This report is an update to our initial report on NQ dated 2/22/13.
Several meaningful events have occurred since we wrote that report that warrant an update:
- A transformative deal with America Movil (AMX), the world's third largest carrier, was announced
- An additive deal was announced with US Cellular under which US Cellular will offer NQ Mobile's Family Guardian product under the name US Cellular Family Protector to its 5.9 million customers
- NQ "beat and raised" Bloomberg consensus estimates during their 4Q 2012 earnings event last night
- More high-profile hacker attacks made headlines after Dropbox, the most popular online file storage and syncing service, announced an investigation of a potential security breach and then Evernote, the most popular online note-taking and productivity tool company, announced a major security breach that forced 50 million of its users to change their account information. Both these companies' users access their services via mobile devices, and Evernote's apps are in the process of being updated to be rolled out shortly in response to the attack
- Baidu (BIDU) published its most recent quarterly Internet update and devoted this issue (through 4Q 2012) to mobile, further confirming the breadth and speed of development of the mobile opportunity in China
- Both Baidu and Tencent (TCEHY.PK) reaffirmed their interest in acquisitions of "companies that make products for smartphones", confirming the strategic value of NQ, a uniquely positioned company in the space, value that we believe the market pricing is ignoring completely at the moment
In short, all of these events are highly confirmatory of our initial investment thesis for NQ and call for a substantial upgrade to our originally envisioned 3x capital appreciation for investors. We now believe that NQ could deliver closer to a 3.5x return over the next 18 month period even after the quick 37% rise in price per ADS (as of yesterday's close of $8.77) since our original report.
In other words, given the new news above, we believe NQ is a meaningfully more attractive company today at a materially higher price than it was last week at a lower price before all the new information became public. We believe NQ is intrinsically cheaper now than it ever has been in light of the new information. We will publish next week a detailed financial analysis of this view in a follow-up report after we have an opportunity to more carefully model in both the America Movil deal's potential impact to NQ's 2013 financials as well as the new insights we gained on their overall business performance from the earnings release. We will keep this update report more qualitative in nature.
I. America Movil Deal
On March 4, 2013, NQ announced a partnership with America Movil, the third largest wireless carrier in the world with 262 million subscribers across 18 countries. AMX will white label NQ's three primary products (Mobile Security, Vault and Family Guardian) to its customers and, as part of the deal, underwrote significant marketing expense to promote NQ through SMS, online promotions, an outbound call center and pre-load on handsets and other mobile devices.
Aside from the obvious financial impact of partnering with America Movil, this deal underscores several key elements of our investment thesis:
1. It provides further industry validation of NQ's superiority as a global smartphone security leader
During its recent 4Q 2012 earnings conference call, Co-CEO Omar Khan was asked by Piper Jaffray's analyst Mark Murphy about the competitive dynamics involved in AMX's vendor selection process. Mr. Khan described how NQ's best-in-class technology and product breadth differentiated NQ vs. its competitors:
"I can't specifically talk about which competitors they did -- they did evaluate us against multiple competitors, I can tell you that it's folks that you could expect them to be evaluating as a large provider as they are. And they want to a significant feature functionality testing process, evaluation process in terms of how -- in the end we were selected. I would tell you that, here are some of the things that really differentiated us during the process. One is the breadth of our products and services. The fact that with one provider, we can launch security services for the consumer, privacy services with the consumer, as well as family guardian or family protection services was definitely an advantage to us. So the scope of our product breadth of being able to partner with one provider and address multiple consumer segments and multiple channels at one time definitely is one factor.
The other part of it frankly is technology. The performance of our technology, as well as the experience that we have globally, our customer base being large as it is to a customer like America Movil, which is extremely large, there is definitely an advantage."
2. It suddenly expands NQ's immediately addressable market by opening up Latin America and the Caribbean region, where the America Movil brand resonates with exceptional recognition and trust. In totality, the breadth of the long-term opportunity in these emerging markets is comparable to that of the Chinese market given its current relative underdevelopment
3. Given the level of diligence undertaken by one of the world's most prominent companies in the smartphone ecosystem, we believe the deal squashes whatever doubt remains of NQ's legitimacy as a world-class company. Refer to this unaffiliated Seeking Alpha report for further commentary on this topic.
Again, we will publish next week a follow-up report that describes in detail our view of this major deal's impact to NQ's projected financial performance for 2013.
II. 4Q12 Review
We noted several important trends in NQ's financial performance:
1. Gross and Operating Margins have bottomed and are poised to improve through 2013
One of NQ's most attractive fundamental qualities is the inherent operating leverage of its SaaS business model - high incremental margins should drive margin expansion as the business scales. Part of NQ's past price volatility was due to skepticism of NQ's acquisition of NationSky, a lower margin business than NQ's core, which was optically negative to post-acquisition overall margins. Investor fears appeared to be confirmed when NQ reported overall margin contraction in 3Q 2012 due to the lower margin hardware procurement sales of NationSky. A key aspect of our thesis was the realization that the margin dilution due to NationSky was manageable and would bottom out in 3Q12. The following chart illustrates NQ's gross margin trend since 2011:
Importantly, note that both NQ's business excluding NationSky as well as NationSky itself reported sequentially expanding gross margins in 4Q 2013. Furthermore, management highlighted that the possibility of significant synergies between the Consumer Security business and Mobile Games and Advertising (Feiliu) business:
"We not only see strong growth ahead for our mobile games & advertising business, but we also see significant synergies with our consumer security business. We have already begun the integration of marketing, user acquisition and the operations functions between the two businesses. In addition, we are planning to implement a payment method for our mobile security application where users who are mobile gaming consumers will be able to earn payment credit that can be used towards paying for premium mobile security features. We also continue to leverage Feiliu's interest based social communities and digital storefront for our user acquisition. Stay tuned for additional product synergy that we have on our road map." - Co-CEO Omar Khan, 4Q 2013 Earnings Conference Call March 6, 2013
These synergies, along with the operating leverage of NQ's SaaS business model, suggest to us that margins will continue to improve in 2013.
2. NQ's core Consumer Security Business Continues to Exhibit Exceptionally Strong Organic Growth
Excluding its recent acquisitions of NationSky and Feiliu, NQ's core consumer security business continues to exhibit exceptionally strong organic growth driven by continued user adoption.
Despite a much higher user and revenue base 12 months ago, NQ's user metrics and organic growth rates remain healthy. Furthermore, given the impending ramp due to the retail rollout and America Movil partnership, organic growth and user metrics may re-accelerate despite growing nearly triple digits in 2012.
Regarding its retail strategy, management noted that NQ now has access to 1,600 retail stores in the US and over 2,800 locations globally. Performance at the retail stores was described as strong during the holiday season, with The Cellular Connection and Wireless both achieving an attach rate over 20% in December 2012. Management also noted that there is a strong pipeline of new retail partners that have yet to be announced.
3. NQ's Business Outside of China Continues to Grow and Diversify its Revenue Mix
NQ's core Consumer Security business continues to diversify into markets outside of China as the percentage of sales outside of China continue to rise.
NQ will continue to diversify its core Consumer Security business away from China due to the higher user growth rates, significantly higher ARPU and rollout of its retail and America Movil partnership.
III. Insights from Baidu's 4Q12 mobile Internet report
The original report can be found here. (N.B. It is only available in Chinese.)
We have summarized key insights that support our view of the enormity and likelihood of sustainable secular growth in mobile monetization, which for the Chinese mobile Internet industry ex-gaming is starting in earnest this year:
- As of the end of 2012, Baidu's mobile traffic increased 11x
- Roughly 80 million active users use Baidu's mobile products out of a Chinese Internet market of over 538 million users, so there is substantial headroom for sustained growth
- 48% of large- and medium-sized websites launched smartphone-compatible Web pages, up 18% YoY and 8% QoQ, which suggests an accelerated rate of smartphone content production in 2013 and 2014
- 80% of all of Baidu's mobile search queries were directed to a smartphone-compatible Web page, up from 69% in 3Q12
- 53% of the mobile versions of the aforementioned large- and medium-sized websites fell into three categories: lifestyle services, online communities, and tools/apps. Notably, all these require user identification and present opportunities for security threats
IV. Strategics on the Prowl
On March 6, 2013, both Baidu's and Tencent's CEOs publicly reaffirmed their interest in mobile acquisitions.
In our original article, we noted that NQ's best-in-class status in a vital part of the mobile ecosystem could make it an attractive strategic asset for numerous industry giants. Although our investment thesis does not rely on exit via acquisition, it is notable that Baidu and NQ share a common board member (this same board member owns ~15% of NQ) and Baidu considers mobile an increasingly strategic area for its business, having spent 25% of its R&D budget on smartphone products as of 4Q12. It is also notable that an acquisition of NQ by either Baidu or Tencent (not to mention many others potentially interested as well) would be accretive even in the $30/ADS price range, which is approximately 3.5x where NQ trades today.