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Jay Chang – CFO

Wang Leilei – Chairman and CEO


Andrey Glukhov – Brean Murray

Ming Zhao – SIG

KongZhong Corporation (KONG) Q3 2010 Earnings Call November 22, 2010 7:30 PM ET


Good day, ladies and gentlemen, and welcome to the third quarter 2010 KongZhong Corp. earnings conference call.

My name is Jeremy and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the conference over to your host for today, Mr. Jay Chang, Chief Financial Officer. Please proceed, sir.

Jay Chang

Thank you, operator. 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 discussions 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 conference 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, company's CFO.

I will first go over our 3Q results before handing over the call to Leilei.

Total revenues for the third quarter of 2010 were $37.7 million, a 7% sequential increase and a 7% 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 8%, and combined mobile and internet games, made up 45% of total revenues.

Total gross profit was $15.6 million compared to $16.9 million in 2Q, while gross margins declined to 41% compared to 48% in 2Q.

Total OpEx was $14.4 million, a slight increase from 2Q of $14 million, as we continued to maintain strict cost controls due to the ongoing restrictive WVAS policy environment.

Total operating profit in 3Q was $1.2 million compared to $2.9 million in 2Q, while operating margins were 3.3% compared to 8.2% in the previous quarter.

3Q net profit was $1.2 million compared to $2.6 million in 2Q with net margins of 3%.

The non-GAAP net profit, excluding stock-based compensation charges and amortization of intangibles primarily associated with the acquisition of Dacheng, was $4.1 million compared to $4.5 million in 2Q.

Based on $37 million basic and $38.3 million fully diluted ADS outstanding at the end of 3Q, net profit per basic ADS was $0.03, net profit per diluted ADS was $0.03 and non-GAAP net profit per diluted ADS was $0.10. At the end of 3Q, our cash and cash equivalents were $139 million, equal to roughly $3.7 per basic ADS.

In terms of business line reporting going forward, during the third quarter, the company has consolidated our wireless internet services or WIS business line into our WVAS business line to reflect the ongoing changes in the wireless services industry.

More importantly, a key revenue driver for our WIS business going forward is expected to be a partnership with China Mobile’s mobile literature platform. This new revenue stream relies on significant resources from our WVAS business to operate this business, and as such, the company believes is more appropriate to combine WIS into our overall WVAS business lines.

Now, I’d like to turn to each business units’ financial performance namely mobile games, Net internet games and WVAS.

For mobile games, total mobile game revenues in 3Q were $13.9 million compared to $13 million in 2Q or 70% increase from the same period last year, and a 7% quarter-over-quarter increase. Mobile games gross profit for 3Q was $5 million compared to $5.5 million in 2Q, while mobile game gross margin was 36%, a decrease compared to 43% in 2Q.

Mobile game gross profits and gross margins declined sequentially as the company sought out new non-operator distribution channel to offset the decrease in marketing activities by China Mobile and our mobile games subscription business. The effectiveness of these new distribution channels was significantly lower than existing China Mobile channels, leading to lower gross profits in our overall mobile game business.

We expect mobile game gross margins to stabilize around the 37% to 38% levels in the near future as we work more closely with China Mobile, our mobile operator partners to offset the mix of lower margin distribution channel.

Revenues from downloadable mobile games were $13.1 million, representing an 84% increase from the same period last year and an increase of 6% from 2Q. In 3Q, growth in our downloadable mobile game business, primarily mobile game monthly subscriptions for China Mobile decelerated from previous period growth levels due to a moderation in promotional activities from our mobile operator partners.

In 3Q, average monthly mobile games subscribers were roughly 2 million per month at a similar level compared to 2Q.

For the remainder of 2010, we expect our mobile operator partners to continue to decrease their mobile game package marketing activity, limiting the near-term ability for us to grow our mobile game business, but expect these marketing activities to resume sometime in 2011.

Revenue from mobile online games were $0.87 million, an increase of 34% from 2Q, but a decrease of 22% from the same period last year.

In July, we launched Dream Tian Jie, a new mobile online game, whose revenues accounted for roughly 26% of the company’s online mobile game revenues in 3Q. Revenues for Tian Jie accounted for another 18%, while revenues from Feng Shen accounted for the remaining 56% compared to 51% in 2Q.

Turning to internet games, internet game or Net games revenues in 3Q were $2.96 million or 26% decrease from 2Q. Net games revenues underperformed our expectations as the launch of Xiakexing which had its open beta in August underperformed our targets and the commercial launch of Loong in the South Korean market was delayed until the fourth quarter.

However with the launch of Loong in Korea and other overseas markets in the fourth quarter as well as the launch of a new online game, Shengmozhixue in October in Mainland China, we expect our Net game business to rebound in the fourth quarter. Total overseas revenues as a percentage of total Net games in 3Q was 18% compared to 37% in the second quarter.

For the three-month period September 30th, Mainland Chinese online game operations achieved average concurrent users or ACUs of 69,000, aggregate paying accounts of 68,000 with quarterly ARPU of RMB 240. However, with the launch of Shengmozhixue in October, we expect ACUs to stabilize or moderately increase in 4Q compared to the 3Q level. Net game gross profit at 3Q was $2.14 million, a 39% decrease from 2Q. Net game gross margin was 72% in 3Q, a decrease from the 87% gross margin level of 2Q.

3Q cost of services increased as we increased our investments in our online game operational infrastructure to go from supporting two online games to more than four online games, including those we launched in 3Q and continue into fourth quarter. We’d expect improvements in fourth quarter Net game revenues to improve fourth quarter Net game gross margins as the bulk of Net game cost of sales are fixed in nature.

Lastly, we also started closed beta testing of our first licensed overseas online game, World of Tanks, developed by Wargaming. Although, we don’t expect to launch the game until the first half of 2011, Chinese gamer feedback has been very encouraging, and we note that in Wargaming’s home markets at Belarus and Russia, World of Tanks performance to date has shown the game has the potential to be one of the top MMOs in those markets in terms of both concurrent users and revenues.

Lastly, turning to WVAS, our WVAS revenues in 3Q were $20.78 million, a 14% increase from 2Q, but a 23% decrease from the same period of last year. WVAS revenues declined over the same period last year due to the ongoing implementation of WVAS policy restriction from our mobile operator partners, and the overall operating environment for our WVAS business continues to remain difficult.

As mentioned previously, we have now consolidated our WIS business into our WVAS business unit. If excluding WIS from the WVAS, WVAS revenues would have been $19.16 million, up 10% QoverQ, but down 25% from the same period last year. The sequential increase reflects seasonal marketing activities related to color ring-back tone services, related to the Chinese students summer holiday period we undertook during the quarter with various provincial mobile operators.

WIS prior to consolidating into WVAS for 3Q was $1.6 million, an 81% increase from 2Q and a 7% increase from the same period last year. The strong sequential growth in WVAS is due to our mobile literature business in partnership with China Mobile's mobile literature platform.

Newly reported WVAS gross profit in 3Q was $8.43 million US dollars, an 8% increase from 2Q, but a 32% decrease compared to the same period last year.

3Q WVAS gross margin was 41% compared to 43% in 2Q. As although we were able to grow overall WVAS revenues on a sequential basis, the incremental WVAS revenues from color ring-back tones and mobile literature have lower gross margins due to the higher revenue share to content owners, provincial mobile operators and China Mobile's mobile literature platform.

Finally, turning to the 4Q guidance, we expect total revenues for the fourth quarter of 2010 to be within the range of $35.5 million to $36.5 million, with business unit revenues at the midpoint expected to consist roughly of WVAS revenues of $18.5 million, mobile game revenues of $13 million, and internet game revenues of $4.5 million.

We expect total gross profit to be within the range of $15.5 million to $16.5 million, total operating profit to be $3 million to $4 million, which implies total 4Q OpEx to be roughly $12.5 million as we’re benefiting from some of the restructuring and consolidation of WIS into WVAS. And, lastly, we expect 4Q non-GAAP net profit to be roughly $5.5 million to $6.5 million.

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

Wang Leilei

Thank you, Jay. Against more stable WVAS environment, we continue to focus on building our device by digital entertainment player from single WVAS player in the Mainland China market.

In the third quarter, we streamlined our wireless internet service and WVAS business to more efficiently to drive the coming consolidation that we see in the China Mobile service market, so is integration [inaudible] back to realize cost saving in fourth quarter, but this doesn’t reduce our ability to compete, and we believe the integration of the key KongZhong assets and the to mobile games and the WVAS only enhance our leadership positioning in mobile games and the mobile books in the market.

For example, we can combine the, our mobile game community platform into our mobile game team to enhance concurrent development to increase the user base and develop stronger synergies in monetizing online mobile games.

For, our mobile books platform, the combination with WVAS will strengthen our ability to leverage the strong contemplate of, our online book platform, and also our – come to be leader in the development of the pay mobile books market in close partnership with mobile operators.

In the third quarter, we continued to lift the mobile game market, but as Jay mentioned, we expect stable performance in our mobile game business for the rest of 2010 as China Mobile has reduced their marketing activities as we approach yearend. However, we would expect our mobile game business to return to growth in 2011 as the mobile internet market continues to develop in China, and the KongZhong intends to maintain our leadership positioning in this important segment of the 3G market.

Lastly, while our 3Q result in our internet game business were lower than our expectation, I believe we continued to make significant progress in our internet game strategies to develop a robust and a differentiating online games pipeline for 2011.

In October, we launched our fourth self development three-dimensional MMORPG game, Shengmozhixue. And based on the games performance to date, we believe whether we will see a rebound in our Mainland China online game revenues in 4Q compared to 3Q.

We have also continued to develop our online game business in the overseas markets with all of our games being launched over the next six months in Korea, Europe, North America, Taiwan, and other markets, and we expect our Q3 revenues to be a major contributor to our overall internet game revenues over the next few quarters, while we prepare our 2010 – 2011 internet game pipeline.

For the next year, we have three games currently under development with Kung Fu Heroes planned for a mid-2011 open beta. We believe Kung Fu Heroes has the potential to be a top three dimensional MMORPG in both the Mainland China market as well as our top export of Chinese game for the overseas market.

Given the games high-quality 3D graphics and the unique contemporary materials, over the other two announced games underdevelopment, we expect to launch either in or other two at the end of 2011, depending on the development of quality of either games with the launch of the other coming in 2012 change all the self development in the three dimensional MMORPG games which is Chinese costs online game highlighting on the [inaudible] system. The other two is a [inaudible] and is based on the popular online the World of Tanks same name where we’re still have the two-thirds of the novel content to [inaudible].

Finally, we are the exclusive operator for War of Tanks in China. We expect to launch WoT sometime in the first half of 2011, and the recently held closed beta test over this game on November 8th, which exceeded our expectations in terms of user feedback on the platform’s abilities. We believe WoT is truly differentiated team-based, the first player shooting games which where it’ll be widely accepted by Chinese gamers.

Operator, I would like to open the call to questions now.

Question-and-Answer Session


(Operator Instructions). Our first question comes from Andrey Glukhov with Brean Murray. Please proceed.

Andrey Glukhov – Brean Murray

Yes, thank you for taking the question. I guess two things. First, some of your, I guess, industry counterparts suggested that they believe starting Q1 of next year, the mobile operators might be a little bit more, I guess, active with their service providers when it comes to kind of WAP billing. What do you guys think about the macro landscape and the regulatory landscape as you look into 2011?

Jay Chang

Well, overall, I think things have definitely stabilized, but things still, at least going till the end of the year, things still remain relatively policy tight. Going into next year, in our discussion with the operator policies or operator or mobile operators, there’s definitely areas of things where they will boost in billings, opportunities, and different billing platforms we should benefit the larger players like ourselves with some of the other – some of our other peers.

There is talk of potentially early next year, maybe after Chinese New Year they may look to open up some of the WAP billings to specific billings, where about those billing channels have potentially higher margin revenue share to partners like ourselves instead of, so for example, some of our mobile games business has a 50-50 revenue share, we can potentially used some of those billing channels at a more favorable revenue share like 70-30, which would help improve some of our margins, but not so much it being a huge revenue growth driver.

So it’s – the things that are being talked about from the operator side is areas where they could be more flexible in some of their billings policies towards larger players like ourselves which will benefit disproportionally given that we already have a revenue base and that would continue to accelerate this consolidation we foresee in the WVAS market.

Andrey Glukhov – Brean Murray

Okay. And then, as I think about your online games business, so it sounds like you can have a couple of pretty significant game launches in the first half of the year, how do you think about, I guess, the margin profile as you ramp up those games from a marketing standpoint? And, maybe, qualitatively, I mean can you share how you think about sort of the ultimate operating profile of Dacheng and how you’re rethinking the operating targets for them?

Jay Chang

I think – so we’re out of state where we’re still building up, hopefully our growth full of large contact sub developed. If that’s the case, our operating profile, we believe should be near term of the – our peers in the market which have majority of the revenues from self developed titles.

That said, as we talk, we are a licensor of WoT, World of Tanks for Wargaming and that has a revenue share to them. If that game is more successful than we think and our self-developed games are not successful, then obviously our operating profile would trend more toward our larger players who have bulk of the revenues from license games. But until we have more traction and actual service and user feedback out there, I think right now it’s a little premature for us to talk about target operating margins for our business next year in the Net games segment.

Andrey Glukhov – Brean Murray

Okay. Last question is really housekeeping. Jay, as I look at the tax rate, I mean is the fact that it’s a little bit higher than in the past periods purely function of the fact that it’s sort of at certain minimums or did something specific happen this quarter and how does this look going forward?

Jay Chang

Yes, specifically if you look back at our 3Q guidance for internet games, we missed out quite a bit in our actual results. The key reason there was some of the Xiakexing as well as I mentioned in prepared remarks Loong now coming online in South Korea which is a very high, and those revenue flow through Decheng which has currently attacked holiday [inaudible].

So, because of that, and because our WVAS has performed better than our expectations in the period, that’s within the kind of 25% tax rate. So that mix in terms of cash flow or net profits is the reason why it’s slightly higher tax – mixed tax rate in the 3Q compared to the previous periods.

Andrey Glukhov – Brean Murray

All right, that makes sense. Thank you very much.

Jay Chang

Yes, thank you.


(Operator Instructions). Our next question comes from Ming Zhao with SIG. Please proceed.

Ming Zhao – SIG

Thank you for taking my questions. Good morning, Leilei and Jay. First question I had is your reclassification of the WIS into WVAS. Other than the reason that you said in the press release, is this because you – your expectation about this segment’s growth is not going to be big, so that you made reclassification? So that’s my first question.

Wang Leilei

I think we just to make our cost savings for our content session [ph] and we’re focused on building community base, while it’s internet and service platform for KongZhong, especially like the books community and the game community, which is either a monetizing to our games, mobile game revenues and mobile books revenues.

I think for this integration, both from wireless internet and the WVAS of KongZhong led the cost more efficiency and we have a more clear developing strategy for WVAS platform in the future.

Ming Zhao – SIG

Okay. Yes, and on the mobile literature partnership with China Mobile, can I ask how many partners have – how many partners has the China Mobile chosen in the active partnership structure? Are you the – one of the major ones or is it opened to everyone?

Wang Leilei

It’s about – the major partners is the content providers provisioning like maybe six or seven major partners with China Mobile’s book platform, because we just acquired last year and we have a running content based provisionings.

So that means in China Mobile’s book platform, they only cooperate with content based partners, not the China based partners, so we just leveraged our internet platform, also the, our mobile internet platform to provide more contents to the China Mobile books platform.

Ming Zhao – SIG

Okay. And the last question is a – literally if we look at KongZhong’s overall strategy, if we look back this year what you have done, my impression is, it seems like this year the online game performance is a bit below expectation that you had a year-ago. So my question to you is when you look at your business on the mobile side and then on the internet game side, what is your long-term strategy for the upcoming years, what change should we see there?

Wang Leilei

Okay. No matter what our internet game performance is below expectations from market and from our sales, but I think we only run our internet game business only for one year. And for me, I’m very satisfied with what we’ve got, what achievements we’ve got for this year. We’ve got our in-house development internet game team and also we successfully launched the four internet games, and also we also expanded our overseas market.

I think for the next year, our internet game strategy is more the life like [ph]. And as we mentioned we just – we have the licensing game WoT which is our expectation during the technical casting period, and also we have a 203 ourselves development online game which is launched for the next year, will be launched for the next year.

I think in the further, KongZhong will focus on buildup cross platform under payment driven platform, especially focus on the mobile game and the internet game business. And also we believe that the WVAS is a long-term driven cash flow business, especially for music and the mobile books revenues generated for the next year. So this is our major strategy.

And also we don’t believe those strategy everybody wants to do as the next game and everybody wants to do a platform driven business. And we believe that product driven is mainstreaming which means the content is king especially in the digital entertainment area.

Ming Zhao – SIG

Okay, thank you very much. Good luck.


At this time, there are no questions queued.

Jay Chang

Okay. Thanks everybody for attending the call. We look forward to speaking to you over the next few months. Thank you very much.


Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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