Hard Times for Linktone

Includes: CHL, LTON
by: David Riedel

David Riedel of Riedel Research Group recently published a note for clients regarding Linktone's (NASDAQ:LTON) tough outlook. Excerpts follow:

Profit Margins Continued to Recover

LTON revenue in 2Q2006 increased slightly by 1.3% QOQ to $23.3 mn, while net profit in 2Q2006 increased rapidly by 32.1% QOQ. Stagnant growth in 2Q is due to the audience rating of ‘Super Girl’ TV program as the main income source is not as high as before, when other TV programs started to imitate ‘Super Girl’.

High net profit growth rate came from continuous margin improvements. Revenue increased $0.3mn, while cost of service decreased $0.2mn. Therefore gross profit margin rose by 1.9 percentage point. Further, 2Q operating expense maintained the same level as 1Q. But we note that LTON restructured operating expenses. ‘Selling and marketing’ expense rose by $1.5 mn, while ‘Product development’ and ‘General and admin’ expenses declined by $0.5 mn and $1.0 mn. Development expense reduction and selling expense rise reflect a severe competition, while admin expense reduction is always reasonable at any time.

Short Messaging Services Segment Declined

As mentioned above, ‘Super Girl’ program hosted by Hunan Satellite TV is not as popular this year as last year, therefore Short messaging services [SMS] revenue (2G segment) decreased by 12.7% QOQ to $13.0 mn. But ‘Super girl’ will have nothing to do with LTON in the following quarters, because LTON’s agreement with ‘Super Girl’ expired and Hunan Satellite TV would not like to continue the partnership with LTON. Hunan Satellite TV is going to cooperate with China Mobile (NYSE:CHL). It is another case of content providers [CP] skipping over service providers [SP] to cooperate with the mobile operator directly.

However, LTON signed on to provide SMS services to another TV program, ‘Super Boy’, hosted by Shanghai Media Group. We can expect ‘Super Boy’ to outperform ‘Super Girl’ in audience ratings. And the ‘Super Boy’ nation-wide contest will be held in 3Q. Therefore ‘Super Boy’ may partly offset the impact of the double confirmation policy from China Mobile (NYSE:CHL).

Other segments ran well in 2Q generally. Audio revenue rose by 19.8% QOQ, while 2.5G revenue rose by 54.4% QOQ. Both helped 2Q total revenue, but both will be impacted by China Mobile’s (NYSE:CHL) re-confirmation policy.

Joint Venture with Shandong TV
On September 13, LTON announced that it would establish a joint venture with Shanghai Zhongbang Culture Media Co. Ltd, a subsidiary of Shandong Province TV Station. The joint venture will exclusively operate value added services [VAS] for Shandong TV. LTON has the experience from ‘Super Girl’ and ‘Super Boy’, so the Company does know how to make money from TV programs. Further, in the severe competition situation, it is a right strategy to strengthen relationships with CP.

R2G, the Music Content Monopolist
On August 29, the Copyright Alliance of Internet Society of China launched a meeting to discuss the R2G problem. Attendants were not only from Service Providers [SP] like china.com (HKSE:8006), Hurray (Nasdaq:HRAY), Kongzhong (Nasdaq:KONG), and 9Sky etc., but also from governmental and semi-governmental authorities like the National Copyright Administration, the Music Copyright Society of China, and the China Audio & Video Association.

R2G is a music copyright agent, which has become a music copyright monopolist recently. It owns 19,000 music copyrights in China from international music giants like Universal Music, Warner Music, and BMG, and 3,000 pieces of China copyrights of European, American, and native classic music. Recently R2G recovered in many lawsuits against SPs. SPs argued that R2G is illegal to engage in collective copyright management without the approval by National Copyright Administration. A survey by the Copyright Alliance presents that R2G charged an SP for a monthly fee of RMB150 thousands and shares 9%-30% of SP revenue. To another SP, R2G charged RMB300 thousand monthly and shares 3% of revenue. Under charge and lawsuit pressures, SPs have to have recourse to the National Copyright Administration. It suggests that SPs are facing monopoly and losing bargain power if they do not diversify content from music.

Valuation and Recommendation
In our model, we assume 2.5G and Audio revenue will decrease by 15% QOQ in 3Q06 and 4Q06 for China Mobile’s (NYSE:CHL) double confirmation policy. We also assume 2G revenue will decrease by 20% QOQ in 3Q06 and 4Q06, (Ibid.) considering both the double confirmation policy and contingencies in big projects like ‘Super Boy’ or ‘Super Girl’. Projecting cash flows in 2008-2010, we calculated a target price of $4.76. LTON may experience a very hard time in the following quarters, during which cash flow is definitely needed. But we believe LTON can survive the period because of sufficient cash. Cash and short-term investments accounted for 30.5% of total assets at the end of 2Q, while debt ratio was 15.8%. We are not optimistic to LTON’s operations, but considering the stock repurchase program, we maintain our HOLD recommendation.

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