Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

KongZhong Corporation (KONG)

Q1 2006 Earnings Conference Call

May 18 2006, 8:30 am EST

Executives

Yunfan Zhou - Chairman and Chief Executive Officer

Nick Yang - President

JP Gan - Chief Financial Officer

Analysts

Michael Zhang - Thinkequity Partners

Paul Beaver - Bear Stearns

Jason Brueschke - Citigroup

Lu Sun - Lehman Brothers

Ming Zhao - SIG

James Lee - Americas Growth Capital

Chang Quong

Andy Collier - New York Global

Leah Hao - Thomas Weisel

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2006 earnings conference call. My name is Jackie and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. If at any time during the call you require assistance, please press star, followed by zero, and an operator will be happy to assist you.

I would now like to turn the presentation over to your host for today’s conference, Mr. JP Gan. You may proceed, sir.

JP Gan

Thank you, Jackie. Welcome to KongZhong Corporation’s First Quarter 2006 Earnings Conference Call. You can find our Q1 earnings press release at our website, ir.kongzhong.com. I am JP Gan, Chief Financial Officer of the company. We also have Yunfan Zhou, our Chairman and CEO, and Nick Yang, our President, on the line.

I will go through our first quarter financial highlights first. After my discussion, I will turn it over to Yunfan. He will review our operations and talk about our outlook and new business initiatives.

We had a great first quarter. Our total revenue increased 64% year over year and 26% quarter over quarter, to reach a new record of almost $28 million. Both MMS and SMS were the main gross drivers of our revenue growth. MMS revenue was almost $8 million, an increase of 60% quarter over quarter. This is about the same level as MMS revenue in Q4, 2004.

SMS revenue was about $8 million this quarter, which is also very strong, and grew by 46% from last quarter. Many customers used our SMS and MMS digital greeting card during the Chinese New Year. It is evidence of increasing adoption of mobile entertainment applications in China.

The strong growth is also the result of our increased promotion through handset manufacturers and traditional media. Now we have partnerships with 28 cell-phone manufacturers in China, including Nokia, which was a big win for us.

Our gross margin also improved to 58% this quarter. The improvement in gross margins is primarily due to lower transmission costs paid to telecom operators. In Q1, it was about 7% of total revenue, lower than 10% of the total revenue in Q4 2005.

Revenue sharing payments to telecom operators was about 16% of the revenue. Payments to the handset manufacturers were about 12% of total revenue. Fees paid to content providers accounted for about 5%. All these three items. as a percentage of total revenue, were about the same as the previous quarter.

Total operating expense in the first quarter of 2006 was $9.23 million, an increase of 73% year over year, and a 48% increase quarter over quarter.

We began to adopt FAS 123R to account for share-based compensation. The total share-based compensation costs in the first quarter was about $350,000. Our U.S. GAAP net income was $8.6 million, an increase of 37% from Q4 ’05. Dilution of U.S. GAAP earnings per ADS was $0.24 for the first quarter, up from $0.17 in the previous quarter.

Because of several one-time items in the past year, and adoption of FAS 123R, we begin to present you with non-GAAP income starting this quarter. We think this will give you an apple-to-apple comparison to analyze our target growth trends.

First quarter non-GAAP income was $7.9 million, a 24% increase from the previous quarter. Dilution of non-GAAP income per ADS was $0.22, up from $0.18 in the previous quarter.

With that, I will now turn the call over to Yunfan for his remarks.

Yunfan Zhou

Thank you, JP. First of all, we are very pleased with our record-breaking first quarter 2006 results. Our revenue growth momentum continued, and we were able to grow our earnings substantially in the first quarter.

We believe we have surpassed some of our industry peers, and become the clear number 2 player in terms of in terms of revenue in the Chinese WVAS industry. We are very proud of achieving this milestone.

In addition to having sustained our leadership position in the 2.5G space, with our acquisition of Sharp Edge, we have gained a significant market share in the overall WVAS market and have become a top player at China Telecom and China Netcom. Our Q1 revenue grew 26% sequentially to a new record of $27.91 million, exceeding our forecast.

We are also proud to report our U.S. GAAP net income grew 37% sequentially to a new record of $8.6 million. Excluding share-based compensation costs, diluted earnings per ADS was $0.25, exceeding the high-end of our first quarter guidance of $0.22.

We expect our Q2 revenue to be between $29.5 million and $30.5 million. We expect our U.S. GAAP diluted earnings per ADS to be between $0.21 and $0.22. Our non-GAAP income per ADS is estimated to be between $0.23 and $0.24.

In terms of 2.5G services, we achieved 21% revenue growth in Q1 over Q4. We expect our 2.5G revenue may decline about 10% in Q2.

In terms of 2G services, we achieved 36% revenue growth in Q1 over Q4. We expect to see continuous high growth in 2G revenue in Q2, driven by the growth of SMS IVR color, ring-back tone, and the revenues consolidated from Sharp Edge.

In terms of revenue breakdown from different outfitters, our revenue from Unicom, Telecom, and NetCom accounted for about 9% of the total revenue in Q1. With the completion of the acquisition of Sharp Edge, we believe this ratio may be over 15% in Q2. The diversified operator relationships will give us more advantages in preparing for the upcoming 3G services.

To summarize, we are very confident about the overall WVAS industry in China. We believe KongZhong will continue to execute well and gain market share in the future.

As we have reorganized our business in two major business lines, WVAS and the Wireless Internet Portal, I would now like to talk about the KongZhong Kong.net wireless Internet portal. We believe wireless Internet is now at a very early stage of development in China

Only a very small part of China’s 400 million mobile phone users are using wireless internet today. We believe the consumers’ increasing familiarity of the wireless media and entertainment applications offered by the WVAS providers currently, and with China’s adoption of 3G technology, wireless internet portals will gain popularity fast and become an important channel for consumers to gain information and entertainment applications.

We think wireless internet will wow them, and it is critical for us to make the investment to establish an early leadership position. Our vision is for Kong.net to be the largest wireless internet portal in China in terms of traffic, user base, as well as advertising revenue, eventually.

In Q1, we launched our new domain name, Kong.net, for the wireless internet portal. We now have an over 130-people team working on it. Although we have not launched any marketing campaigns for Kong.net yet, we believe Kong.net is already among the top 5 wireless internet portals in China in terms of traffic.

In Q2, we will launch our first national marketing campaign for Kong.net, with a focus on the brand and the wireless internet concept. We believe Kong.net is the first, so-called free WAP wireless internet portal in China to launch such a grand campaign.

We recently hired a very experienced marketing Vice President from Motorola to lead this campaign. We plan to spend about $1.5 million in this marketing campaign in Q2. We will put ads on TV, LCD, on buildings, radio, billboards, buses, subways in Beijing, Shanghai, Quangdong and other major cities in China. So if you have a chance to come to China, I believe you will see our ads.

The main business model of our wireless internet portal is an advertising model. Although wireless advertising is very small today, we believe it will take a very similar path as internet advertising markets. It will first take some time for customers to understand the wireless advertising while they start to use wireless internet themselves. Then they will spend money buying ads. The key to success is to become the top 2 player in the market. As the top 2 player, you will take more than 50% of the market share, which is now happening in the Chinese internet market.

Thus, we believe it is worth investing early in the wireless internet. One dollar spent today may be equivalent to $5 spent a year from now. Although spending marketing dollars will hurt P&L, KongZhong’s management firmly believes that we have the right strategy to achieve our vision, and the investment in our brand now is the right choice. We are making our best effort to balance achieving good EPS and making such investments in our brand.

This is definitely a challenge we will face in the next few years. However, we are confident that we will be able to handle this challenge well.

To summarize, the two strategic business lines we have, WVAS and the wireless internet portal, are equally important and very complementary. We believe we have become the clear number 2 player in the overall WVAS industry, and will continue to grow our WVAS business and gain market share in the future.

Wireless internet portal is currently in the investment stage, but it will be our important revenue and profit growth driver in the next one to two years times. The Kong.net brand will become our core asset, which will have long-lasting value. Thank you.

JP Gan

Thank you, Yunfan. Now we will open the floor for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from Michael Zhang. You may proceed, sir.

Michael Zhang - Thinkequity Partners

Good evening, Yunfan, Nick, and JP. Congratulations on the great quarter and becoming the number 2 player in the market. Just a few quick questions. The first is about the Sharp Edge integration. How did it go, and how much revenue did it bring into the quarter?

JP Gan

Thank you, Michael. We completed the acquisition of Sharp Edge in late January. Right now, Sharp Edge still operates as a semi-independent entity. In the first quarter, it contributed about $1.3 million in revenue, and about $300,000 in net income.

In the next two quarters, we will gradually integrate Sharp Edge into our KongZhong family. We hope that we can achieve both revenue and profit synergies with this acquisition.

Michael Zhang - Thinkequity Partners

Thank you. You mentioned right now you have 28 cell-phone manufacturers as partners. What percentage of your total revenue is from various channels, including the manufacturers?

JP Gan

We do not specifically break out the revenue from different channels. Roughly about 20% of our total revenue in the most recent quarter comes from handset manufacturing partners.

Michael Zhang - Thinkequity Partners

Okay. As the alternative channel contributes more and more to your total revenue, where do you see your margin trend say toward the end of this year?

JP Gan

I think we have always talked about our gross margins. We expect in the second quarter our gross margin to be 1% to 2% lower than first quarter. Toward the end of the year, we hope that we can maintain our gross margins at about the 55% level.

Michael Zhang - Thinkequity Partners

My last question is about your guidance. Based on Q1, with what you achieved, and Q2 guidance, it implies a flat second half. What caused you to be so conservative, and do you have any update on the profitability, which right now stands at $25 million to $30 million?

JP Gan

Are you talking about the second quarter or the second half?

Michael Zhang - Thinkequity Partners

The second half.

JP Gan

We cannot give guidance for the second half.

Michael Zhang - Thinkequity Partners

No, no, I mean, you increased the full-year guidance from 105 to 110, from 110 to 115.

JP Gan

Yes.

Michael Zhang - Thinkequity Partners

Just based on what you achieved in Q1 and the Q2 guidance, which implies the second half is pretty flat.

JP Gan

In terms of revenue?

Michael Zhang - Thinkequity Partners

Yes.

JP Gan

I think that is a great question. I think we also said tentatively that our guidance is assumed, absent of any significant changes in the policies and regulations of telecommunication operators, as well as the Government regulator.

We think our first quarter revenue growth is definitely partially because of the Chinese New Year holiday that allows users start to use our SMS and MMS products as digital greeting cards. Also, partially because we had spent quite a bit of money in terms of promoting and also marketing our various products.

In the second half, we will have to look at the environment, as well as how we are going to spend our marketing dollars. So we think our revenue guidance is prudent at this time.

Michael Zhang - Thinkequity Partners

Okay, on the Q1 conference call, you mentioned the net income should be between $25 million and $30 million. Do you have any update on the bottom line at this moment?

JP Gan

I think based on the information available at the current time, and also our performance in the first quarter, we think we probably can raise our 2006 net income estimate by $2 million, so we think our net income will be between $27 million and $32 million.

Michael Zhang

Thank you very much, and congratulations again.

Operator

Your next question comes from Safa Rashaiki. You may proceed.

Paul Beaver - Bear Stearns

Good evening, this is Paul Beaver for Safa Rashaiki. Congratulations on a good quarter. My first question relates to music. I was hoping you could tell us what percentage of your revenue is music-related, and whether the costs there are rising. Also, what are your thoughts on China mobile’s potential music initiative?

Secondly, just on the operating expenses, the G&A line was higher than we had estimated. What is going on in the G&A line this quarter? Thank you.

JP Gan

To answer your first question, in terms of music revenue, roughly about 30% of our total revenue comes from music-related services. As you probably know, we often buy music and lyrics and compose our own ringtones. I think impossible comparing to our industry peers. Actually, our music portion is actually smaller than some of our industry peers.

In terms of China Mobile’s music strategy, Nick, our President, will answer that question.

Nick Yang

I think China Mobile is considering partnering directly with the music label to provide music onto their mobile network. But you have to understand that it is a matter of content and distribution, because what KongZhong provides is KongZhong provides a great distribution channel for these musical content. So when these labels try to sell their music to the customers, they will soon find that selling directly to the customer will be very, very difficult without a big customer base. So partnering directly with China Mobile, they still have a very long way to go before they can have a critical mass of users to buy music directly from the label. So then the labels, I believe, once they sign these agreements with China Mobile, they will still work with us, with service providers, to distribute the music, otherwise they will have a very small revenue from music, because they will only sell directly to the customer.

This is sort of like Coca Cola selling directly to the customers themselves, without going to stores like Wal-Mart or Target.

Paul Beaver - Bear Stearns

Right.

JP Gan

The next question is about the G&A expense?

Paul Beaver - Bear Stearns

Yes.

JP Gan

Okay, well, there are a couple of things. First of all, we increased our company-wide salary level by 10%. We also accrued a significantly larger bonus in the first quarter because of our excellent performance. Secondly, we start to adopt share-based compensation expense based on FAS 123R. About half of that, roughly $180,000, is actually reported in G&A, so that will give us higher G&A expense.

Paul Beaver - Bear Stearns

Thank you.

Operator

Your next question comes from Jason Brueschke from Citigroup. You may proceed.

Jason Brueschke - Citigroup

Thank you. Let me just stand back and ask a more general question. I will drill down. There is 400 million cell phones, and we know the advertising business in China is booming, and that advertisers are in some ways actively searching for new alternative ways to reach customers with the success of Focus Media. Focus Media clearly believes in online advertising with their Dotad acquisition. What is your view about how big wireless internet can potentially be in terms of advertising? Is it as large as kind of the pure internet size? Is it 50% as big? Just help us understand what the potential is you guys are going after.

Yunfan Zhou

I think the number, 400 million, is actually a very big number, however, right now, as I said, only a very small part of users are using wireless internet, which implies that currently, they probably do not understand this market well. However, we believe that it will take the similar path as the internet, but I think this is a faster trek because when the internet came, nobody knew what the internet was like, and it took advertisers a long time to actually learn about this market.

However, wireless advertising is actually similar to advertising on the internet, but there is a different screen on the mobile phone. So we believe that advertisers who do advertising on the internet, they will soon understand about the wireless advertising.

What we see today in the Chinese market is that it is at the very beginning stage. There are some advertisers, for example, Nokia, Motorola and other SMPG companies, well, some of their competitors also have these kind of trial advertising that is probably a very small amount.

One reason is that the user base is still small. The other reason is that they do not understand what kind of phone and what kind of metrics that wireless advertising can go in. So we believe that it will take probably a few years for the wireless advertising to really get into the mainstream.

But eventually, in five to ten years time, I believe that wireless advertising may become a bigger market than the internet advertising, because of the three to four times user base of mobile phones than the internet users.

So right now, our strategy is to become the leading brand and the leading player in this wireless internet market, while gradually accumulating wireless advertising dollars. So we believe, as I said, in the next one to two years, wireless advertising will become one of our important revenues and a profit growth driver.

Jason Brueschke - Citigroup

That is a great answer. If you will, let me just drill down two questions. Will you guys, and if you already have this, forgive me, but is there an opportunity or a need for you to maybe partner with one of the search companies that can provide search as people are using WAP and using wireless internet? One of the things that makes a lot of sense is to be able to have search capabilities. Is that something that you have done or that you are in the works of, to partner with one of the major players there?

Nick Yang

The way we think about this wireless internet market is that it is going to take a similar path of the development of the PC internet. In the beginning of the PC internet, I do not know if you guys still remember, there is not many sites. So the search companies do not really have a big need, a big demand. So at first, when the PC internet first got developed, it first brought out many of these destination sites. These sites where a customer with e-mail, with news, with sports, with the entertainment, with communities, these guys sprout up first because there was a lack of sites. There is not enough sites.

So that is what we are building. We are building a portal first. We are building the Kong.net brand and the Kong.net portal because we believe it should be the thing we do now.

But we also have a team which is working on search in our company, because we believe search is the next step. When there is a proliferation of WAP sites all over the world that the search companies, the WAP search, will definitely play a very much bigger role in terms of user behavior.

Then the next step, of course, everybody saw it, is the blogging and the 2.0 stuff, which comes after the search age. So we believe this mobile internet, or the WAP internet, will probably take a similar path.

Yunfan Zhou

Just to add one point, right now, we actually discussed a few days ago that we partner with two of the leading Chinese vertical internet companies, [Hoshi] and [E-Net] to provide cooperatively the financial channel and the IT products channel. Both of them are exclusive.

We are also signing a few other leading verticals in the near future, and we are also exploring the possibility of doing the search ourselves and also seeing the partners, because there are many people out there that are plain search, but as Nick said, it is probably too early to explore this opportunity. We are right now still watching the patterns of what users on the wireless internet. Right now, our first step is to focus on the portal stuff.

Jason Brueschke - Citigroup

Great. My last question is about the marketing campaign. It strikes me that you clearly have almost a greenfield opportunity to go out, especially in terms of establishing the Kong.net brand as the, or one of the maybe two, as you said, the key is to become one of the two players, but it also strikes me on the other hand from what you have said is that the opportunities, say whether the handset penetration or what have you, is maybe a little bit elongated out a year or two. Should we just be thinking conceptually that this is maybe the first of a couple of campaigns that you will do as you kind of exploit this opportunity? Or is it once you have established the power of the brand, say with the basis of this campaign, your ability to maybe promote through the other part of your business, through your wireless services provider, allows you to maybe take the brand and extend it once it is there? Thank you.

Yunfan Zhou

That is a good question. I think one reason only a small part of the 400 million Chinese mobile phone users use the wireless internet is that -- actually, a lot of people, there are 2.5G enabled phones, and probably half of the 400 million people have 2.5G enabled phones, or a little bit less, perhaps. However, only a part of them, only a small percentage of them are using wireless internet. Others are probably using [Passaman] or [Othermas] or other kind of WVAS.

Our first marketing campaign is actually on the Kong.net brand, so we educate wireless internet users with a 2.5G phone, they can immediately use our Kong.net wireless internet portal.

Probably a bigger part of the users are the users who do not have the 2.5G phones, who do not know how to use the 2.5G. Right now, for them to get into our brand, which is the leading brand in the wireless internet portal, it is very similar to what Sima and Sohoo, the Chinese leading internet companies, what they did in 1998.

I remember Nick and I, we started China.net in late 1999, and let me put out that in the year 2000, we were one year later than Sina and Sohu. Although we did great, we could not catch up with them, because the first early adopters, they actually have a lot of impact to the later user, and the users who did not use internet in 1999, they remember Sima and Sohoo, and when they first use the internet, they still go for Sima and Sohoo.

So that is the similar pattern we believe will happen on the wireless internet. That is why we are the very first company to put out this national campaign on the wireless internet, so we believe this is critical for our future development.

JP Gan

Let me just add a comment, just to quantify Yunfan’s remarks. We, as mentioned previously, plan to spend about $10 million on this wireless internet portal in 2006. About $3 million to $4 million will be on daily operational expenses, and the remaining $6 million to $7 million will be spent on marketing and in promotions.

While spending this $10 million, we still believe that we can potentially grow our net income by, as mentioned earlier, somewhere between 10% to 25%.

Jason Brueschke - Citigroup

Great, thank you. It sounds like a really great opportunity, guys. Thank you, that has been very helpful.

Operator

Our next question comes from Lu Sun from Lehman Brothers. You may proceed.

Lu Sun - Lehman Brothers

Good evening, and congratulations for a really good quarter. I actually have two questions. One is on your guidance for your 2.5G service. Why do you expect such a big drop in the revenue from WAP and MMS in the second quarter?

Secondly, what is the revenue contribution from Sharp Edge in the first quarter? Thank you.

Yunfan Zhou

I think when I said our 2.5G revenue will go down 10% on Q1 levels. There are a few reasons for that. One is that we grew our 2.5G revenue by 21% in Q1 over Q4. A lot of it was because of the Chinese New Year holiday effect and our promotions in the New Year. So we have this pretty high growth, and a lot of users may unsubscribe after the Chinese New Year, so that is one reason that probably will keep our 2.5G revenue.

Another reason is that our last revenue probably will decline because we actually are facing more intensified competition in WAP, in mainly two fronts. One is the free WAP, the wireless internet area. As I mentioned earlier, the free WAP growth in China is very high. There are right now probably over 10,000 wireless internet free sites, and the number is still growing fast. So these number of users probably taking part of the pie from the paid ramp from monster.net.

And another competition comes from the intensified competition for the placements. So we believe that in Q2, our WAP and also java facing more intensified competition, so the revenue may go down, so that is why we projected a 10% decline in Q2.

Lu Sun - Lehman Brothers

Thank you.

JP Gan

Sue, you asked about Sharp Edge and its revenue contribution, right? In the first quarter 2006, Sharp Edge contributed about $1.3 million in revenue. We expect Sharp Edge to contribute a multiple of that in the second quarter.

Operator

Thank you. Our next question comes from Ming Zhao from SIG. You may proceed, Ming.

Ming Zhao - SIG

Thank you. Good evening, guys. Congratulations on a good quarter. First question is about your performance in Q1. Can you give us some color on what you did differently on the SMS segment and the ringback tone segment? The growth is very robust.

JP Gan

In terms of SMS and MMS, there are a few things. First of all, as Yunfan mentioned, the Chinese New Year holiday effect has played an important role in MMS revenue. We allowed the consumer to actually send digital greeting cards, whether it is the SMS or MMS, to their friends and family.

Secondly, we have always relied on the handset manufacturers as a very important promotional partner or channel for our SMS and MMS product. I think during Chinese New Year some of the handset manufacturers had sold more handsets than the other time. The mobile phone makers kind of tried to dump inventory during the Chinese New Year holiday season when people buy more things, when they get a better bonus and a higher salary increase, so on and so forth. So there are a lot more handsets in the channel in the consumers’ hands. That helped our MMS revenue growth, both SMS and MMS.

Thirdly, we spent close to $700,000 in advertising in the traditional media -- TV, newspaper, magazines, so on and so forth. This advertising campaign also helped with our revenue growth.

In terms of the ringback tone, I think we just -- ringback tone is a relatively small business, and our base is very small. I think in the quarter, we have established several additional connection points. Also, in the previous quarter, we also added on a few connection points. With more connection points and a better quality product, our ringback tone revenue has also grown.

Ming Zhao - SIG

So looking forward, you just mentioned you spent $700,000 on the ad campaign. Would you do more of these media promotions? When we look at Linktone or TOMO, they are doing more channel partnerships, so what is your strategy going forward?

Yunfan Zhou

I think the ad campaign I mentioned earlier is actually the Kong.net, for the wireless internet portal, which is not related to WVAS, but WVAS, I think the major channels we have, number one is the carrier channel. We partnered closely with four major carriers in China under their local branches. Second, our handset manufacturer relationships -- we have close to 30 handset -- we have almost all the major handset manufacturers partnered with us in China. Third, we have the media stuff, media buy-in.

So these three channels are actually our major channels, and we probably will try to increase advertising on all three to grow our revenue in the future.

Ming Zhao - SIG

Finally, a question on Kong.net. I note the purpose seems like to do the advertising model in the future, but if we look at the free WAP sites now in China, one of their business models is also to link those fee-based WAP services. So would you predict any increase, or rebound, if you will, in the WAP segment because you will have a more powerful portal, maybe to link some pay WAP services?

JP Gan

At the end of last year, China Mobile actually had a new regulation, which actually banned the free WAP sites to promote the paid WAP sites. So after that, I mean, all the free WAP sites, they were not allowed to do this. So I believe that for our Kong.net, the major business model will still be the advertising model.

Ming Zhao - SIG

Sorry, you said branded advertising?

JP Gan

That’s right. I do not think the major revenue source will come from WDF providers, and it is our intention to link the two together.

Ming Zhao - SIG

Okay. Congratulations again.

Operator

Our next question comes from James Lee from Americas Growth Capital. You may proceed.

James Lee - Americas Growth Capital

I was wondering if you guys can maybe elaborate the guidance for Q2 a little bit, especially on the 2.5G decline. Maybe JP can talk about this. For the 10% decline, do you see the greater contribution from MMS decline, or is it really coming from WAP? Maybe you could give us a sense of that.

JP Gan

It is still too early to tell, I would say. You know, as Yunfan mentioned partially, our MMS experienced explosive growth in the first quarter. So it is inevitable that some users, after the Chinese New Year holiday, they are going to cancel their subscription.

On the WAP front, the competition is very intensive. We are seeing a lot of competition from media sites, WAP WBS providers for multiple, many placements.

In terms of which segment is going to contribute more, based on the current information, it is probably going to be WAP. However, it is still too early to tell.

James Lee - Americas Growth Capital

Right. Maybe within the WAP, maybe JP, you can give more color. You talk about increased competition there, and at the same time, China Mobile continues cleaning out this database. If you just look at the WAP segment, and the potential decline from 1Q to 2Q, which one is a greater contributor? Is it the cleaning of the database or is it really competition from free WAP?

JP Gan

They are talking about cleaning out the inactive users, right?

James Lee - Americas Growth Capital

Exactly, yes.

JP Gan

I think as we remember, the policy was introduced in April, 2005, and the definition of the inactive user is 8 months. So that impact was pretty much washed out by the end of December. So we are turning a new user acquisition to offset that inactive user cleaning up.

I think, if I had to pick one, it probably will be intensifying competition.

James Lee - Americas Growth Capital

Is it fair to say that the SMS going forward, you may see the similar type of pressure as we have seen from 1Q to 2Q for MMS? You say that you did very well with digital cards. What are people using SMS or MMS platform? You expect some subscriber coming off that base heading to Q2, so I kind of expect a similar impact on the SMS side as well.

JP Gan

Actually, one of our strategies is to diversify our revenue streams as well as operator relationships. As mentioned previously, we expect the revenue from China Telecom, China NetCom, and China Unicom will increase, proportional revenue from those three operators will increase.

As you probably know, those three operators primarily offer 2G services to their users. We believe that our 2G revenue growth will more than offset the decline in 2.5G.

James Lee - Americas Growth Capital

Got it. So the SMS growth that is implied in your guidance is not so much from organic growth from China Mobile, rather than diversification into other carriers other than China Mobile.

JP Gan

That is correct. Also, in terms of market position, as you probably know, we are, by far, the number one player in WAP, MMS, and Java. Given the larger revenue base, it is getting more difficult to grow those product lines because everybody is looking at us as the guy to beat.

On the other hand, SMS, also in 2G, we are still a much smaller player. The market is actually twice as big than 2.5G, so we still have a lot of room to grow.

James Lee - Americas Growth Capital

Maybe, JP or Nick, you guys can comment about the prospect for mobile games this year. There has been a lot of talk that this might be -- last year was sort of a transition year, maybe this year is an inflexion year. How do you see that growing? Any plans? Maybe talk about plans a little bit in terms of how many games do you plan to launch? Have you seen anything change in terms of the game life-cycle, consumer demand, and so on and so forth?

Nick Yang

I think that is a good question. We have recently went to Japan about a month ago to study the Japanese WAP market, the mobile internet market, and we came back with some very clear conclusions. We listened to some very big name game companies in Japan -- the guys who made the PS2 games, X-box games, and what they told us is that making single-player games is not profitable. It is very difficult to make a profit in this area of making single-player games, whether it is for PS2, X-box, or the mobile phone.

What we have learned is that many of them are starting to make these network games, or online games as a big part of their development effort. What we found is that in China, this is apparently the same thing as well. Single-player games are not very profitable, but online game with Netease, with Shanda, you can see, or with TheNines, it is a very good business to make PC online games.

We believe a similar model will follow on the mobile phone as well. Making single-player games will be very difficult, and making online games will be the way to go, mobile online games will be the way to go in the future. We have seen very good traction in our mobile online games.

In the single-player game side, there is a lot of software piracy for the mobile single-player games, so that has been hurting some of the Java downloads, the single-player game downloads. Whether many of the websites are pirating whether it is through the PC internet or on the WAP sites, on the free WAP sites are pirating some of these Java single-player games, but they cannot pirate mobile online games.

So we believe in the future, mobile online games will definitely be a good business and a direction we will head into.

The China mobile platform, of course, we are still waiting for the China Mobile platform to improve. The platform, we are still talking to them to try to get them to improve the environment for the platform.

So hopefully in many of these efforts, these sites, in conclusion the, we believe games, we are still positive on games. We have a big team working on games, but right now, temporarily, games has not taken off as much.

James Lee - Americas Growth Capital

It sounds like based on what you said, Nick, there are still some capacity issues with China Mobile on their game portal, that being first, and also the network capacity restriction does not really offer environmental online games, network games -- it sounds like, you know, your view for the mobile games to really take off is after 3G when there is more capacity within the network and obviously more capacity with the game portal.

Nick Yang

Yes.

James Lee - Americas Growth Capital

Could you also comment about Kong.net? I know there have been questions that have sort of been asked. I just want to make sure I do not miss it. Do you have a statistic in terms of your traffic, how many unique visitors per month or per day, and at what point do you feel you have the critical mass to really monetize the traffic?

Yunfan Zhou

I think web statistics we can disclose. Currently we have about 20 million page views a day. In terms of unique users, we actually cannot track very accurately, because China Mobile has a policy of not giving the phone number for the free WAP sites, so the page views we believe right now is the important statistic to disclose.

What I believe is that traffic is actually one thing. Monetizing this traffic and making -- advertising sprite ads is another thing -- the key thing is a brand name. There are thousands of different WAP sites out there. We believe that education of the advertisers is also very important.

So as I said, maybe in one or two years time, we believe the mobile advertising will definitely become one of the key growth drivers for us. Also, I believe that the traffic and users will also grow very fast in the next one to two years time.

James Lee - Americas Growth Capital

So Yunfan, you basically said the only metric that we can sort of gauge on some investment community is the number of page views at this point in time, in terms of tracking progress from quarter to quarter?

Yunfan Zhou

I think in the future we may disclose other metrics, but right now I think it is probably too early to say that, so we disclose page views right now.

JP Gan

It is also because of competitive reasons.

James Lee - Americas Growth Capital

Thank you.

Operator

Our next question comes from [Chang Quong]. You may proceed.

Chang Quong

I think the wireless internet opportunities are quite attractive and huge. You know, a while, maybe a few months ago, Focus Media bought a firm called Dotad. I just wonder whether you guys benchmarked their business practice, and whether what they are doing can be of any use to you guys?

JP Gan

I think Dotad is mostly 2G based advertising, that type of business. For us, we are actually more on the real mobile internet business. So in the mobile internet business, as Yunfan mentioned, this is the very early stages. So that is why we have this marketing campaign and that is why we are putting a lot of effort into our mobile internet business because we want to grab this leadership. Going forward, when the mobile advertising markets do take off, and we believe that being the leader, we will capture the majority of the benefits.

As far as Dotad is concerned, I think they are 2G based, because they are more SMS based advertising. This is something different than what we do.

Yunfan Zhou

If we understand correctly, this company, most of this company’s customers are actually WVAS providers. They help wireless internet service providers to acquire customers or to generate revenue, and we are one of their customers.

Chang Quong

In the other aspect, in terms of the benefit for wireless internet, one of the benefits, I think you guys mentioned it before, is you can target individual users. Right now, given China Mobile does not give out phone numbers, do you think any of those characteristics have changed?

JP Gan

That is a very good question. I think that is part of the reason why Yunfan has said we do not have -- we have estimates on the number of users, but we do not have the exact number of users. It is just like on the internet. Many of the companies share IP’s, many of the users share IP’s. For example, for a company, usually they are allocated one IP and they have another one at their station. So to the website, sometimes they see the number of IP’s, it is actually very small because we actually have more users behind the firewall to use the internet sites.

The good thing about the internet is that it supports cookies and support sessions, so a lot of times you can figure out who is using your site. As far as the mobile internet is concerned, only the advanced phones support cookies and support some of these features that you can recognize the user.

I think that when the mobile phone gets into developing to a more advanced mobile phone and when all mobile phones become OS-based, operating systems based mobile phones really become advanced, they will support features such as cookies, such as better session supporting. So we will definitely be able to tell users apart, even without the phone number.

I think this is the future and we are confident that, although right now we cannot give the exact number of users, but in the future, I believe we should be able to do so.

Chang Quong

Maybe one clarification for your wireless games. In earlier discussion, it looks like what you are saying is the network games are more profitable, which means are your right now developing network games for mobile applications?

JP Gan

Yes, we have several games on our Kong.net portal that, if you have a chance to take out your mobile phone, you can access Kong.net and you can play our mobile network games. They are very popular today.

Chang Quong

I see. Thank you.

Operator

Our next question comes from Andy Collier from New York Global. You may proceed.

Andy Collier - New York Global

Thanks for your time. This goes to your earlier comments about the expansion of capacity in the network and what kind of services can be offered. When do you think there will be the current music market, which I know is only 20% of your revenue now, may move into downloads of 30 second clips? I mean, in other words, longer portions of music, and what would that mean in terms of your content costs?

JP Gan

I think that is a good question. We are very impatiently waiting for the 3G licenses, because we fee that once the 3G network gets rolled out, services such as music, such as video will become a very popular services to the users.

Right now, under the 2.5G model, although customers can download music, they can download videos, the experience is not very good, because they have to wait a very long time to download these music, or download the video.

So that is why we are building our Kong.net distribution platform, our Kong.net portal, to attract users. Although we say this is a free portal, right now, this is our view of the future of the 3G environment. Some things should be free. Some things will always be paid. What should be free is information-based services, such as news, such as sports, such as entertainment news and financial information -- these should be free. They should be free in the PC internet environment, they should be free on the mobile internet.

What should be paid should be the licensed content, licensed copyrighted content, such as music, video, and these licenses copyrighted games. These should be paid for.

So I believe in the 3G environment, when the network becomes faster, these services will always be paid -- music, video and games. For us, our business model will be we will build a distribution platform for these licensed materials. The analogy I like to make is that we want to build ourselves into a digital iTunes, a mobile iTunes, rather than Warner Bros. Music. That is our strategy.

Andy Collier - New York Global

Thank you. Very good answer. That gets into the question then that it looks like the WAP portal will be a cost centre until 3G comes through? Is that a fair way of looking at it?

JP Gan

A what centre?

Andy Collier - New York Global

In other words, if you are looking for licensed content for payment at that point, you are saying that licensed content will not be wildly popular until you reach 3G, which means that the WAP portal will be difficult to derive revenue because the advertising market is not highly developed, and the licensed content is not going to be arriving?

JP Gan

Initially, of course, we have to do that to build this portal, right? It is just like when Yahoo got build in 1993, 1994, the first couple of years was investment time. Then, once it reaches a critical mass in terms of number of users, then you can monetize it through advertising, right? In the future, you can have Yahoo Marketplace, you can have Yahoo Music, you can have many of the business models that were derived from having this user base and traffic.

I personally believe that the Kong.net model is that it will be advertising driven, and potentially in the future you can distribute digital licensed material. Much of this digital licensed material won’t be distributed in our wireless data services model, so we are very bullish on the wireless data and services, as well as our wireless internet business. We are very bullish on both sides.

Andy Collier - New York Global

Earlier you had said that advertising will take a while to take off because of the lack of familiarity, and certainly we did see that with the portals. It took them quite a period of time before there was an understanding of that market.

Now you seem to be implying that advertising, you can monetize your traffic of $20 million page views a day fairly soon. I mean, what is your time frame? You think mid ’07?

JP Gan

Obviously it is too early to tell. We are just starting to market and promote this wireless internet portal, but I think we do not expect to see any meaningful advertising revenue in 2006. We do think that it is possible that we will generate relatively higher revenue from advertising in 2007.

Let me just share some specifics with you that I learned from Japan recently. Understand that in Japan, they launched 3G services in 2002 and 2003, and in 2004, so-called wireless advertising revenue is about $100 million plus. In 2005, it actually doubled to over $250 million. So we think China’s culture and consumer behavior is very similar to Japan and Korea. So we hope China will follow similar pattern as Japan when the 3G is adopted, and when customers are more familiar with wireless internet portal.

I hope that answers your questions.

Andy Collier - New York Global

Yes, thank you very much.

Operator

Our next question is a follow-up question from Lu Sun with Lehman Brothers. You may proceed.

Lu Sun - Lehman Brothers

Actually, I think my question has been answered, so thank you.

Operator

At this time, you have a question from Leah Hao from Thomas Weisel. You may proceed.

Leah Hao - Thomas Weisel

Good evening, guys, very nice quarter. Just a couple of quickies. First of all, I understand the rationale behind your Q2 guidance regarding 2.5G versus 2G. Just on a full-year basis, can you give us a little bit of your current outlook and by product categories, which ones are stronger product categories versus a little bit less strong?

JP Gan

As you probably know, in China, the 2G market is about $600 million to $700 million, and the 2.5G market is about $300 million to $400 million in 2005, so the total market is about $1 billion, which is the single largest market for internet in China. So the 2G - 2.5G ratio is about 2-1. Right now, as you can see from our first quarter earnings release, our ratio is actually the reverse of that. Our 2.5G is twice as much as 2G. On an ongoing basis, we believe our 2G revenue will continue to grow. On a four-year basis, we continue to think both our 2G and 2.5G will continue to grow.

I hope that answers your question, but at this point, I think it is very difficult to give you some precise breakdown of our total revenue.

Leah Hao - Thomas Weisel

That is helpful, thank you. Also, lastly, can you give us a little bit of an update in terms of the progress of China Mobile royal is 2.5G services to prepaid market. If you remember last time we were talking about Shanghai, Beijing and Guangdong. Are there any new markets that you are going into so far?

JP Gan

We are actually not aware of any new markets that are opening up to GPI services at the current time. I think we said previously that the prepaid users in general are lower-end customers. I think China Mobile’s ARPU for prepaid users is much lower than postpaid users, and their [inaudible] probably much cheaper or with less features than the postpaid users.

We currently do not expect significant revenue contribution from the so-called prepaid users.

Leah Hao - Thomas Weisel

Still a big user base there though. Thanks again, very nice quarter.

Operator

At this time, you have no further questions.

JP Gan

With that, we would like to thank everybody for attending our conference call. We look forward to talking to you again in the next quarter. Thank you very much.

Operator

Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude today’s presentation. You may now disconnect and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: KongZhong Corporation Q1 2006 Earnings Conference Call Transcript (KONG)
This Transcript
All Transcripts