the handsets direct. Also, we just did partnerships with the traditional media like TV, radio, and some traditional print magazines to sell our mobile music.

So that means mobile music revenue coming from the carrier-related sales channels. We believe the music labels – everybody benefits or profits. They can clearly understand it is only 20% of their revenue-sharing from the carrier-related channels. So that is very clear. They didn't want to lose any profit from the existing partnership with the service provider.

Also, as I mentioned, China Mobile just wants to enhanced their mobile music platform just like their ringback tone portal, 12530.com. Also they want to enhance their music, WAP portal's music sessions. One year ago just launched music renting services on the platform to contain more service providers music items. So I think it is very healthy for us to enhance our music-related services with music labels and also to the carriers.

Nat Schindler - Piper Jaffray

Do you think it would be fair to say that the smaller SPs are more affected by this change in strategy by China Mobile than you are with the less developed distribution outside of --?

Wang Lei Lei

I think it is a little bit impact to the small service provider because the public rights issue is very important and we had our meeting because the music labels just complained. Many of the small service provides have no public rights on their new songs or music contents. The big service providers have no [inaudible] about public rights.

At TOM Online, the other key source we just built up our public rights alliances a month ago to protect our public rights. We have the unique strategy to the music labels.

Nat Schindler - Piper Jaffray

Thank you.

Operator

Our next question comes from Tian Hou.

Tian Hou - CE Unterberg Towbin

I have a question regarding UMPay. I know you have been developing the software for awhile. Based on your presentation, I want to get more color about it. Have you started to generate revenue on the UMPay? If not, when do you expect to generate some revenue from this technology?

Wang Lei Lei

Actually we haven't generated any revenue from the cooperation with UMPay yet. We used one quarter to set up the clear strategy with UMPay for the two cooperation points. One is micro payment. We just leverage our online web alliance teams to promote the micro payment of UMPay. Also, we have the revenue-sharing with UMPay.

The other very important mobile payment function is the banking mobile payment. We view this as the future function for mobile payment. Just like the user leverage access at a mobile ATM, anytime they want to pay for something, they have a number and input their bank account number and the password and they can transfer the money from the debit account to the merchant's account.

The killer app for the UMPay mobile payment is to the phone bill recharging services just like China Mobile, for every year phone bill recharging market, they sold over RMB150 billion. We can push some SMS messages to the debit card user when their mobile phone account is below RMB100 to tell them to use mobile payment services dialup number; input their debit card number and password, and you can immediately transfer the money to recharge your phone bill account. We believe this is more efficient.

We have acquired [inaudible]. The user is very active and likes to use this high-efficiency payment phone bill recharge services. So for the next few quarters we will discuss several major Provinces like Kwong Dong, which has over 50 million mobile users and also to the top three mobile users number in China to launch the mobile payment services for the phone to recharge.

We will focus on these two killer apps: one is the micro payment online for internet services. One is the phone bill recharge mobile payment banking services. It is the revenue-sharing model with UMPay.

Jay Chang

Let me put some more color on the business model. I think in terms of expectations, more towards the early '07 time period, I think is reasonable. Because we do need some time to mobilize a lot of different resources.

I think roughly just to think about the business model, it will be roughly a low single digit commission. It's roughly about a $15 billion total transaction market per year. We split that roughly 50/50 with UMPay. That is how the business model would roughly work.

Tian Hou - CE Unterberg Towbin

Thank you. The second question will be on the SMS business. There are lots of swings and movement in the SMS business in China. As SMS becomes more commoditized and some SPs may give SMS for free. Do you see this as a trend? If you do, how are you going to go against this to protect your revenue and your earnings?

Wang Lei Lei

I think it is a reason because people like all free services for the fixed line internet services just like MP3 download. But for the mobile services, people's behavior is they must pay money to get any of the services for the mobile.

For example, many of those free WAP portals have launched. But people always used free download from the China Mobile WAP portal because they do that behavior. They pay services to use the mobile data service.

I think those free SMS services don't really affect any of our SMS revenues. As I mentioned before, in terms of the higher penetration, the SMS market will mature. It is still a cash cow, but not of a key growth driver for TOM Online.

Jay Chang

On top of that, you have to remember for SMS to send SMS to users for delivering services, those SPs would have to still pay for transmission costs. As you know, across the industry transmission costs are a big bulk of a lot of people's sales, marketing, and operating costs our cost of sale. It is not like they can do it for free either.

Tian Hou - CE Unterberg Towbin

The next question would be. As 3G is coming, I listened to what you mentioned in your presentation; mobile payments, mobile advertisements. What are some immediate products you can just put on the market that could generate some new revenue immediately? It seems that there were several places that the 3G network already started trial version. People already started to pay for 3G services.

Wang Lei Lei

I think we can easily migrate existing pay services from our WAP portals to the new 3G platform, because compared with 2.5G and 3G, it's just like from the narrowband to broadband. In 2.5G you can download some ring tones. From the 3G platform you can download from MP3 as your ringtone. This is the same behavior and the same context.

Mobile music and mobile game continues to be very popular in the new 3G broadband platform. But some new ways we will generate revenues are like mobile ads. Maybe some internet portals can combine their fixed online ads and the mobile ad together and give more return to the existing customers.

Tian Hou - CE Unterberg Towbin

The last question is for Jay. Your operating margin this quarter is at 21.9% and the same quarter last year it was 22.8%, slightly decreased. Can you give me some color on that?

Jay Chang

Year-on-year the biggest reason for that decline is the stock-based compensation – roughly $780,000. If you strip that out, actually our operating margins improved over the same period year-on-year.

Tian Hou - CE Unterberg Towbin

Thank you. That's it.

Operator

Our next question comes from Richard Ji - Morgan Stanley.

Richard Ji - Morgan Stanley

Hi Lei Lei, hi Jay. I have two questions. First one is regarding your Q2 guidance. Can you give us a little more color on that.

Jay Chang

Sure. Online advertising revenues, on a quarter-on-quarter basis, will be roughly in the 25% to 30% and potentially plus range. Wireless will be roughly in the 3% to 5% range. Overall it will be 3% to 6%.

Richard Ji - Morgan Stanley

When do you think your wireless service is going to renew the robust growth we have seen over the past couple quarters?

Jay Chang

On a year-on-year basis, our top end of our guidance is still roughly 20%. In the near term, online advertising is doing quite well for us because, although our traffic is quite large, even though we've improved on it, I think we're still under-monetizing a lot of it. Especially as a lot of our combined mobile music/internet/wireless promotions like Wanleba are getting a lot of traction with advertisers as well as a lot of the sports activities in the second quarter. Those things take a little bit longer time than basic consumer-driven services.

I think in the short term you are in seeing first quarter MMS and WAP have some, I think, short-term issues. Hopefully in the second half of the year as things progress and hopefully there are also new service opportunities in terms of mobile payments and so forth, we'd like to get back to that type of growth. I think in the near term, we're very happy with our Q2 guidance.

Richard Ji - Morgan Stanley

My final question, again regarding your gross margin, obviously we understand the reason for the decline. Can you comment on the future churn going forward.

Jay Chang

As we've discussed before, I think the 40% to 45% range is something that we're going to strive for. One thing, I think for this year, as you see IVR continue to perform very well, that has slightly lower margins within that 40% to 45% range. I think for the remainder of the year, our 40% to 45% is still where we're targeting. Even if online advertising does well, it probably won't be up to 45%. It will probably be closer to 40%.

Richard Ji - Morgan Stanley

Okay, very well. Thank you.

Operator

Our next question comes from James Lee.

James Lee - DE Investment Research

Thanks. Can you comment about mobile games a little bit? It did very well this quarter. I remember the press release your success was attributed to it on the China Mobile platform. Can you talk about what you did there?

Mr. Wang, you said last quarter you were ranking number 25. I want to get a sense of where you are now. Are you still aiming to be top 2 to 3 provide by year end 2006?

Jay Chang

On the other wireless internet revenue line, the bulk of that is actually Indiagames. They are still going through some billing changes with some of their major Indian mobile operators.

The bulk of the sequential increase that we saw in the first quarter is due to our distribution of hundreds of domestic studio games in China through our wide distribution platforms. I think we're still at the very early stage of that. Part of it is, we've gone from I think maybe two quarters ago, one person to now I think roughly maybe 10 to 20 people focused on it. That is the key driver. It is still relatively small to our overall business. However, I think when I was talking about growth going forward, it is one of the areas where there is opportunity in the second half of '06.

Wang Lei Lei

Our ranking has improved as well. From 25, to about number 10 for the [Jowa] game in Mainland China in terms of the revenues up to this month.

James Lee - DE Investment Research

Okay, that makes sense. In terms of the game portal, which China Mobile is managing, have you sensed there are some improvements in terms of increased capacity? In the past there were issues that the portal couldn't bring enough games onto the platform and therefore holding back the revenue generation for mobile games. Mr. Wang, have you seen any improvements lately?

Wang Lei Lei

Yes. Last year China Mobile just moved their java game platform from Guangjo to Beijing and Shanghai. Shanghai as a game platform operator, Shanghai Mobile. I think the billing rates and also the platform quality and their efficiencies improved from before. But the java game market is still a smaller market than the other existing scalable business like SMS, WAP, IVR, and also color ringback tones. Still a smaller annual business.

James Lee - DE Investment Research

Maybe you can talk about competitive landscape a little bit. You elaborated that well, from quarter-to-quarter what you are seeing in the industry. Maybe talk about what happened in 1Q. Have you seen more competitors? Less? What about carriers' behavior in terms of working with less and less service provides. Give some color, what you see there.

Wang Lei Lei

As a carrier strategy we will focus on having a close relationship with strategic partners, which is the top three or top five in each business line. Like TOM, Sina and also include [Kwong Jung] and some big service providers.

For the micro market, we believe the existing business still has the space to grow, like WAP services, MMS, especially for MMS services. China Mobile MMS services is still in the low user penetration. MMS is the market focus. SMS still is a cash cow because it is a mature market with a high penetration.

Our strategy for this year is for the product strategy. We will focus on music strategy. We believe some seasonal revenue flow through will come in from Q2 because of the World Cup in June and July. So that is the strategy. We will focus on developing TV partnerships with many of the TV stations. Also we'll maintain the handset distribution strategy.

James Lee - DE Investment Research

Also, Mr. Wang, you had talked about sports World Cup being a big event for second half of this year starting in June. You said you'll do something similar with music. Can you elaborate that a little bit? Does that mean some user generated content of the application? Can you talk about that a little bit more so we can get a better understanding of that?

Wang Lei Lei

I think for World Cup, our promotional strategy is similar to the others. Maybe some differently, but many of the pay services four years ago, have become free to promote our new services like some notified match results or notified matches were free to promote our new services like some interactive IVR TV game services, IVR remote TV game services.

We believe because of bandwidth limitations and is only now, the data service in China is only capable of a simple text message, some simple pictures, and also the low capacity, low bandwidth WAP services. We want to get more focus on the product. Also the platform can now transfer the video-based content. We believe that distribution is the key in the sports in June and July.

We have the exclusive rights to get to the two powerful distribution channel partners is CCTV-5, which is national coverage, the largest sports TV channel in China for Titan Sports weekly, which is the largest print media in China for circulation weekly. It is over 4 million per week. These are the two largest TV distribution channels to help us promote our products to the end users.

James Lee - DE Investment Research

To make sure I understand correctly, so it's a combination of news and information, some sort of interactivity through SMS in conjunction with the TV program? And at the same time to be able to distribute video to the mobile phones the highlights and clips of the games?

Wang Lei Lei

I think the product format for this time we will focus on message-based and web-based, not include the video-based.

James Lee - DE Investment Research

Okay, that's fine. In terms of online advertising, maybe Mr. Wang can talk about some of the success you had in 1Q. Give some additional data points. Is that part of the business on track to really ramp-up over the next couple of years?

Wang Lei Lei

I think it is a good year for us for the advertising business because of TOM's branding and our portal strategy; more and more customers. Even in Q1, our advertising results had a seasonal decline. During the sales period, I feel many customers was the lack of a strategy; [inaudible] and the payment sports season. We have a strong wireless access to support our internet portal. The advertising business still has a faster-growing business for TOM Online. Maybe Jay says something about our key customers.

Jay Chang

Was there anything to follow-up on that?

James Lee - DE Investment Research

No. Just talk about some key recent success in terms of major sponsorship in key channels. Give some additional data points on how you are doing there.

Jay Chang

In the first quarter because that is usually seasonally weaker, it's probably not the best quarter to talk about it. I think in the fourth quarter and going forward this year, people like Reebok, auto manufacturers, China Mobile and other handset manufacturers as well as eBay. They fit our demographic of wireless – young and trendy, sports, and entertainment.

James Lee - DE Investment Research

If I can squeeze a last question. On the free WAP portal initiative, can you elaborate what you are doing? What is your end game, if you can talk about it. Is that to drive mobile advertising, mobile search? I want to get a sense, if eventually you can get enough traffic, how you want to monetize that.

Wang Lei Lei

Before 2006, we had only two people to run the free WAP portal. For this year, just like our critical mass, the free WAP portal is more popular. We just took about 40 people added to our team, which is easy for TOM Online to migrate or combine our internet content application community services to the free WAP portal.

We believe just as our Skype, our first target is to develop our free WAP portal traffic user base. We believe this is a good way to monetize the future wireless to use the free WAP portal traffic for user base to promote our pay services for the wireless. Secondly it is to monetize to the mobile advertising business combine our existing online advertising business.

James Lee - DE Investment Research

Okay, great. Thank you.

Operator

Our next question comes from Lu Sun - Lehman Brothers.

Lu Sun - Lehman Brothers

Thank you for taking my questions. The first one is regarding your gross margin. Can you give me a rough idea on your gross margin for the wireless business versus the online advertising business in the first quarter?

Jay Chang

Wireless margins in the first quarter were roughly 39.5%. That compares to roughly 38% in the first quarter of '05. Advertising was roughly in the 65%, 66% range relative to under 60% in the first quarter of '05. That explains the improvement year-on-year.

Lu Sun - Lehman Brothers

Do you think that online advertising margin will further improve going forward, especially when you are projecting a robust revenue growth in this business?

Jay Chang

It generally does because that has a bit more scale than our wireless business. Just for your reference, in the fourth quarter of '05, we had roughly 75%, 76% online advertising gross margin.

Lu Sun - Lehman Brothers

Also, I have a follow-up question on the business model for the UMPay business. You mentioned that the prepaid card top-up is going to be a very big market for your business. Can you help me understand what kind of role you play in this kind of business? It seems like this is just an accessory service that China Mobile could be providing to their own prepaid customers on their own instead of relying on a third-party SP to help them with the marketing.

Wang Lei Lei

It is not a pure service provider's business. The China Mobile just developed many of their offline traditional agents to help them sell the prepay card. Also the people recharge the phone bill going to the bank or to their offline agent of China Mobile. So we believe the business model or the corporation model with China Mobile – we just want to be an online agent, a mobile banking agent to have 1% of the agent fee from the total phone bill charge money from the users.

We have the revenue-sharing model with UMPay. If this model has success and acquired by the users, this is a big number because the market for the recharging service market is over RMB150 billion per year.

Lu Sun - Lehman Brothers

Can you tell us what is the percent commission that China Mobile is paying to the offline agents at this moment?

Wang Lei Lei

There are different type of rates, like Beijing China Mobile just gave 1.5% of the agent fee to their offline agent; Like [Georgio], they gave the agent 2% of the agent fee. For us, maybe there is about 1% because they want to show advantage.

Also we can help protect China Mobile from bad debts because many offline agents receive the money from the user. But maybe we can generate money off the bad debts to China Mobile. Also China Mobile has some cost reduction because for every recharge card, they have the cost of the card.

Jay Chang

On top of that, in addition to what we think is an attractive business model – and we are in the certain provinces where we are starting the tests, we can see up to as much as 10% penetration happening very, very quickly. The take-up is quite good.

The reason why I bring this up is we have a slightly ulterior motive as well. Because we are the exclusive agent for working with UMPay, we want to get people to sign up UMPay accounts. We think this is a great way to get that user take-up. If we can help UMPay to get critical mass, base them to other payment systems across the world maybe to the online, once you can get that, then you can start thinking about signing up merchants and so on and so forth.

You are seeing the beginning parts of our game plan. We do have a secondary kind of motivation for focusing on this application specifically now.

Wang Lei Lei

Also this kind of business is easier to do the self-promotion. When the people's prepaid card account, their money lags just below RMB100, China Mobile billing system gives the people a message and tells people anytime anywhere access dialup number and input your debit card number and password. It's just like an mobile ATM. You can immediately let them flow the money to recharge your phone bill. This is more high efficiency user service.

Lu Sun - Lehman Brothers

That sounds very interesting. Also, my last question is on your earlier comments about actively building more alliances both in terms of content and also in terms of distribution going forward. It seems like you already have a comprehensive portfolio right now. If you are missing parts of the puzzle, what would be it, what areas would you want to expand into going forward?

Wang Lei Lei

You mean the product or distribution?

Lu Sun - Lehman Brothers

In terms of alliances, what areas would you want to expand into by forming alliances in terms of product or distribution in your portfolio?

Jay Chang

It's not entirely just alliances. We are actively looking at M&A as well. I think they break down into three rough areas, which Lei Lei touched upon in the presentation. The first is value-added wireless distribution channels that can help China Mobile or China Telecom or Unicom in the future to -- they don't sell most of their own value-added services through their own sales channels; most come through ASPs or other sales channels.

Another area is other online communities. I don't want to use the word Web 2.0. But those type of things enhance our current user base that I think help us going into 3G. I think Huanjian Shumeng is a good example of that. A lot of interesting startups and companies out there that have, what we think, are the next generation mobile applications. Some of them are related to payment. On that basis, we've done an alliance. Some are related to other type of mobile applications. I won't go into specifics right now. We are very, very active right now to make sure we're the number one player in the wireless internet going forward.

Lu Sun - Lehman Brothers

Okay. Thank you very much.

Operator

Our next question comes from Jay Ji.

Jay Ji

Good morning. I have just brief questions given the time. Can you comment on your business trend for the WAP service for the next few quarters.

Wang Lei Lei

I think our WAP service is ranking number 2 in terms of revenue below [Kung Jung]. In the future, I think the WAP service is major service in just 3G platform because this is user-based services. This is the user behavior from the internet portal and use internet services.

From people's behavior, they have to check mail and do a lot of these internet applications, and account and community services through the WAP platform. We believe in the future, WAP is really mobile internet services compared with message-based services like SMS and compared with traditional voice-based services.

The free WAP portal is our strategy for many of the Internet companies because we believe in the future the WAP platform is new mobile media. They are going to attract more user-based page views, monetized for paid consumer-based services and monetized through the mobile advertising services. So WAP is definitely the number one important service for the wireless internet.

Also to China Mobile, last year we focused on developing of their WAP portals, but from the historical records like some [inaudible] fixed, some internet consideration in China. For some internet websites, it is not coming from a commercial company. It is coming from some local telecom carriers. But now they disappear because Sina, Sohu and Baidu has come out.

We believe the carrier cannot run media well. The government didn't want the carrier run the new media. We believe we have more bargaining power to pull strength from our internet portal and from our operational abilities from our fixed internet portal to the WAP portal.

Jay Ji

That's great. What about your revenue for this quarter and the coming few quarters. Is the cleaning up issue largely over? Or do you expect it to last for while?

Wang Lei Lei

I think the clean up issue is for WAP. The China Mobile clean up the inactive user that haven't had any log-on records for eight months. As I mentioned two quarters ago, these various clean up actions happened. This is the right way to reduce the non-active user for us. I think it is a one-time impact in Q1 and still have the growth for WAP services.

Jay Chang

We've included those factors in our guidance. I discussed the different growth rates between our wireless internet revenues and our online advertising within the 3% to 6% guidance. So it's included in that.

Jay Ji

So Jay, in terms of your revenue guidance, most of it growth is in wireless. In that way, would it be from WAP and IVR or maybe from caller ringback tones?

Jay Chang

I think for the second quarter, it will be a mix. It will be between SMS, IVR depending on how some of these things play out, what the WAP has opportunity. I think we always try to give a realistic view to the market of our business as we currently see it today. We've budgeted a lot of those things that Lei Lei has been talking about into guidance already.

Jay Ji

Jay, in terms of operating expense, it looks like you did a very good control for the first quarter. For the future quarter, can you give us some color going forward?

Jay Chang

We are definitely going to try to manage our operating expenses to the best of our ability. Sales and marketing for us will increase in the second quarter, but not anywhere near the fourth quarter levels. In terms of overall operating expenses, if you exclude the stock-based compensation, there are some lifts going into because this is our Sarbanes-Oxley 404 compliance year. We've engaged a lot of consultants, a lot of resources, and our auditors charge us more fees for their work associated around it. That is one of the key factors, which I think is a variance for us going forward this year, which will cause some OpEx increase. Overall, I think we're going to try to keep it at a relatively controlled level where we can.

Jay Ji

You mean relative to revenue?

Jay Chang

Relative to current levels.

Jay Ji

I see, okay. Also, in terms of effective tax, it looks like originally my impression is in '06 you will be having higher effective tax rate. But this quarter it looks like you are still almost at zero effective tax. Can you give us some color there too.

Jay Chang

For most of this year, most of our tax rate will be very similar to our first quarter. Part of it is because some of our subsidiaries are still enjoying tax holidays. We also have some tax loss carry-forwards as well.

Jay Ji

So this rate will be for most of 2006?

Jay Chang

Yes, maybe sliding up to 1%.

Jay Ji

Okay, alright. Thank you.

Operator

Our next question comes from Ming Cheng - Calyon Securities

Ming Cheng - Calyon Securities

Thank you. Good evening. Just a very quick question. It looks like among your business, the IVR has a better visibility than other segments. Is this because this segment benefits greater from your massive distribution channels? What will you do on the other products in terms of the visibility?

Wang Lei Lei

For IVR, the products still we focus on the voice-based, music-related products. For the IVR distribution channel, we focus to leverage our TV alliance to leverage the TV coverage to sell our IVR services.

Ming Cheng - Calyon Securities

A very long-term question on the revenue structure. Your advertising is growing much faster year-over-year or quarter-over-quarter right now. What do you see maybe in one year or two years, the revenue mix of your advertising versus the [inaudible] business?

Wang Lei Lei

At least I believe the revenue breakdown will be a little bit changed. As advertising business seems to be growing faster because our portal branding and our portal strategy convinced our traditional customers. So this number will have more IVR, not necessarily the advertising revenue will have more percentage of total Company revenues. Also for Q2, we will have more focus on the sales piece for the portal on our advertising sales teams.

Ming Cheng - Calyon Securities

Okay. Thank you.

Operator

Our next question comes from Kip Lu - Goldman Sachs.

Kip Lu - Goldman Sachs

My question has been answered. Thank you for taking my question.

Operator

Our next question comes from Tian Hou from the US.

Tian Hou - CE Unterberg Towbin

I have one more question. I guess one of your answers to James Lee reminded me about that question. A lot of people talk about TOM and Sina. The last conference call you talked about it. I think I want to ask one more time. What is going on? Is there a pending deal? I sort of expect you to say no. I still want to hear from you.

Jay Chang

I guess I will meet expectations and say no. There is nothing going on. It's difficult to talk about something that is based on market rumors. One of the things I can point to is, we're 66% owned by TOM Group. They do have stock exchange filing saying basically the same, that nothing is going on.

Wang Lei Lei

All I can say, we believe our TOM Online operational ability is the best one of the internet portals. But our internet assets like user base and traffic is still [inaudible] compared with Sina and Sohu. Sina is a good internet asset.

Tian Hou - CE Unterberg Towbin

Okay. Thank you.

Operator

Our next question comes from Michael Jung.

Michael Jung - SG Cowen

Just a quick follow-up on the 2Q guidance. You said the advertising will be in 25% to 30% range. Do you mean year-over-year growth?

Jay Chang

No. Quarter-on-quarter.

Michael Jung - SG Cowen

Quarter-on-quarter. Okay. Thank you.

Operator

Our next question comes from Andy Collier.

Andrew Collier - Bear Stearns

Just one question on the music discussion that has been going on. China Mobile was discussing in Chengdu and other areas how to change the current business model. Could you give me some color on when you think there might be a change? What would the timing be? Or do you think this is just a gradual process that will occur over the next 12 to 18 months?

Wang Lei Lei

I have joined the meeting. They haven't talked any about the revenue model changing. They just discussed how to announce to their existing user base and their existing WAP portal and music platform of China Mobile to support the key service providers. And also as a whole value chain. if they want some several music labels to talk about having a meeting together. We believe this is healthy for us and healthy for the whole wider channel, healthy for the partnership between the service provider and the music labels.

Andrew Collier - Bear Stearns

How do you see the role of Montornet going forward in the music industry relative to other distribution platforms?

Wang Lei Lei

I think the Montornet is only a function portal containing more paid services for China Mobile. Most of their revenue comes from the dial-up ringtone and the local dialup services. We believe for the future more and more people will move to the internet portals – WAP portal like WAP Delfina, WAP dotcom.com. The coverage of the Montornet portal in the future will be rich.

Andrew Collier - Bear Stearns

That's all for me. Thank you.

Operator

Our next question comes from Michael Jung.

Michael Jung - SG Cowen

I know people here will bug me all the day for this so I want to read to you. Your Q2 guidance seems a bit below the current consensus. But I believe there is one off-liner, which is about $59 million estimate. If you exclude this off-liner, what is the real consensus?

Jay Chang

I suspect the consensus is something you make up. I give you guidance based on our business outlook, based on current business condition.

Michael Jung - SG Cowen

Yes, I understand. I just don't have access to all the estimates. I assume you have.

Jay Chang

I do. But we don't manage our business based on whatsoever is on some [inaudible], to be honest with you. We really don't. We are giving you our best analysis and update for what we see at the current period of time.

Michael Jung - SG Cowen

Okay. That's fair enough. Thank you.

Rico Ngai

If there are no further questions, I'd like to thank everybody for attending the call. We look forward to speaking with you soon. Thank you. Thank you, Operator.

Operator

Thank you. That concludes today's conference call. We would like to thank everyone for participating in today's conference. All lines may disconnect now and good day to you all. Thank you.

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