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Originally published on Thursday, 28 August 2014.

KongZhong (KZ, profile) released Q2 FY2014 results which included net revenue of 57.4 million USD and net income of 0.07 million USD. On balance, Q2 results were better than management's earlier guidance (revenue was in line, but the company previously expected a net loss for the quarter). Strength in the quarter came from the company's core Mobile and Internet game's businesses, which both delivered solid YoY and QoQ revenue growth. Operating and net margins were lower than previous quarters, in part due to advertising and promotion expenses related to game launches during Q2, investments fully expensed up front, but which could deliver potential benefits down the line.

In addition to solid financial results, operating metrics also showed signs of growth. KongZhong reported Monthly active users exceeding 2.6 million gamers, up over +50% YoY, and 427,000 Active paying accounts, also up nearly +50% YoY. Average revenue per user (ARPU) was lower YoY and QoQ, however new game launches late in the quarter were a contributing factor to the ARPU calculation.

Management's guidance for Q3 was encouraging, including revenue growth over +30% YoY and net income rebounding vs. Q2, along with a significant margin increase to approximately 16%.

Recent Quarterly Performance FY2014
(000) USD, Except per share amountsQ2Q3Q4Q1Q2
Revenue41,99942,57842,96248,95557,367
Gross profit17,85019,09521,71623,31824,496
Operating profit5,237-8677,3928,477-1,219
Net income6,512-2,68110,0269,95066
Earnings per share (GAAP, diluted per ADS)0.15-0.060.210.210.00
Comparison YoY
Revenue-13%-12%4%6%37%
Gross profit-17%0%21%25%37%
Operating profit-30%n.a.99%51%n.a.
Net income-17%-143%110%46%-99%
Earnings per share-16%n.a.90%30%-99%
Comparison QoQ
Revenue-9%1%1%14%17%
Gross profit-4%7%14%7%5%
Operating profit-7%n.a.n.a.15%n.a.
Net income-4%n.a.n.a.-1%-99%
Earnings per share-7%n.a.n.a.-1%-99%
Margin analysis
GPM43%45%51%48%43%
OPM12%-2%17%17%-2%
NPM16%-6%23%20%0%
EBITDA19%-4%27%23%8%

The Q2 balance sheet included highly liquid assets of about 194 million USD (cash and cash equivalents, term deposits, securities), up from 165 million USD last quarter and 144 million USD in Q2 FY2013. KongZhong generated about 25 million USD from operations, up from about 5 million in Q1.

Operating cash flow in the quarter was approximately 24.5 million USD, up from 4.8 million USD in Q1 and about 3.7 million USD in Q2 FY2013.

The company's Q3 FY2014 outlook included the following:

  • Revenue: 64-65 million USD (growth of about +33% YoY, +7% QoQ)
  • Gross profit: 26-27 million USD (gross profit margin of about 42%)
  • Net income 9-10 million USD (U.S. GAAP basis, or about 15% net margin)

Operating Metrics

The increases in Monthly active users (MAU) and Aggregated paying accounts (APA) were due to the addition of new players following the launch of Guild Wars 2 and World of Warplanes. Average revenue per user (ARPU) was lower YoY and QoQ mainly due to the timing of the Guild Wars 2 and World of Warplanes releases (May), affecting the quarterly calculation of monthly values.

Key Business Developments during Q2 FY2014

The company released Guild Wars 2 in mid-May, and the game launch was relatively well received, and management commented that the launch was more successful than their original expectations. As of Q2 FY2014, the company had sold over 1 million CD keys for the game.

KongZhong released World of Warplanes in May, the second major title from Wargaming.net, and along with the release announced the launch of its new War Saga brand. According to management, the new brand is intended to provide a sense of cohesion for its different military-themed games, but also help gamers identify the company as a leader in online military games in China.

Financial Performance

KongZhong Income Statement FY2014
(000) USDQ2Q3Q4Q1Q2
Revenues43,58144,08443,83849,60757,870
Sales tax-1,582-1,506-876-652-503
Total revenue, net41,99942,57842,96248,95557,367
YoY-13%-12%4%6%37%
Cost of revenues-24,149-23,483-21,246-25,637-32,871
Gross profit17,85019,09521,71623,31824,496
YoY-17%0%21%25%37%
Gross profit margin43%45%51%48%43%
Operating expenses
Product development-6,455-6,991-6,819-5,934-6,510
Sales and marketing-4,644-10,942-6,520-6,737-16,009
General and administrative-2,166-2,029-2,356-2,364-3,463
Government subsidy65201,371194267
Operating profit/loss5,237-8677,3928,477-1,219
YoY-30%n.a.99%51%n.a.
Operating profit margin12%-2%17%17%-2%
Impairment loss on intangibles0-1,562000
Interest income1,4311,6852,1702,2691,751
Interest expense-360000
Impairment loss on equity method investment0-2,000000
Imputed interest, long-term payables-150-150-150-150-150
Exchange gain/loss221210898-348-316
Investment income026000
Pretax profit/loss6,703-2,65810,31010,24866
Income tax expense-191-23-284-2980
Net income/loss6,512-2,68110,0269,95066
YoY-17%-143%110%46%-99%
Net profit margin16%-6%23%20%0%

KongZhong's Q2 revenues were driven higher by performance in its core Internet and Mobile games segments, with combined revenues contributing nearly 75% of the total for the quarter. Management characterized World of Tanks' performance as 'stable' and noted in the official release that the marginal improvement in revenue growth was from new titles launched in the quarter (Guild Wars 2, World of Warplanes).

Costs of revenues increased faster than revenues, resulting in a lower gross margin, due to a higher proportion of Mobile game revenues from relatively more expensive billing channels, and higher content costs for the WVAS business.

Operating costs were higher during the quarter, driven up mainly by Sales and marketing expenses related to new game launches. As a result of lower gross margins and increased spending on fixed costs, the company reported an operating loss for Q2, a marked reversal from the 17% operating margin in Q1. Despite the impact on operating margins, the marketing and promotion activities related to game launches can arguably make or break the game's economic future. So although heavy spending on sales and marketing has a negative margin impact in the current period, it can also be seen as an investment in the game's long-run success, but one which can't be capitalized and put on the balance sheet.

KongZhong recorded non-operating income from interest received on its cash balance, which helped offset the minor operating loss, and ultimately resulted in a slim net profit.

In addition to the income shown on the quarterly P&L, management's earlier investment in game studio Ourgame also benefited shareholders. Following Ourgame's June 30, 2014 IPO, KongZhong recognized an unrealized gain in the value of its investment, which bypassed the income statement and was directly recorded on the balance sheet.

Disclosure: None.

Source: Parsing KongZhong's Q2 FY2014 Results