Kong's market price has risen by 37% since our buy recommendations in July. So the attraction of a low P/E is not as strong as before. Impacted by policies from China Mobile (CHL), KONG’s total revenue in the September quarter decreased by 16.6% QOQ, but increased 23.8% YOY. EBIT decreased by 36.6% QOQ, but increased by 40.7% YOY. Gross margin declined slightly by 2.4 percentage points QOQ, but EBIT margin and net margin declined by 6.1 and 7.8 percentage points QOQ. The 15% layoff in July lowered general and administrative costs by 15.1% QOQ, but total operating expense declined to merely 3.3% QOQ. We believe revenue will decline further and profit margins will be thinner in the next two quarters, but we do not believe the Company will be distressed, because cash and equivalents balance is high. KONG continued to acquire content, news by qianlong.com and mobile TV by 100tv.com. There are two reasons for KONG to try hard acquiring content for WAP [Wireless Application Protocol] . First, WAP is the second largest business line for KONG, which accounted for 23% of total revenue. Second, 2.5G WAP competition is a tryout for 3G completion.
Impacted by policies from China Mobile (CHL) and the Ministry of Information Industry [MII], KONG’s financial data in 3Q suffered a QOQ decline. Total revenue decreased by 16.6% QOQ, but increased 23.8% YOY. EBIT decreased by 36.6% QOQ, but increased by 40.7% YOY.
Gross margin declined slightly by 2.4 percentage points QOQ, but EBIT margin and net margin declined by 6.1 and 7.8 percentage points QOQ. [Exhibit 2] Obviously, operating cost is not as flexible as cost of revenue. The 15% layoff in July save general and administrative cost by 15.1%, but total operating expense declined merely 3.3% QOQ [Exhibit 3].
We believe revenue will decline further and profit margins will be thinner in following two quarters. But we do not believe the Company will be distressed, because the Company’s cash and equivalents balance accounted for 74.1% of total assets.
KONG continued to diversify its service distribution channels. Revenue from China Mobile declined from 77% in 2Q to 75%, while revenue from other phone operators increased. [Exhibit 4] Since China Mobile’s double confirmation policy became an MII rule so that all other operators have to follow. Therefore such diversification may not cushion the impact of double confirmation.
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1) Qianlong.com: On November 3, KONG released that it would set up a Beijing local news channel in Kong.net, KONG’s WAP portal. Qianlong.com will provide news content for the channel. Qianlong.com is an Internet news portal held by many Beijing local media like TV stations, radio stations, and newspapers. Nick Yang [Yang Ning], President of KONG, announced that KONG would acquire similar local news content in Shanghai and Guangzhou, two other biggest cities in China.
2) 100TV.com: On October 10, KONG announced that it would establish a mobile TV community for 100TV.com in KONG’s mobile WAP portal. 100TV is a mobile TV provider invested by Cisco (CSCO), ID techventures, etc.
We note that within this year KONG acquired many different content portals - financial, real estate, etc. There are two reasons that KONG is trying hard to acquire content for WAP. First, WAP is the second largest business line for KONG, which accounted for 23.1% of total revenue. Second, 2.5G WAP competition is a tryout for 3G competition
On September 18, KONG announced that Jianping Gan, CFO of KONG, indicated his intention to resign from the Company to pursue a career in venture capital. Bad financial performance is not the only reason for the resignation. Recently it is in vogue for high-tech company management to transfer to venture capitals.
Valuation and Recommendations
We believe revenues in all business lines will continue downward trend in 4Q2006 and 1Q2007, while 2-4Q2007 will be a slight growth period. Assuming that free cash flow will grow by 3% from 2008 to 2010 and increase to 6% thereafter, we project a target price of $8.62, 3.1% higher than the current market price. We recommended BUY in our last two notes because KONG was over sold under the impact of China Mobile’s new policy, not because of high financial potentials. KONG’s market price has risen by 37.3% and 23.9% since our buy recommendations on July 21 and August 15, so we believe KONG’s low P/E advantage is not as strong as before. We therefore downgrade KONG to HOLD.