KongZhong Q4 2006 Earnings Call Transcript

TRANSCRIPT SPONSOR

KongZhong Corporation (KONG)
Q4 2006 Earnings Call
March 1, 2007 7:30 pm ET

Executives

Sam Sun - CFO
Yunfan Zhou - Chairman and CEO
Nick Yang - President

Analysts

Li Tang - Pacific Crest Securities
Paul Bieber - Piper Jaffray
Lin Shi - Lehman Brothers
Andy Lang - Deutsche Bank
Kit Low - Goldman Sachs
Ming Zhao - Susquehanna International
James Lee - WR Hambrecht
Chang Qiu - FORUN Technology Research

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the 2006 KongZhong Corporation Fourth Quarter Earnings Call. My name is Shaun and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions).

I will now like to turn the presentation over to your host for today's call, Mr. Sam Sun. Please proceed.

Sam Sun

Thank you. Hello everyone. Welcome to KongZhong Corporation's fourth quarter 2006 earnings conference call. You can find our Q4 earnings press release at our website ir.kongzhong.com. And this is Sam Sun, Chief Financial Officer of the company. We also have Yunfan Zhou, our Chairman and CEO and Nick Yang, our President on the line.

I will first go through our financial highlights. After my discussion, I will turn it over to Yunfan. He will review our operations and talk about our business outlook.

Overall, our Q4 financial results are better than what we expected last November. Our Q4 total revenue increased 7% year-over-year to $23.71 million, about 10% higher than the top end of our guidance.

Our full year 2006 revenue reached $106.77 million, also exceeding our guidance of $97 million to $105 million we made last August.

In Q4, our mobile advertising revenues generated from our wireless Internet portal, Kong.net, reached $104,000, a 76% increase from Q3.

Our gross margin in Q4 was 51%, about 4 percentage points lower than the previous quarter. This is actually in line with our estimate three months ago. The lower gross margin is primarily due to the higher percentage of revenues derived from China Unicom, China Telecom and the China Netcom, which generally charge a higher revenue sharing fee.

Talking about total operating expenses in Q4 2006, the total operating expenses were $8.71 million, an 11% decrease sequentially. We continue our efforts to improve efficiency while investing for the future. So, on efficient improving side, in Q4, we saved approximately $500,000 resulting from headcount reduction made in Q3.

On the investment for future side, in Q4, we spent $0.7 million when building costs for the wireless Internet portal, Kong.net.

Our US GAAP net income was $3.66 million in Q4. Diluted US GAAP earnings per ADS were $0.10 in Q4.

Operating margin was 14% and net margin was 15%. Fourth quarter non-GAAP income was $4.20 million, which excluded share-based compensation costs of $301,000 and amortization of intangibles of $230,000. Diluted non-GAAP income per ADS was $0.12.

So for the full year 2006, our US GAAP net income was $24.69 million and diluted earnings per ADS were $0.69.

So with that, I will now turn it over to Yunfan for his remarks.

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Yunfan Zhou

Thank you, Sam. We are pleased that both our fourth quarter revenues and fiscal year 2006 revenues exceeded the guidance despite the regulatory changes in 2006. Our Q4 revenue grew 7% year-over-year to $23.7 million, well exceeding our guidance of $20.5 million to $21.5 million.

Our Q4 US GAAP net income was $3.66 million. Our total revenues in 2006 increased 37% from 2005 to reach a new record of over $106 million. Our net income in 2006 increased 11% to $24.7 million.

Based on the information available by now and after having the significant changes in policies and regulations of telecom operators at MII, we expect our Q1 revenues to be between $20 million and $21 million.

Although we have been working very hard on the wireless value-added services business and delivered a much better than expected Q4 revenue results, we anticipate continuous challenges in the WVAS industry in 2007. However, with these upcoming 3G opportunities, we are confident about the long-term growth of China's WVAS industry in the future.

In addition to our WVAS business, we are also pleased about the good progress in the wireless Internet portal, Kong.net business in 2006. We have seen very fast growth of users and traffic at Kong.net in 2006. In addition, we have seen a rapid growth of mobile advertising revenues, which were mainly generated from our wireless Internet portal Kong.net.

Total mobile advertising revenues in 2006 were about $210,000 compared with almost nothing in 2005.

Our founders and the management team's strong experiences in the wireless value-added services and the Internet portal and community are very helpful to develop our wireless Internet portal business.

Nick and I were founders of Chinaren.com in 1999, which we built to be the first largest Internet portal in China within a year. ChinaRen is alone in that club. It's still one of the largest internet communities in China today with more than 15 million users.

We were also senior executives at Sohu.com for one and a half years before we founded the KongZhong. We have the knowledge of how to develop good contents and sticky community products, as well as how to spend the marketing dollars effectively.

In 2006, we spent a total of about $9 million in our wireless Internet portal business, including about $3.5 million in marketing. We have built a team of close to 200 people working on the Kong.net business. We believe Kong.net is one of the leading wireless Internet portals in China today in terms of user number, traffic and brand awareness.

We are very confident about the future of our wireless Internet portal business and we’ll increase our efforts to develop Kong.net in 2007. We plan to spend about $50 million in our wireless Internet business and the wireless search business in 2007. We’ll launch at least two major marketing campaigns for Kong.net with the focus on key products and our brand.

We also plan to increase our mobile advertising sales effort in 2007. We target to increase our mobile advertising revenue five times from about $200,000 in 2006 to about $1 million in 2007.

To summarize, although we are facing a difficult time in the WVAS business, our management firmly believes that continuous spending on marketing dollars and investment in Kong.net is the right strategy for us to achieve our vision, which is to build Kong.net to be the largest wireless Internet portal in China.

We are making our best efforts to balance, making such investments in our brand, while maintaining profitability. The two strategic business lines we have, WVAS and wireless Internet portal, are both very important. We believe we have maintained the number two player in the overall WVAS industry.

Wireless Internet portal is currently in the investment stage, but we are very serious about it, and we believe it will be our important revenue and profit growth driver in one to two years time. The Kong.net brand will become our core asset, which will have long lasting value. Thank you.

Sam Sun

Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Li Tang with Pacific Crest Securities. Please proceed.

Li Tang - Pacific Crest Securities

Thank you. I guess the key question here is gross margin. Given the negotiation power carriers have over WVAS vendors, what do you think a reasonable revenue sharing plan with carrier should be? And over the long term, what kind of a growth margin model is sustainable for KongZhong?

Sam Sun

Hello Li Tang. About the revenue sharing percentage and if we you are asking about a reasonable revenue sharing percentage, and if you are asking about a reasonable revenue sharing percentage, it is difficult for us to comment, what is reasonable and what is not. But, what we have seen till today is that China Mobile has maintained the 15% revenue share ratio for quite a few years. And we don’t see any sign that they are going to change it, at least for 2007.

And as for other telecom operators, I think we have in our press release. I already mentioned that China Unicom said they were going to increase the percentage from 20% to 30% from Q2 of 2007. But that will have some impact on us and hopefully that will not be so significant. And for other telecom operators, we don’t really see any sign that they are going to change their revenue sharing ratio. So, hopefully it would be at that level. So, I hope that answers the first part of your question, the revenue sharing percentage.

As for the gross margin model, I think right now we are somewhat kind of stabilizing our gross margin model, at least for now, for the WVAS side. Like what we had already commented in last two quarters, we think our gross margin will be like around 50% to 52% for WVAS. And actually we think that the mobile advertising revenue grows faster than the WVAS and covers the larger portion of our revenue. Normal advertising, mobile advertising revenue has much higher gross margins than the WVAS revenue. So, we will see probably a slight growth in our gross margin if our mobile advertising revenue can really kick-off.

Li Tang - Pacific Crest Securities

That's great. And my second question is on the revenue mix by carriers. If I look at China Mobile, their value-added services probably $68 billion R&D in 2006, China Unicom, probably $16 billion in 2006, and I estimate like Telecom, Netcom added together probably less than Unicom. So, it seems like from that perspective, total revenue by that mix, about 30% of the total industry was contributed by China Unicom, Telecom and Netcom. And your revenue contribution from those three carriers reached 41% in Q4, which imply the revenue from China Mobile declined in Q4. What was the reason that revenue from China Mobile declined? Was that because of the subscriber decline or revenue per subscriber decline? And what's the trend going forward?

Sam Sun

Yes, Li Tang. You are right. In Q4, the non-China Mobile revenue we've got was like 41%. But if you look at the other three quarters, Q1, Q2, Q3, we actually started pretty low, and because of in the past, maybe in 2005, KongZhong was really focused on China Mobile. So, starting from, I think at the end of Q1 2006, we acquired Sharp Edge, and Sharp Edge was pretty strong in China Unicom, China Netcom and China Telecom. So, since then our revenue with those three telecom operators actually increased a lot in the Q2, Q3, Q4, like from 9% to 25% in Q3 and 41% in Q4.

We think the major reason why in Q4 the 41% was high, mainly as you mentioned, revenue from China Mobile declined. That was the convenient effect of the double confirmation for the subscription users, all the regulatory changes and the effect from other regulatory changes. So, looking forward, we think, that our revenue mix probably should match with the market share of those telecom operators. So, I guess probably we will think the China Mobile revenue, as a proportion of our total revenue, actually will increase. And we believe a more healthy revenue mix will be, like non-China Mobile revenue would be around 30% of our total revenue.

But of course, it really depends on, like in 2007, in the future how the telecom market share is going to be shared by those major telecom operators. For example, if China Mobile really kicks-off in terms of its user base and in terms of its revenue growth, then definitely we should catch up with them.

Li Tang - Pacific Crest Securities

That makes sense. So, you're pointing out that China Mobile decline was due to the policy change, and it seems like it will eventually overcome that portion. One last question, what's your headcount by the end of 2006?

Sam Sun

Our headcount by 2006 is 785, I think.

Li Tang - Pacific Crest Securities

Okay. Thank you very much.

Sam Sun

798. Sorry, 798 at the end of 2006. 798.

Li Tang - Pacific Crest Securities

Thank you very much.

Operator

Your next question comes from the line of Safa Rashtchy with Piper Jaffray. Please proceed.

Paul Bieber - Piper Jaffray

Good morning. This is Paul Bieber for Safa. A couple of quick questions. First, did you say that with the increased revenue share, the gross margin will still be in the 50% to 52% range in Q2 when the increased revenue share becomes effective?

Sam Sun

You mean in Q2? I mean last year in Q1 we haven't -- right now we are announcing the Q4 2006 number.

Paul Bieber - Piper Jaffray

Right. But, you said something about the 50% to 52% gross margin, and I missed what you said. Can you just clarify what you said about maintaining the 50% to 52% gross margin?

Sam Sun

Yeah, I guess hopefully, we think we can at least stabilize around 52% in terms of gross margin. And I guess with the Unicom new policy mentioned in our press release that will have some impact on our gross margin. But it will maybe have like 1% decrease in our overall gross margin, because our revenue with China Unicom was around 15% of our total revenue on average. So, if the revenue sharing ratio just changed from 80% to 70%, and it's just for three quarters for the full year 2007, the effect, you can do the calculation, is just 1% to 2% of the gross margin.

Paul Bieber - Piper Jaffray

Okay. And two quick follow-ups; one is, when do you think growth will resume in WVAS? And then secondly, what tax rates will you be assuming for 2007? The tax rate seems to be a little high in Q4, so can you just clarify that?

Yunfan Zhou

Yes, this is Yunfan. I think for the overall WVAS industry, as I said, it has been a challenging year, because there where a lot of regulatory changes in the second half of 2006. So, we previously estimated that, hopefully, we could resume in the first half of 2007. We actually had a very good quarter in revenue in Q4. So that unfortunately becomes our high base. So, we actually projected a Q1 revenue decrease from Q4 level. And what we are trying to do is to try to stabilize from the Q1 level, and hopefully in 2007 we will stabilize and then grow from the Q1 level. So, defiantly we cannot guarantee anything, because we don't know if there are any other major policy changes in 2007.

Paul Bieber - Piper Jaffray

And then quickly on the taxes, what tax rate should we assume for 2007?

Sam Sun

Yes this is Sam. About the tax rate, actually starting from 2007 most of our KongZhong group's companies, their tax holidays ended. But of course starting from 2007, we are going to have 50% tax rate reduction. The standard tax rate for our type of high-tech companies is 15%. So the 50% reduction, meaning that in 2007 we are going to have an average 7.5% income tax rate. But in addition to that, there will be some expenses that according to our China tax code that are not allowed for tax deductions. So, I think a reasonable estimate would be 7.5% of tax rate plus a rough $1 million tax expenses for those non-tax-deductible items.

Paul Bieber - Piper Jaffray

Okay. Thank you very much.

Sam Sun

Thank you.

Operator

Your next question comes from the line of Lin Shi with Lehman Brothers. Please proceed.

Lin Shi - Lehman Brothers

Hi, good morning. Thank you for taking my question. The first question is on Kong.net. If possible it would be great if you can provide us some growth or any data on user traffic and also the ranking of China Mobile?

Nick Yang

This is Nick, the President for the company. About the user traffic and data, we haven't disclosed this number. There hasn't been an [operative] party who has a good track of all the websites. The problem with that, by disclosing by our self is that, because in the market there are lots of people, lots of private sites who yell out very number and also they have different ways. They can increase their traffic and increase their data, page views, and other numbers. So, we don't want to get into game, that's why we haven't disclosed these numbers. But we can assure you that we are one of the leading wireless Internet portals and we have continued to invest a lot of efforts in building our traffic and user numbers internally. And also because the number I think Yunfan has given in his comments is a number we gave out as our revenue target, until the amortizing is in this space.

Lin Shi - Lehman Brothers

Okay, thanks. Also for your advertising client base would you give a little bit more color?

Sam Sun

Yeah this is Sam. Now for the advertising customers, say for Q4 of 2006 we actually have about 10 advertising customers. They come in from all different categories. First category, they comes from the cell phones manufacturers which is quite outstanding because they are may be the first group of people who kind of set this mobile advertising concept, so Motorola and Sony Ericsson. The second category is coming from car manufacturers like BMW. Third category is coming from consumer products like Pepsi. Fourth category is coming from financial institutions; we have DBS as our advertising customer. And we also have some other customers, small ones.

Lin Shi - Lehman Brothers

Alright, that's helpful. Another thing is I noticed your SMS revenue despite a very hard market condition actually grew Q-on-Q. Could you please explain the reasons behind?

Sam Sun

Yes the SMS revenue grew in Q4, primary coming from the non-China Mobile revenue because of the Sharp Edge integration. As we mentioned before, we acquired Sharp Edge in Q1 2006. And towards the end of Q3, we have successfully integrated Sharp Edge's operation into our operations. So in Q4, we actually enjoyed some synergy from them. And also in Q4, we made a lot of efforts in working with those non-China Mobile telecom operators, namely; China Telecom, China Netcom and China Unicom. So, we got pretty good revenue from them. Those are 2G services, so most of those 2G services are actually coming from the SMS.

And also looking forward, we think the SMS revenue is going to have a decrease in Q1, mainly because the double confirmation implemented by China Unicom actually. They also implemented double confirmation. And we think the other two, probably China Telecom and China Netcom they are also implementing this double conformation, although a little bit later than China Mobile. So, SMS revenue in Q4 still high was again, better than our expectations, but I guess probably it's more of a one-off case.

Lin Shi - Lehman Brothers

Okay, thank you. My last question, would you please just give us some of a trend for each of your business lines going into Q1 '07?

Sam Sun

Yes, sure we can. In terms of Q1, in WAP, I think we are going to have a little growth, may be single-digit growth. That's more of a seasonal factor. And on the SMS line, we are going to have decreased our estimate right now. Probably the decrease will be around 30%. For MMS, MMS is also going to be decreased. We guess, probably it will be around mid teens. And IVR probably will see a slight increase, that's more of a seasonal factor. And for Java's and CRBT, we guess, it will be pretty flat compared to Q4 2006.

Lin Shi - Lehman Brothers

Okay. So for WVAS business as a whole, which would be your highlighted business line going forward in a slightly longer term?

Sam Sun

I guess right now, we actually are focusing on all the major WVAS lines because there is such a big user base there. There are high-end users, low-end users. Someone enjoys WAP, someone enjoys games, online games, and someone enjoy SMS, MMS. So, we are actually focusing on all these major categories.

Lin Shi - Lehman Brothers

Okay. Great, thank you.

Operator

Your next question comes from the line of [Andy Lang] with Deutsche Bank. Please proceed.

Andy Lang - Deutsche Bank

Hi, good morning Nick and Sam. Could you talk about your plans to recruit advertisers for Kong.net in terms of how you work with distributors and how you position yourself?

Yunfan Zhou

Yeah, this is Yunfan. I think we are at pretty early stage in wireless advertising. It's very similar to the early days in the Internet. Our customers are just beginning to realize that wireless Internet is becoming a new media. So, we believe that at the early stage, the most important thing is to educate the customers. So, we have recently appointed our Senior Vice President of Sales, Hai Qi, who has been in charge of the WVAS sales to also be the head of our advertising sales, because he has extensive sales experiences.

So we believe that with his 10 years of sales experience he can establish a very effective organization for us. Right now, we have about 50 sales people working on, either talking to the customer directly or working with the distributors. Right now, more than half of the revenue actually comes from the distributors. So, we believe that we will work both ways, both with the distributors and with the key customers in the future.

Andy Lang - Deutsche Bank

Thanks. My last question is, could you give us the breakdowns of your WVAS revenues coming from subscriptions versus one-time purchases?

Yunfan Zhou

Yeah, sure. Sam?

Sam Sun

Yeah. Well, as you know the double confirmation policy actually gives us really hard time to acquire new customers. And also the one month free trial period actually made the subscription base pretty difficult. But actually there is also a positive effect there. After the double confirmation policy, we still acquired some new subscription users which are really loyal. So, in the past, for example the life cycle of a subscription user probably average three months. Right now we are seeing the trend in subscription users actually.

Although, we have a smaller base of subscription users, but their life cycle increased the level to 4 to 5 months. In turn of our WAP revenue actually, and most of the WAP revenue now comes from downloads instead of subscription users. And for SMS and MMS, we don’t have the exact number, but the trend we think is more and more downloads than subscription. But we believe subscription users will still be stabilized at a certain levels, because as I mentioned there were some really loyal users that will really be there and be with us on subscription purposes.

Andy Lang - Deutsche Bank

Oh, that’s great. Thank you. No more question.

Sam Sun

Thank you.

Operator

Your next question comes from the line of Kit Low with Goldman Sachs. Please proceed.

Kit Low - Goldman Sachs

Good morning. Thanks for taking my questions. Couple of quick questions, first on administrative parts. On the Sharp Edge, on both Q4, 2G revenues at Sharp Edge, when would the growth happen on a year-on-year basis without Sharp Edge? I know it would be difficult given that you have some synergy in that. But to an extent, that you could comment on, that would be great.

Sam Sun

Well, Kit, we don’t have the number right now because internally we no longer analyze our operations that way, since we already integrated Sharp Edge in to our operations. So, I guess, we can get back later on that question if we can get a number on that.

Kit Low - Goldman Sachs

Okay, great. Appreciate that. Secondly, just want to clarify something. You mentioned that you are going to spend about $50 million in 2007, between Kong.net and Kong search, and perhaps a bunch of other stuff. I just want to clarify, in terms of what the proportion of that will be spend on marketing, and what proportion of that will be on a CapEx basis in terms on R&D basis on the Kong search portion of it?

Yunfan Zhou

Yeah this is Yunfan. I think right now we don't have a very detailed breakdown yet, because it's still early in Q1. However for the rough ratio, we believe that we will definitely spend at least 30% similar as last year, at least 30% in marketing dollars, probably more than that. And for the CapEx, right now we don't have a big budget for the CapEx. Probably almost half of the money will be spent on the people and also some will be spent to acquire new contents and some will be spent for the product and technology development. So, that's a rough breakdown.

Kit Low - Goldman Sachs

Okay. Great, that's very helpful. Thank you.

Yunfan Zhou

Thank you.

Kit Low - Goldman Sachs

One quick last question is, has there been any indication on improvement on China Mobile site increasing their capacity to handle Java games in terms of their Java capacity on the servers?

Nick Yang

I think there is a slight improvement in the Java platform, because I think China Mobile has realized that their previous system, the Treasure Box system hasn't really worked very effectively, and I think they want to address that problem. But personally, I believe the opportunity lies more in the future on the mobile online games. Because there you can get a more sustainable revenue growth of online games rather than the single download games. And right now we are actually discussing also with China Mobile on somehow integrating our mobile online games efforts into their system as well.

Kit Low - Goldman Sachs

Okay. Great, thank you.

Nick Yang

Thank you.

Kit Low - Goldman Sachs

That’s all my questions.

Operator

Your next question comes from the line of Ming Zhao with Susquehanna International.

Ming Zhao - Susquehanna International

Thank you. Good morning, couple of small questions. First of all like a big picture question, do you think second quarter, the whole WVAS environment could stabilized. And then probably just If you can (inaudible) --

Yunfan Zhou

This is Yunfan Zhou. I think earlier I just answered another question about the 2007 WVAS for Asia. I think our plan right now is, if there is no major policy changes in Q1 and Q2. We already gave our Q1 guidance, hopefully in Q2 we will stabilize that number or we can grow a little bit. So, that’s our plan right now. But, as I said, it's hard to predict any policy changes.

Ming Zhao - Susquehanna International

Okay, second question. There are some industry talks about China Mobile will do different price schemes for the WAP traffic to the [mass net] and to the few WAP sites. In other words it will increase the pricing for people to use the free WAP sites. So, what do you guys think about that? The other thing is, it is also said that the traffic to these two websites will be directed to Monster Net first and then to for example Kong.net. Are they going to happen? What's your thoughts here?

Yunfan Zhou

Yeah. I think we have actually, that is the rumor in the market. What we have done is that we have discussed with some senior people from China Mobile recently. And I think this is the question not only for Kong.net, it's for the whole wireless Internet industry. And from our discussions, we haven't done any conclusions. From my knowledge, we believe that most likely it will not happen, like whether the way you heard from the rumors. So, we are actually pretty positive about the future of the wireless Internet. And we are working with China Mobile very closely to try to find a mutual beneficial way for both Monster Net and Kong.net. And we believe this will be a very, very big market for the wireless Internet. So, there will be ways that will be mutually beneficial.

Ming Zhao - Susquehanna International

Okay. Thank you.

Yunfan Zhou

Thank you.

Operator

(Operator Instructions). Your next question comes from the line of James Lee with WR Hambrecht. Please proceed.

James Lee - WR Hambrecht

Hey, good morning.

Yunfan Zhou

Good morning.

James Lee - WR Hambrecht

Can you guys talk about the cleaning up the silent users a little bit in WAP? You have talked about most of your users on WAP are one-time download users. I was just curious how much of the base right now is sort of near to border-line, the four months type of silent user situation?

Sam Sun

Yeah. Well, as you can anticipate the clean up of the silent WAP users is not really some kind of new policy. It's actually started from 2005. We've already started to clean up some of the silent users. So, for us, we think, if talking about today for 2007, the silent users should not be that much and will not have any significant impact to our WAP revenue.

And in terms of Q4 2006, I guess probably there will be some hang on there, but probably already clean up after Q4. And we do still have some [screen] users in WAP revenue, but majority of our WAP revenue is downloads right now. And for Q1, we anticipate an increase in our WAP revenue. That's not really subsequent with dollar, that's more of a seasonal factor, the holidays and people visit WAP to get music, get themes etcetera.

James Lee - WR Hambrecht

Okay. Let me ask you another question here. It seems like you guys did really well in SMS and you had articulated well that you guys have went after carriers other than China Mobile to increase the revenue and growth. Are you also doing something differently in terms of products, how you offer your products, which will increase the user interest and use your SMS service in 4Q?

Sam Sun

Well, in Q4, in terms of the revenue growth, revenue from China Unicom, China Netcom and China Telecom. Definitely, innovation execution, we believe in our industry innovation execution is the key. So, we continue innovating a lot of new products. But if you talk about, really speak innovation, at least not in Q4 we think. In Q4, we think it's more of an execution side, because we know we cannot totally rely on China Mobile's revenue because of all of the regulatory changes. So, we actually spend a lot of efforts, and maybe you can call extra efforts to go out to try to get issues resolved with China Unicom, and other telecom operators. And we get probably, it's close to Yen to a lot of telecom operators, because they also want to try to represent that, and we just took the opportunity. So, we got a kind of seasonal high better than expected results from those three telecom operators.

James Lee - WR Hambrecht

Okay. If I can ask a last question here. Can you tell me what the revenue contribution is from your handset alliances in 4Q? And also do you continue to think that channel is sustainable, because different industry chatters that China Mobile may potentially create its own operating systems so to control the handset market at the same time controlling the application of those handsets, just curios if you can comment on that?

Sam Sun

Well, in Q4, yeah, handset manufacturers always play important partner for our business and also for KongZhong. And for handset, revenues from handset alliance are coupled with handsets. We think in Q4 around 20% of our revenue coming from the co-operation with handsets. And you can actually also see the numbers from our revenue sharing with handsets. And of course we also have other revenues from handsets, but we don’t need to share revenue handset manufacturers, because, we use co-operation with handset manufactures we can acquire new customers. Then we can do a lot of cross-selling and market our other products. So, for those revenues we don’t need to share revenue with handset manufacturers. In terms of the model of co-operating with handset manufacturers, we think this is a very important channel and we think this is a quite sustainable model and we will continue working on this model.

James Lee - WR Hambrecht

Okay, can you comment about potentially from industry chatters about China Mobile creating its own operating system?

Yunfan Zhou

China Mobile creating what?

James Lee - WR Hambrecht

Its own operating system. And what they are trying to do, I just picked on the industry chatters, what they are trying to do is control the handset market and possibly control the applications to be loaded on to those handsets?

Yunfan Zhou

Yes, I think China Mobile and also China Unicom and other operators, actually they have subscribed a lot of our handsets and they actually are partner with these handsets. The model is that, they buy these handsets from the handset manufacturers so that they can give their own specifications for the handsets. And since they buy these handsets, similar as other foreign operators, like NTT DoCoMo and other Japanese operators, they definitely have a much stronger control of these handsets they buy. But we have been following this very closely. Even for those handsets in China Mobile, they buy from the manufacturers. They need these services. So what they do today is that, they create something called [MIDC] which means that, they select a few peak service providers to provide these value added services in the handsets that they buy. So, there are actually built-in some functions on these service providers and the KongZhong is definitely one of the top service providers in their choice.

So, we have been working very closely with their [MIDC] projects. And this is independent from our partnerships directly with the handset manufacturers. So, we are doing both, to partner with handsets directly and to partner with handsets indirectly through China Mobile.

James Lee - WR Hambrecht

And Sam had a commented about your revenue mix, for China Unicom was 15% in 4Q. I was just curious, what is your run rate for 1Q so far with respect to China Unicom?

Sam Sun

No, well. I mean on average our revenue for China Unicom will be around 15% in 2007. And for Q4 the revenue from China Unicom was higher than that was.

James Lee - WR Hambrecht

Okay. I got it. Thank you so much.

Operator

Your next question comes from the line of Chang Qiu with FORUN Technology Research. Please proceed.

Chang Qiu - FORUN Technology Research

Right. Good morning, Yunfan, Nick and Sam.

Yunfan Zhou

Good morning.

Nick Yang

Good morning.

Chang Qiu - FORUN Technology Research

Actually, I only have two questions for clarification. Answering with earlier questioners, you mentioned SMS in Q1 will decrease 30% or 13%.

Sam Sun

30%.

Chang Qiu - FORUN Technology Research

So, why is that big?

Sam Sun

Well, we think it is community track, as the double confirmation implemented by the other three telecom operators, because they implemented this double conformation policy a bit later than China Mobile. So, for China Mobile the effect is almost there, already. And for the other two, basic [insiders] will last into Q1.

Chang Qiu - FORUN Technology Research

I see okay. The other thing is regarding Kong.net. Last year your total spending or investment is $9 million and this year you're guiding or planning at $15 million. So, if we do the financial modeling, should we just increase the operating expense from, like $38 million for '06 by something like $6 million to $44 million?

Sam Sun

Roughly speaking yes that will be the picture.

Chang Qiu - FORUN Technology Research

I see okay, which means even the revenue is going down somewhat. You are not reducing cost in some of the other areas. Basically right now you are at the most efficient level you are?

Sam Sun

Well, definitely in 2007 we are going to continue our efforts in cost savings and improving efficiency, because the whole industry is not really growing that much and our revenue probably was going down comparative to 2006. So, we definitely need to be more efficient. But on the other hand, we strongly believe that Kong.net is a big business and is our future. So, we are not going to stop spending on that.

Chang Qiu - FORUN Technology Research

Okay. All right great. Thanks.

Sam Sun

Thanks

Operator

(Operator Instructions) At this time you have no other questions and that ends our Q&A session. I would like to turn the call back over to Mr. Sam Sun.

Sam Sun

All right, thank you. Thanks everyone for calling in, and we really look forward to talking to you again next quarter and sharing with you more information about our progress in Kong.net at that time. Thank you.

Yunfan Zhou

Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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