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Executives

Jay Chang - Chief Financial Officer

Leilei Wang - Chairman and CEO

Analysts

Andrey Glukhov - Brean Murray

Ming Zhao - SIG

Adam Krejcik - Roth Capital Partners

Richard Safranek - Wafra Investment Advisors

KongZhong Corp. (KONG) Q2 2010 Earnings Call August 25, 2010 7:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2010 KongZhong Corporation earnings conference call. (Operator Instructions)

I would now like to turn the call over to Mr. Jay Chang, Chief Financial Officer.

Jay Chang

This conference call may contain forward-looking statements. Although such statements are based on our own information and information from other sources we believe to be reliable, you should not place undue reliance on them. For additional discussion of risks and uncertainties relating to forward-looking statements and other factors, please see the documents we file from time to time with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements, which apply only as of the date of this call.

Thank you for your interest in KongZhong. On the call today, we have our Chairman and CEO, Mr. Wang Leilei; and myself, Jay Chang, the company's CFO. I will briefly go over our 2Q results before handing over the call to Leilei.

Total revenues for the second quarter of 2010 were $35.3 million, a 13% sequential decrease from the previous quarter, but a 9% increase from the same period last year.

As we continue to transition our business to become a cross-platform digital entertainment company, mobile game revenues made up 37% of total revenues, while internet online games contributed another 11%. More importantly, for the first time, our non-WVAS businesses combined contributed more than 50% of revenues and gross profit in 2Q.

Total gross profit was $16.9 million compared to $17.7 million in 1Q, while gross margins improved to 48% compared to 44% in 1Q due to a focus on higher-margin WVAS and mobile game distribution channel.

Total operating expenses were $14 million, roughly flat compared to 1Q levels, as we implemented strict cost controls due to the more restricted WVAS environment.

The company's total headcount decreased to 1,200 people at the end of 2Q compared to 1,300 at the end of 1Q. Due to continued restricted WVAS regulatory environment, we implemented cost saving measures, which did lead to some streamlining of our WIS and WVAS business team. However, as a result, headcount in mobile game and online games now represents 50% of total headcount compared to 22% at the end of 2009, prior to acquisition of Dacheng.

Total operating profit in 2Q was $2.9 million compared to $3.7 million in 1Q, while operating margins were 8.2% compared to 9%. 2Q net profit was $2.6 million compared to $3.2 million in 1Q with net margins of 7.3%.

Non-GAAP net profit, excluding stock-based compensation charges and amortization of intangibles associated with the acquisition of Dacheng, was $5.4 million compared to $6.1 million in 1Q.

Based on $36.76 million basic and $38.65 million fully diluted ADS, at the end of 2Q, net profit per basic ADS was $0.07, per diluted ADS was $0.07 and non-GAAP net profit per diluted ADS was $0.13. At the end of the second quarter, our cash and cash equivalents were $135 million, equivalent to about $3.7 per basic ADS.

Now, I'd like to turn to each business unit's financial performance namely mobile games, online games, WVAS and wireless internet services.

Total mobile game revenue in 2Q was $13 million compared to $9.5 million in 1Q or 91% increase from the same period last year and a 37% quarter-over-quarter increase. Mobile games gross profit in 2Q was $5.5 million compared to $3.6 in 1Q. Mobile games gross margin was 43%, an increase compared to 38% in 1Q, but a decrease compared to 56% gross margins in the same period last year.

As previously discussed, the year-over-year decline in mobile game gross margins is due to the company's shift to partner with and promote China Mobile's monthly mobile game subscription package, which has a higher revenue share of the China Mobile. Although we have previously expected China Mobile to release a third-party distribution version of their mobile game package, which allow us for better revenue share, the timing of such a platform has been delayed.

As a result, although we saw some margin improvement in mobile game in 2Q, we would expect gross margins for our mobile game business to stabilize around the 40% level over the short-to-medium term compared to the 45% levels previously discussed.

Revenues from downloadable mobile games were $12.4 million, representing 145% increase from the same period last year and an increase of 38% from 1Q. Revenues from online mobile games were $0.7 million, a decrease of 63% from the same period last year, but an increase of 24% from 1Q.

At the end of 1Q, a new expansion pack for Feng Shen which was launched helped stabilize online mobile game revenues relative to Tian Jie approaching a three-year lifecyle end.

In addition, we recently launched Fantasy Tianjie, a turn-based 2D mobile MMO, but still expect our downloadable mobile game business to be the key driver of our overall mobile game business in the near future.

For the second quarter for online games, combined revenues from our games, Loong and EMoFaZe, were $4 million compared to $4.2 million in 1Q. Of this, roughly 62% of the online game revenues were related to mainland Chinese operations and 37% from overseas licensees and net revenue share from overseas game operation.

Online game gross profit in 2Q was $3.5 million compared to $3.7 million in 1Q with gross margins of 87%. For the second quarter, combined mainland Chinese online game operations achieved average concurrent users or ACUs of 75,000, aggregate paying accounts of 115,000 with quarterly ARPU of roughly RMB149. The lower ARPUs in 2Q compared 1Q reflects the initial commercial launch phase of EMoFaZe which occurred during the second quarter.

Turning to WIS, Wireless internet service revenues were $0.9 million in 2Q compared to $1 million in 1Q. WIS gross profit in 2Q was negative 65,000.

WVAS revenues in 2Q were $17.4 million, a 33% decrease from 1Q and a 27% decrease from the same period last year. The sharp decline in our WVAS business reflects the first full quarter of impact from the implementation of the more recent mobile operator policy. We expect business conditions in the WVAS market to remain difficult through the remainder of the year.

WVAS gross profit in 2Q was $7.9 million compared to $10.12 million in 1Q. 2Q WVAS gross margins was 45% compared to 39% in 1Q due to lower contribution from IVR services and a higher focus on higher margin distribution channels, albeit off a lower base.

Now turning to our third quarter 2010 guidance. We expect total revenues for the third quarter of 2010 to be within the range of $35 million to $36 million, with business unit revenues at the midpoint expected to roughly consist of $17 million for WVAS, $14 million for mobile game revenue, $3.5 million for online game revenue and $1 million for WIS revenue.

We expect total gross profit to be within the range of $14.5 million to $15.5 million, total operating profit and net profit to be within the range of $1 million to $1.5 million, while non-GAAP net profit to be roughly $3.5 million to $4.5 million.

The reason we expect gross profit to decline sequentially is due to higher revenue share to our mobile operators in both the WVAS and mobile game business lines, and we also expect lower overseas revenues in our online game business which has higher margins compared to our domestic operation, although we expect overseas game revenues to improve in the fourth quarter as we see our operations from Loong and other games to be launched in markets such as Europe and Korea in the fourth quarter.

Now I'd like to turn the call over to our CEO, Mr. Wang Leilei, to discuss our second quarter business highlights and recent business developments.

Leilei Wang

Thank you, Jay. Despite a difficult operating environment for WVAS, KongZhong continued to generate positive cash flow and execute our plan to be the leading mobile game player in the China market and become a leading 3D online game developer and operator in both a strong domestic and international presence.

In addition, for the first time since I arrived at KongZhong at the end of 2008, our non-WVAS businesses now make up a majority of our revenues, and more importantly gross profits. We expect our mobile and online game businesses to be the key drivers of our business in the coming years.

In partnership with China Mobile, we continue to grow our mobile game subscription business, which during 2Q averaged roughly 2 million monthly subscribers. Moreover, as our mobile online game business has recently stabilized, we have increased our efforts to develop high quality downloadable and online mobile games for the China market, while recently building iPhone and Android mobile game development capabilities.

Regarding our online game business, I'd like to make a few points. Firstly, I'm personally not satisfied with the performance of our online game business, but I continue to have confidence in our ability to deliver significantly better results in the coming 12 or 18 months. Also, we are still a relatively small player in the Chinese online game market compared to KongZhong's performance for all of 2009.

Our current quarterly revenues are already at a similar level, showing we have made significant progress as a relatively late entrant in the market. In addition, from one game in operation at the end of 2009 we now have three self-developed 3D online games in operation, and overall the performance of these games has been a little below our expectations.

We have identified specific areas which will lead to improvement in our future game launches at the end of this year and in 2011. Firstly, in attempts to maximize ARPUs in the first game, Loong such as timing and the development of content relative to user exchange rates could have been managed much better, and it is through better game lifecycle management.

We are already making preparations to address this issue for our new games next year. In addition, with the close of the first six months we have already made improvements through our 3D game engine to lower the hardware requirements to play the game, as this was an issue with Loong. This also leads to higher than expected exchange rates.

And lastly, our operation and the design of in-game events has been significantly below market in terms of quality. So we have already made efforts to improve in this area for future game launches.

So while our overall performance in the domestic online game business has room for improvement, I continue to believe online games especially in the 3D online game is now an important and a key strategic area for KongZhong and in fact we expect us to continue to make significant efforts and investments in this business line to complement our mobile businesses.

Jay Chang

Operator, we would like to open the call for questions now. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Andrey Glukhov with Brean Murray.

Andrey Glukhov - Brean Murray

I guess a couple of things if I may. When it comes to your mobile games business, can you give us a little bit more insight into the dynamics there? You guys have an average of I think 2 million APA. What are you seeing in terms of ARPU? Are the marginal users going for higher priced to lower priced bundles?

And maybe can you talk us through some of your efforts to improve the churn characteristics in that business and how is that progressing?

Jay Chang

So for the mobile subscription packet, I'll just maybe highlight our role as China Mobile. We're both a CP as well as kind of a distribution partner; we help the markets to bundle. A lot of the things that happen in the back in terms of current user management is actually almost 100% done by China Mobile. So we don't have a whole lot of leverage there, and mostly work very closely with them which we try to do.

But then there's obviously a lot of infrastructure to work through. In terms of the ARPUs, because a lot of the promotions, targets for the monthly subscription package are done actually at the provincial level, a lot of the packages are at the five Renminbi level which is almost the provincial version versus the national version, which is the 15 Renminbi.

So we do have a higher mix of five Renminbi of users compared to 15. But in terms of a specific breakout, I think right now we would prefer not to give that. Overall however in terms of market share, based on our quality content, our ability to aggregate not only our own content, but also other players like Gameloft, we do believe we are well over 50% market share in the market as a key partner with China Mobile today.

As we mentioned in our 3Q guidance, we do see growth moderating in the second half compared to the first half. A function of that is obviously trying to manage, and as we together with China Mobile try to manage the active user ratio as well as relative to their own internal targets, they have actually exceeded that based on some of our support. And I think obviously we want to evaluate the second half before they set targets for 2011.

Andrey Glukhov - Brean Murray

As you think about your online games business, we talked in the past about Dacheng working on some new MMO launches such as (Kung Fu R), how do you guys feel about the quality of the content as you're finalizing the development of those games? And how do you think about the schedule of launches for the next two to three quarters.

Jay Chang

So for the remainder this year, we only have one additional game launch. We launched Xia Ke Xing a few days ago, but that's always been smaller content.

In terms of larger content, we actually have a game called Sheng Mo Zhi Xue. It's tough to translate. I think it's the blood of the demon god or something. But we expect that to be launched right after the October holidays.

In terms of (Kung Fu R), that's still kind of internal testing. What I've seen so far is actually a game which we hope can rival console game quality graphics with a much improved kind of action, fighting kind of style, a contemporary martial arts game which we think is something that's relatively unique to the market.

In terms of timing, we still expect it to be in the first half of 2011. Whether that's in 1Q or 2Q, I think it depends on the testing and how that goes. We also have a second game at Dacheng called Ching, which is kind of a more pets ghost story driven game with similar or better graphics compared to Kung Fu 2. That will be probably the second half of 2011. And then our team is now looking to do a second version of EMoFaZe sometime in 2011, but that's right now at still a very early stage.

We are also evaluating other internal kind of smaller content as well as potential game licensing content to fill our portfolio as we try to execute much better in 2011.

Andrey Glukhov - Brean Murray

And then lastly, as I think about the P&L since you guys talked about some of the cost control measures that you implemented in the WIS business? Do we get the full benefit of that in the third quarter or does it fade through the remainder of the year?

Jay Chang

More broadly speaking is we do think as the policy environment has stabilized, and clearly today, actually we do think things will stabilize, things have room for some improvement in the fourth quarter as our OPEX should stay relatively level from here on out, including new game launches I mentioned after October holidays. Whereas overseas revenues normally again should improve.

And those cost savings should at least should stabilize as WVAS improves or stabilizes in the fourth quarter which we do believe there's room for improvement on a cash flow basis but not much significant unfortunately right now.

Operator

Our next question comes from the line of Ming Zhao with SIG.

Ming Zhao - SIG

Just want to get some more color about the operating environment you just talked about. You said that China Mobile has changed the revenue split. Could you tell us more details about what sort of percentage of splits stand at right now? Just for us to understand, is there any more room for that to go to the other favorable direction?

Jay Chang

As you probably know, China Mobile over the course of the last three years has set up a number of centers, whether it's mobile games, separate content music, ebooks and so forth where those services are marketed under their brand and they aggregate different CPs and SPs to help them promote and develop the content. In most of those centers, the revenue share is 50:50 compared to the historic 15:85 on a traditional WVAS site.

The traditional WVAS revenue share has not changed, it's still 15:85 for SMS, MMS, WAP which obviously still are currently shut down because of the billing platform, and IVR being 70:30, because there is a platform fee within there. So that's the revenue change I'm talking about is actually you're seeing a lot more attention from China Mobile to develop their 3G services and new WVAS services that the revenue share has now gone to the 50:50 model.

Ming Zhao - SIG

Would you say that China Mobile intends to shift more revenues towards that budget instead of the old scheme?

Jay Chang

The flip side of that is they're dedicating a lot of their own internal resources to promote those services. So that's why if you look at our mobile game business, although the revenue share is lower, the revenues increased quite significantly in the second quarter compared to first quarter because they've put their whole group efforts behind putting a service where historically if it is just a pure SP service they wouldn't promote it with any of their internal resources.

Ming Zhao - SIG

And last question is, could you give us an update on the payment to Dacheng? Is that on track to meet with your initial goal in terms of net profit, and how should we see the payment trending based on that profit level?

Jay Chang

We already made the first payment of roughly $24 million both stock and cash. The first half of the year they did not achieve the $5 million threshold; they were more in the $4 million range. So there was no need for us to make a second payment which would have been both in cash and stock. In terms of the final payment, that's really based on the second half performance, which we are still relatively early today, given that they still have another game launch in the fourth quarter.

So I think currently today, I'd rather not specifically speculate that they would achieve the full earn-out. Based on our balance sheet today, we're assuming that we would payout in total consideration of $75 million. However, obviously if they continue to go in line or below their first half performance, the payments and cash flow out to them and share issuance would be significantly lower than what's currently implied on our balance sheet.

Operator

(Operator Instructions) Our next question comes from the line of Adam Krejcik with Roth Capital Partners.

Adam Krejcik - Roth Capital Partners

Just a follow up on the policy questions. I guess, is your view that things have stabilized here or is there room for improvement in the second half? And then I think I've read some more in the news about possible real name registration for mobile users and additional payment reminders. Can you discuss if any of that has been implemented or you've already factored for it.

Jay Chang

So in terms of kind of the additional policy that we've seen, in our discussion with China Mobile, those are just kind of more discussion areas. Internally I think they're still debating whether or not those should be implemented or not. Our kind of current take is that it doesn't make a lot of sense for those additionals to be implemented given that the market is fairly stable now. We're seeing a lot of the nefarious SPs basically having the business either currently being shutdown or are loss making or considering exiting the market.

So in terms of things improving in the second half, we don't see anything improving. However, we think things should stabilize from hereon now. But more importantly, we think in 2011, there'll be a lot less players in the marketplace where there is room for improvement in the overall WVAS environment. And we're trying to position ourselves for that more in the next quarter or so.

Adam Krejcik - Roth Capital Partners

Have you seen any impact from that I guess here about taking market share from some of the smaller SPs, or is that more of a 2011 event?

Jay Chang

Perhaps it's more of a 2011 event. I think there's no benefit or no risk/reward that it's trying to aggressively go after new distribution channel's market share. Some (inaudible) and some partners like handset partners and vendors are also themselves been cautioned, given that they are worried about the policy environment as well.

So I think for the remainder of this year hopefully, if you kind of categorize or kind of look at our cash flow, we hope that 3Q is kind of at the bottom, 4Q hopefully to get slightly better, and then hopefully we can see more improvement in 2011. But we'll update the market as we go through the next three months or six months.

Adam Krejcik - Roth Capital Partners

And then finally on the mobile game guidance, $14 million roughly in your third quarter guidance, the growth rate on a sequential and I think year-over-year basis has slowed quite a bit from what you just reported in Q2. Can you talk about what's a normalized run rate for that business going forward? Is there one or is that still largely determined on how you work with China Mobile and how well received your games are on mobile platforms?

Jay Chang

I would say more than 50% is determined by China Mobile in terms of a medium-term run rate. That said, I think the overall market today, you're looking at $300 million to $350 million a year market. I think China Mobile would still like to see this market grow to $1 billion, given their size and the number of mobile users in China, especially as they come on 3G.

I can't specifically say that is going to happen in 2012, 2013, 2014, but I think that is a size that is one reason why China Mobile feels that they should get 50%. Otherwise, if this remains $100 million type of market, it doesn't help them at all. So I think that's the way we look at the market.

Unfortunately, it's not a natural growth rate, given that we are currently relying a lot on the operators to nurture the market. But I think as we see more smart phones, more 3G subscription, our ability to promote our own kind of operator distribution channels like ko.cn, we think we can hopefully get to more normalized and more self-controlled rate. But I think we're still very early in the development of the mobile game industry in China.

Operator

Our next question comes from the line of Richard Safranek with Wafra Investment Advisors.

Richard Safranek - Wafra Investment Advisors

Is there any merit or benefit in terms of scale from your development infrastructure? And specifically, I'm just wondering if you considered or if it makes sense to also develop as you're developing games for China Mobile to maybe developing games for Apple's platform in terms of apps for the iPhone or the iPad?

Jay Chang

One of our games on the U.S. App's iPad store was top 15, a game called Ninja Chicken. The revenues from that were very, very insignificant compared to our mobile game business in China.

So whilst we are looking at some of the WAPs and those opportunities, it's not a core focus for us, because there is lot of different operational nuances to becoming successful on that business.

Secondly, I think for us more is to learn about that market and then develop other additional platforms to develop the capabilities whether it's iPhone or Android for the China market as that market develops over the next two or three years, so that we maintain our leadership not only in Java and Symbian games, but also Android and iPhone games for the Chinese market where we have a relatively unfair advantage, given our relationship with the operators here, as well as the growing channels we have.

So on that basis, you will see more iPhone games from us over the course of the next three to six months. You can go on the app store for KongZhong; you can see our games there. But it's a very insignificant contributor to our revenue.

Richard Safranek - Wafra Investment Advisors

Given the sizeable cash balances, is there any intention to increase share buybacks or be more aggressive in terms of buying back your shares and returning the cash to shareholders?

Jay Chang

We are always considering that option. One thing we have to keep in mind is that the vast majority our cash balance is actually in renminbi. So currently, China today is still a closed capital accounts economy, and getting to buy ADS is somewhat difficult and has withholding tax issues. But we are always considering that option. But it looks like if the renminbi does continue to appreciate on U.S. dollar basis, balances would be very near to that appreciation, given the bulk of it is the renminbi.

Operator

I have no further questions at this time. Jay, would you like to close out?

Jay Chang

Thank you again for all your interest in KongZhong, and we look forward to speaking to over the next few months and hopefully also in the next quarter's results. Thank you very much and have a good rest of the evening and day.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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