Environment for Chinese Mobile Content Aggregators Will Likely Remain Challenging

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 |  Includes: CHL, CHU, DCM, KZ, LTON, SINA, SOHU, TOMOY
by: James Lee

WR Hambrecht analysts James Lee and Xiaofan Zhang recently sent a note to clients (pdf file) in which they outline the competitive environment faced by Chinese mobile content aggregators TOM Online, Inc. (NASDAQ:TOMO), KongZhong Corp. (KONG), Linktone, Ltd. (NASDAQ:LTON) and Hurray! Holding Co., Ltd. (HRAY). Excerpts from their note follow:

Investment Conclusion: We believe the environment for mobile content aggregators in China will likely remain challenging as wireless carriers should continue to have significant leverage. The policies implemented this past July and in H2:04 are clear examples to us of where mobile content providers have little control of their own destiny. Acknowledging that, the so-called middlemen between the carrier and content owners are reinventing themselves to reduce their carrier dependence for distribution and billing. In this report, we outline our belief that the carrier content strategy will continue to be difficult for mobile content aggregators, even moving into 3G. With that in mind, we weigh our analysis based on their diversification strategies, and their likelihood to succeed in the next-generation mobile content world (we call it "mobile content 2.0"). We are initiating coverage of TOM Online, Inc. (TOMO) and KongZhong Corp. (KONG) with a Sell rating, and Linktone, Ltd. (LTON) and Hurray! Holding Co., Ltd. (HRAY) with a Hold rating.

Carrier policies changed landscape. The most recent policy changes reminded us of how vulnerable mobile content providers could be and how little control they had in shaping the direction of their own industry. Coincidentally, this was not the first carrier-led change that rocked the mobile content world. In H2:04, China Mobile upgraded its billing system, which significantly impacted the revenue flow of content operators, pushing industry revenues down 30-50% over the period of implementation. With that in mind, we are cautious about the segment since the business model is very carrier dependent, while services offer little product differentiation and brand recognition.

Changing product mix and market channel. On top of the aforementioned policy changes, the mobile content aggregators can no longer use SMS freely to cross-sell other products and services. To the credit of company management teams, the content aggregators adapted quickly to policy changes in order to slow down the revenue impact by selling through traditional media outlets. However, off-portal sales channels are less effective economically due to much higher marketing costs.

Carriers moving to a direct model? This is a key driver to the sustainability of content aggregators. If carriers such as China Mobile and China Unicom decided to source the content directly, this would effectively eliminate the middle-man model. While there are some data points supporting that theory, such as China Mobile’s recent agreements with international record labels and News Corp., we believe the content aggregation business still appears viable, but will likely be limited to applications complementary to those targeted by the carriers.

Finding a diversification strategy. Given the challenging environment that mobile content providers face, we are assessing the fundamentals of publicly traded companies on their strategies to reduce the dependence on wireless carriers. We are initiating coverage of TOM Online, Inc. (TOMO) and KongZhong Corp. (KONG) with a Sell rating, and Linktone, Ltd. (LTON) and Hurray! Holding Co., Ltd. (HRAY) with a Hold rating. Our views of each company will be outlined later in the report.

INDUSTRY OUTLOOK
Carrier policies changed landscape. The most recent policy changes reminded us how vulnerable mobile content providers could be and how little control they had in shaping the direction of their own industry. Coincidentally, this was not the first carrier-led change that rocked the mobile content world. In H2:04, China Mobile upgraded its billing system, which significantly impacted the revenue flow of content operators, pushing industry revenues down 30-50% over the period of implementation. With that in mind, we are cautious about the segment since the business model is very carrier dependent, while services offer little product differentiation and brand recognition. We summarize the key policy changes below:

Double confirmation. Although double confirmation (requiring two positive confirmations from the subscriber) has been enforced since H2:04, as we understood it, the policy was relaxed until mid-2006, applying only to mobile content providers with low credit scores with China Mobile as opposed to being mandatory when it began. Since July, the policy has implemented on a unified basis, and should be fully implemented in all provinces by year- end. This policy change increased customer acquisition costs for mobile content, thus lowering ROI.

Monthly reminder. This policy requires the mobile content provider to send a reminder to its subscribers once a month, indicating the number of services and their respective prices. The service will be canceled unless the subscriber responds positively to the message. We believe this policy change has increased customer churn, thus lowering profit margins for mobile content providers.

Free trials. China Mobile requires mobile content providers to offer free trials in the first month for all subscription offerings if the service is ordered before the 20th day of the month. If later than that, the service will be free in the remaining days of the current month plus the entire subsequent month.

Per message to flat fee rule. This policy requires all mobile content companies to change their per-message services to monthly subscriptions with a pricing cap of 10RMB/month. Previously, the per message service allowed mobile content providers to send SMS messages to subscribers and charge on a per-message basis with a cap of 30RMB per month.

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Changing product mix and marketing channels. On top of the aforementioned policy changes, the mobile content aggregators can no longer use SMS freely to cross-sell other product and services. To the credit of company management teams, the content aggregators adapted quickly to policy changes in order to slow down the revenue impact by selling through traditional media outlets. However, off-portal sales channels are less effective economically since marketing costs are higher as a percentage of sales generated.

Limited cross-selling through SMS. Based on our conversations with industry insiders, mobile content providers can only use SMS on a very limited basis to promote their product and services. Historically, SMS was a very effective (economically and operationally) distribution channel for new mobile content products, leveraging subscriber information from the carrier. However, this sales tactic created many unwanted messages, leading to customer complaints that ultimately ended such a marketing practice. With that in mind, mobile content providers are shifting their marketing to off-portal channels, such as the Internet or traditional media like TV, radio and magazines advertising. However, marketing costs are much higher off-portal, and thus lowering the profitability for mobile content operators from roughly 50-60% gross margin to 20-30% gross margin, pending on what offline channels are used.

Products are moving to one-time. Responding to carriers’ policy changes, mobile content providers quickly shifted their product mix from subscriptions to one-time downloads. During Q3:06, the products sold were largely shifted to the transaction model with a varying degree of success. However, margins from one-time downloads are lower than those of subscriptions due to lower ARPU and revenue visibility (no recurring revenues).

Financial impact. As highlighted in the table below, we saw margin declines across the board in Q3:06. Revenues of publicly traded mobile content players dropped on average 14% sequentially while GM and operating margin shrank 253 and 539 basis points, respectively. We expect Q4 revenues to remain under pressure as the policies mentioned above will be fully implemented in all of China’s provinces. Although the impact on revenues was not as severe as the guidance provided by management, what happened in Q3 certainly demonstrated the speed and magnitude of fundamental changes resulting from regulatory changes. Going forward, as revenues from off-portal promotions become a greater contributor, we believe this will create additional pressure on profitability.

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Carriers moving to a direct model? This is a key driver to the sustainability of content aggregators. If carriers such as China Mobile (NYSE:CHL) and China Unicom (NYSE:CHU) decided to source the content directly, this would effectively eliminate the middle-man model. While there are some data points supporting that theory, such as China Mobile’s recent agreements with international record labels and News Corp. (the two companies are expected to co-launch a wireless platform for user-generated songs to be uploaded, listened, and voted, and News Corp.-owned Channel [V] and Star TV will produce music videos for the most popular songs), we believe the content aggregation business still appears viable, but will likely be limited to applications complementary to those targeted by the carriers.

Carriers taking a hybrid approach. We believe that carriers in China will take a hybrid content approach, working with aggregators while developing/sourcing their own content functions. We feel that carriers will likely continue outsourcing existing content such as music and games, where the products are widely available, but with little differentiation. For example, China Mobile has created a new platform for the aggregator content, including five major channels (games, music, lady, auto/real estate, and education). According to industry insiders, China Mobile has selected key partners to provide content for these channels, including TOM Online, Sina (NASDAQ:SINA) [Hold], Hurray! and KongZhong. At the same time, revenue sharing will remain at 85/15. On the surface, it appears that China Mobile is centralizing its content sourcing, working with few WVAS players. Looking at it a bit deeper, we believe the implication is that China Mobile is acknowledging that established content such as music and games are commodities. As a result, the carrier will outsource the above content as a white-labeled offering, realizing mobile content providers have a comparative advantage (in terms of operational experience and economics).

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Carriers likely to develop next-gen apps in-house. For next generation applications such as IM, mobile search and video, we sense that the carrier will likely keep these contents in- house. As China moves into 3G, we see opportunities for the next generation applications. However, based on China Mobile’s recent movements, we suspect that the carrier will keep these next-gen products and services in-house.

o Mobile video. China Mobile and China Unicom recently signed agreements with CCTV to provide video clips of the TV station’s programs. These agreements suggest to us the carriers’ intention to work with media companies directly to offer video content on the mobile platform.

o Mobile IM. The Chinese mobile carriers also initiated their in-house IM applications. For China Mobile, the mobile operators launched its internal IM application in June, which enables subscribers to use IM through both the PC and handset. The application is currently on trial. China Unicom also recently launched its own IM. Although China Mobile recently extended its mobile IM agreement with Tencent for six months, we believe these initiatives indicate that the carrier may limit its existing IM offerings from MSN and Tencent (Mobile QQ).

o Mobile search. According to our research, the Chinese carriers are working on offering its own branded mobile search engine with their partner Cgogo. Apparently, the little- known mobile search company recently received $20M in investments from the Hong Kong tycoon Li Ka-shing, and is currently working with China Mobile and China Unicom to develop search functions within the carrier portal. Recently, there has been speculation that Google (GOOG: Not Rated) and China Mobile will soon jointly offer mobile search.

o Carriers’ content strategy – similar to that of DoCoMo’s (NYSE:DCM) iMode. We believe that mobile carriers in China are shaping their next-gen data offerings similar to those of NTT DoCoMo’s iMode. By that, we mean that China Mobile and China Unicom want to create a “walled garden”, driving mobile internet traffic to their default portal by offering best of breed content services. This model has served NTT DoCoMo well, as the carrier has signed up nearly 47M of ~100M subscribers in Japan. If our assessment is correct, the key question for mobile carriers in China is how to keep the users inside the “walled garden”. Based on our checks, only 15% of the mobile data traffic goes to Monternet (China mobile’s wireless portal), which is far less than what China Mobile desires. With that in mind, we believe that the carrier will keep premium content inside the portal, including content directly from media companies, next-gen apps and best-of-breed products from aggregators.

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o Portals are better positioned to monetize through mobile advertising. Outside the “walled garden”, wireless sites will likely continue offering products for free, driving revenues from advertising. In that environment, brand recognition and application stickiness that will drive repeat usage are critical success factors. We believe leading online sites such as Sina, Sohu.com (NASDAQ:SOHU) [Buy] and Tencent are better positioned since they can migrate their popular PC-based applications such as e-mail and IM onto the wireless platform. At the same time, they have an established sales infrastructure and user-base to drive advertising.

Finding a diversification strategy. Given the challenging environment that mobile content providers face, we are assessing the fundamentals of publicly traded companies on their strategy to reduce the dependence of the wireless carriers.

TOM Online, Inc. (TOMO): We are initiating coverage with a Sell rating. We believe the valuation implies an increased market share in portal and a successful monetizing strategy for Tom-Skype and UMPay. We feel that the execution risks are high given the competitive environment in the portal space, relatively smaller subscriber base for Tom-Skype and the lack of adoption of mobile commerce in China. We believe the recent JV with eBay China will have limited success in the near-term due to the immaturity of eCommerce in China and a yet to be proven monetizable business.

KongZhong Corp. (KONG): We are initiating coverage with a Sell rating. We believe the company’s wireless portal model faces strategic and operational difficulties. KongZhong does not have the sales and distribution relationships that Sina and Sohu have with advertiser/agencies. In addition, we believe marketing costs on creating brand recognition will erode margins without good visibility of producing returns (also, lacking loyal users, sticky applications and Internet presence).

Linktone, Ltd. (LTON): We are initiating coverage with a Hold rating. We feel the company is evolving into a traditional media company by creating a JV with TV and radio stations. However, we believe the company’s lack of experience in running TV programs in a “hit or miss” industry creates uncertainty in the near-term.

Hurray! Holding Co., Ltd. (HRAY): We are initiating coverage with a Hold rating. We like the fact that the company thinks “outside the box” by acquiring music labels in China and taking advantage of a very fragmented market. However, we believe that managing a portfolio of record companies could be quite challenging due to cultural differences and a lack of apparent synergies with existing wireless operations.

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Editor's note: for an expanded version of this report in pdf form, click here.