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Executives

Jay Chang – CFO

Leilei Wang – Chairman and CEO

Analysts

Adam Krejcik – ROTH Capital Partners

KongZhong Corporation (KONG) Q2 2011 Earnings Call September 6, 2011 8:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 KongZhong Corporation Earnings Conference Call. My name is Jonathan, and I’m your operator for today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session after the prepared remarks. (Operator Instructions).

At this time I would like to hand the call of to one of your speakers for today Mr. Jay Chang, CFO. You may 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 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. I will first go over our 2Q results, before handing over the call to our CEO, Mr. Wang Leilei.

Total revenues for the second quarter of 2011 were $41.6 million, a 4% sequential increase, an 18% increase from the same period last year. As we continue to transition our business to become a cross-platform digital entertainment company, mobile games made up 26% of total revenues, Internet games contributed 25% and combined, mobile and Internet games made up over half of 2Q total revenues.

Total gross profit was $17 million compared to $16.5 million in 1Q, while gross margins remain stable at 41%. Total OpEx was $12.3 million, an increase of – from 1Q levels of $11.4 million as we increased sales and marketing activities for the long-term loan to tax for the full period of 2Q.

Net profit in the quarter was $4.39 million compared to a net loss in 1Q of $0.46 million, but this included a charge related to the change in the fair value of the Dacheng contingent consideration of $3.73 million. Basic net profit for ADS was $0.11 based on $40.9 million ADS which included the full quarter – first two quarters impact of new shares issued to the shareholder’s of Dacheng at the end of March.

Non-GAAP net income was $6.2 million in line with the company’s guidance range of $6 million to $7 million, while non-GAAP diluted net income per ADS was $0.14.

At the end of 2Q, the company had $134.2 million in cash and cash equivalents or $3.3 per basic ADS in cash compared to 11 of a $118.3 million at the end of 1Q. However, cash and cash equivalents exclude to $21.6 million third party loan and it’s including the value of the RMB third-party loan which was made totally for the purpose of treasury management.

Total cash and third-party loans amounted to $155.8 million at the end of 2Q or equivalent to $3.8 per ADS.

Now, I would like turn to each business unit’s financial performance in the Internet games, mobile games, and WVAS. Internet game revenues in the second quarter were $10.35 million a 59% increase from 1Q and 158% increase compared to 2Q 2.10. Net game revenues were driven by the strong performance of World of Tanks which was launched commercially on March 15, 2011.

Domestic net game revenues were $8.3 million, a 66% increase from 1Q and a 228% increase from 2Q 2010 due to the successful commercial launch of WoT or World of Tanks. Overseas, net game revenues were $2 million a 36% increase from 1Q and a 39% increase from 2Q 2010 due mainly to the contribution from a self developed 3D MMORPG game Shengmozhixue or Demon Code Online in Taiwan. Total overseas revenues as a percentage of total Internet game revenues in 2Q were 20% compared to 23% in 1Q.

For the second quarter three month period, domestic Mainland Chinese online game operations achieved average concurrent users or ACUs of 157,000 and aggregate paying accounts or APAs of 445,000 with quarterly ARPU of RMB121. We have previously reported first quarter ACU figures, which assumed as of World of Tanks as operating for the entire three month period of 1Q at post launch levels versus only for the last 17 days of the first quarter of the March 15 or ACU figures of 145,000.

However, if we were to calculate 1Q actual ACU figures in the same manner we do 2Q, 2011 and 4Q 2010, whereby World of Tanks would have only recorded zero ACUs prior to the March 15 of commercial launch date. ACUs for 1Q would have been 66,000 compared to 157,000 in 2Q of 2011 and 81,000 in 4Q of 2010. Net game revenues made up 25% of total revenues in 2Q’11.

Internet game gross profit in 2Q was $5.7 million a 31% increase from 1Q and a 64% increase from the same period of last year. 2Q internet game gross margins were 55% compared to 67% in 1Q due to the higher revenue contribution from WoT or World of Tanks, which compared to a self developed internet games includes revenue share war gaming, our third-party game development partner for World of Tanks.

Now turning to mobile games. Total mobile game revenues in 2Q were $10.97 million, a 11% decrease from 1Q and a 16% decrease in the same period last year. Revenues from downloadable mobile games were $10.6 million, representing a 10% decrease from 1Q and a 14% decrease from the same period last year.

In 2Q mobile games revenues continue to underperform our expectations as China Mobile implemented more strict operating policies and continued to adjust its mobile game marketing strategies. We see these difficulties continuing in the second half of 2011.

In 2Q11, average monthly mobile game subscribers declined to between about 1.75 million to 2 million per month from over 2 million per month in prior periods. However, the Company continues to invest in the development of new mobile game platforms, including iPhone and Android, and expect to accelerate our development of these platforms in the coming quarters as the market demand develops.

Revenues from mobile online games was $0.4 million, a 33% decrease from 1Q. All three of our online mobile games continue to experience a sequential decline in revenues due to the product lifecycle and competitive issues. Revenues from downloadable mobile games made up 96% of total mobile game revenues compared to 95% in 1Q.

Mobile games gross profit was $ 4.11 million, a 5% decrease from 1Q and a 26% decrease compared to the same period last year as policies from China Mobile in our mobile game monthly subscription business led to higher churn and lower profitability. Mobile games gross margin was 37% compared to with 35% in 1Q.

WVAS revenues in second quarter of 2011 were $20.3 million, a 11% increase from the same period of last year, but a 5% decrease from 1Q. WVAS revenues were relatively stable compared to prior periods although the WVAS operating environment continues to remain difficult. 2G revenues represented 84% of total WVAS revenues, while 2.5G services made up 16%.

WVAS gross profit in 2Q was $7.22 million, a 8% decrease from 1Q and a 8% decrease from the same period last year. WVAS gross margin were 36% compared to 37% in 1Q as ongoing policy measures led us to rely more on higher cost distribution channels as a percentage of WVAS revenues compared to previous periods.

Total operating expenses increased 8% to $12.26 million in second quarter compared to $11.4 million in 1Q. Product development in 2Q were $3.95 million compared to $3.6 million in 1Q or a 10% increase as we continue to invest in R&D.

Sales and marketing expenses in 2Q were $ 5.35 million compared to $4.83 million in 1Q11 and $ .14 million in the same period last year. The sequential increase in sales and marketing was driven by activities related to the commercial launch of WoT and we continue to expect to make continued marketing investments in WoT and our other new Net games in the coming quarters.

G&A expenses in 2Q were $2.96 million compared to $2.94 million in 1Q and $2.7 million in the same period last year. We expect G&A to maintain at 2Q levels in the coming periods.

Operating profit for 2Q was $4.77 million and operating margins were 11.5%. The company’s total head count remains stable in 2Q at 1,048 staff compared to 1,037 staff at the end of 1Q.

Now turning to 3Q guidance, we expect total revenues for the third quarter of 2011 to be within the range of $38.5 million to $39.5 million, with each business unit revenues at the midpoint expected to roughly consist of WVAS revenue of 19 million, mobile game revenues of 10 million and internet gaming revenues of 10 million.

We expect total gross profit to be within the range of 40.5 million to 50.5 million, total operating profit and net profit to be within the range of $2.5 to $3.5 million and we expect non-GAAP net profit to be within $4 to $5 million.

Now I would like to turn the call over to our CEO Mr. Wang Leilei to discuss our second-quarter business highlights and recent business development.

Leilei Wang

Thanks, Jay, and good morning and good evening everyone. The company generated a stable non-GAAP net profit and increased our cash balance while continuing to build future growth opportunities in our internet gaming business. More importantly our internet gaming business achieved over $10 million in quarterly revenues for the fourth time after only entering the online gaming market in early 2010, making Kong one of the fastest growing new entrants in the Chinese online gaming market. This performance was driven by our successful commercial launch of World of Tanks, “WoT” in partnership with Wargaming.net Russian Company. Over the next quarter, in addition to further game enhancements developed by Wargaming with plan to introduce WoT’s Clan War add-on to the China market which will bring another level of user engagement to the already strong Chinese WoT community.

Clan War is a web-based function which is carrying out theme based competition in content and applications. This well combined existing clients and web based model and which has already been proved successfully in Russian markets.

In the coming months, Kong will introduce our self-developed online competition or “arena” platform to further enhance the quality of online events that users of WoT and eventually Paperman can participate in this platform. For Paperman, it’s an Anime-based first person shooting game developed by Gamepot from Japan. We expect to launch the game commercially in China by the middle of October 2011 – for this year. And also I want to thank for our partner Gamepot Japan company. They do a lot of localization work for China market.

In addition, we continued to have confidence in our self-developed Internet gaming pipeline. For Kung Fu Hero, we just have many innovations in our game. For example, we learned from World of Tanks that we will give web-based Clan based function on the game and to enhance our theme PK function. And also we have new operation strategy that we have first to launch this game in Malaysia with local partner for (inaudible) version. This time it will help us to find more bucks and to find some user experience and to reduce make more reduction for the user (inaudible) before the official launching in Mainland China.

And we plan to based on the internal testing and user feedback, we now expect to begin open beta testing by the end of 2011 with last scale testing and the commercialization slated for early 2012. We continue to believe Kung Fu Hero has the potential to become KONG’s flagship online game for 2012 and 2013.

Lastly to better align our overall internet gaming marketing resources we are now planning to begin open beta testing for Emofaze III in early 2012 with commercialization now slated for mid of 2012.

Now turning to mobile gaming business you will only see some decline for all the mobile gaming revenue and this caused by some impact patterns with our Java based mobile game business because of the policy impact from our carrier, partner carrier. But now we have almost one and half year to make continue trying to under the new platform markets like iPhone and Android platform and we were invest more people and the more R&D for the new platform product development.

Now for the next quarter we will launch at least three major products for iPhone platform and also the two major products in the Android platform in China. So lastly for the WVAS business as we mentioned before we continue to operate all our existing strategy to our WVAS business to provide more stable cash flow to our company to support our mobile gaming and internet gaming business.

Operator, now I’d like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question is coming from the line of Mr. Adam Krejcik with ROTH Capital Partners. You may proceed.

Adam Krejcik – ROTH Capital Partners

Yeah. Hi guys, thanks for taking my question. A couple of questions, first one on your internet online game business, I wonder if you could give us some color on how World of Tanks is performing here in Q3. I think, we noticed some clean up of maybe some hacking and cheating accounts or bugs in the game, just want to get a sense for how that user base is trending and kind of your expectations here in Q3 and Q4 given your visibility?

Jay Chang

So, thanks for the question Adam. For Word of Tanks, I would say its relatively flat to slightly up and our guidance can reflect that, in the 10 million net game guidance we were that’s reflecting lower overseas license fees, so towards 1 million or 1.5 million versus 2 million 2Q so that implies slightly higher domestic revenue based on our growth, continued growth in the World of Tanks, but not significant growth. And the main reason there is we have actually held off a lot on the internet café promotions because after doing some testing we found that the game needs a lot more location to fit the local market.

And there is a lot of other things I think that the game could do and we are actually in very deep discussions with war gaming to do more localizations features to make it more compatible with the likes of Counter Strike or Cross Fire in the China market. That all says with the game that’s beside the language which really hasn’t been localized for the China market the core user community continues to grow every week which we are very happy with, pleased with, very satisfied with as well as war gaming.

So, I think the base that we have is very strong and I think the next stage for us is twofold. One is working closely with Wargaming to do more localization including more virtual items, including more flexible operations on our side, have to do more events which by now were are not able to do including internet cafe, marketing. And the secondly is the kind of war feature which in Russia, I believe improve things like 20%, 30% almost overnight given that’s the core users really took to that and increased both user play as well as ARPU.

And I think the other thing that in terms of talking about localization, you can probably notice that the ARPU is lighter than we had all expected given that World of Tanks is a pretty significant contributor to internet games. And that would goes reflecting kind of the localization factor of all the tax. But I think our win for game is performed very helpfully and the core user group begins to grow which is the key metric that we are monitoring today until we can get more localization because we are working very closely with and getting great support from the Wargaming teams in this.

Leilei Wang

I think also I think the World of Tanks game have the long life cycles than the other regular MMO game because it is a tool have the promotion of internet cafe and also we learn more from – do a lot of research from crosswire of Tenzen and give more information led the Russian partner to have a more localization job for China markets. And also we just build up some competition platform we call Arena we mentioned to further enhance the quality of the online events that user of WoT. And eventually we can get more revenues from this competition for this platform.

Adam Krejcik – ROTH Capital Partners

Okay.

Jay Chang

Adam I guess going back to guidance again we expect – what we expect in 3Q, but 4Q there is potential for that to grow if we can achieve those things that I talk about successfully and bring it to market successfully.

Adam Krejcik – ROTH Capital Partners

And should we expect with respect to ARPU that to kind of increase in tandem with new localization efforts?

Leilei Wang

Maybe we have intentions to, but it’s the timing of the localization which right now is still being discussed. So I can’t give a clear timeframe on that right now.

Adam Krejcik – ROTH Capital Partners

Got it. And then in terms of pushing up some of your other games like Kungfu Hero too, I think you mentioned on the call just a better align. Is that – I mean is that the kind of better aligned of your marketing dollars or you just be a little more prudent on the cost side or do you think there will be cannibalization or just given kind of that you guys are still in early stage online game company. Just maybe some clarification on why you are waiting a little bit longer now?

Jay Chang

Well, so Kungfu Hero, we don’t see have any conflict with any of our existing games excluding Long and – but that game is obviously towards the tail end of life cycle. For Hero it’s really is product specific. This is a game which now is over two years under development. We still have a lot of potential, but we want to get it right. And in the game business I think it’s better to get it right than rush something out and miss that opportunity.

So for us we had previously kind of discussed the 3Q commercial launch, but given the testing we’ve done internally as well as and coming up in Malaysia, we want to just take our time and do this game right.

At the same time we have a lot of efforts on improving over the tax which we are actually quite optimistic about, but that will take some a lot of work between the two parties ourselves and were gaming and then we have Paperman coming up in 4Q anyways, which we feel actually Paperman given this level of support we are getting from game path we feel actually good to slightly the Dark force type of game given it’s in the first testing the use of feedback that was very positive in terms of its differentiation in the marketplace if we are able to continue to deliver those features in the market. So and then having Emofaze 3 and Kung Fu Heros launch in the first half at the same time was something that we thought was quite better aligned to stagger than a little bit. And then I think that we’re also looking at further pipeline right now, but we have not announced any other specific detail.

Jay Chang

Yeah, I think Kung Fu Hero game, we have many innovations for from operation angle, because we think now is 100% finish for this game and the firstly we will launch in Malaysia which is overseas more market about more Chinese market just like mela like China. And we can get more user experience, more analysis for user of churn rates kind of in-house over KongZhong’s applications from the testing in Malaysia.

And then after two or three months testing in Malaysia and we can got more high quality for our Kung Fu Heros. And also as I mentioned we think WoT’s current war is a very successful Corus platform gaining model they combined web-based game, (inaudible) game and Clan based game together and let user and team user has more and got more revenue and once we add these features in our Kung Fu Hero. This is the reason why we want to get more overseas game producers their products operate in China, they want to learn more from our competitors overseas producers insurance.

Adam Krejcik – ROTH Capital Partners

Okay, that’s helpful. And then moving on to mobile games, you mentioned introducing some products here. I guess maybe just some kind of top-level thoughts on how you see the competitive landscape when 3G becomes relevant shipping out for you guys and some of your peers and I guess potentially is there any type of timeline you can point towards when you’ll start to see some incremental revenue coming from these new platforms?

Jay Chang

I think for the Java game we are number one market share and in China but in China for the Java based mobile game model is too heavily relay on the carrier of speeding systems and the carriers promotion platform and now we want to plan our mobile gaming (inaudible) more to WiFi from the iPhone and Android platform especially for the iPhone platform we now we have almost one and half year making (inaudible) and it’s about 40 people to continue to do a lot of products to make testing analysis from the iPhone platform and we believe for the next quarter we will give more detailed numbers for the performance for our iPhone revenues and also I think Android platform and Android products and Android mobile phone market share in China is bigger than before.

And we think we should be the biggest player in the new platform in China for iPhone market, Android market because we have more experience for the mobile gaming promotion now reached some tons of embedding channels with some local Chinese handset manufacturer. And also we have more experience for the different cross selling strategy and we try to transfer more our Java based MMO mobile gaming team to programming some new RPG MMO online mobile gaming products to new platform like iPhone, Android platform. And we believe in the coming next two or three quarters iPhone and Android platform revenues of KongZhong will have 20 to 30 percentage of our total model gaming revenues.

Adam Krejcik – ROTH Capital Partners

the next – I’m sorry. In the next two to three quarter or ...

Jay Chang

Yeah, two or three quarters.

Adam Krejcik – ROTH Capital Partners

Okay. That’s very helpful. And then I guess finally given your cash position here and where the stock is trading, just wanted to get management’s thoughts on potential share repurchases or buyback programs?

Jay Chang

Yeah Adam, we are always evaluating potential of assets, also the other thing we are also evaluating is the actual effectiveness of given the volume, but our board is actively in discussions around the share buyback issue and we are always evaluating that option.

Adam Krejcik – ROTH Capital Partners

Okay. Thank you very much.

Leilei Wang

Thank you.

Jay Chang

Thank you.

Operator

(Operator Instructions). At this time ladies and gentlemen, I see no further questions in queue. We would like to thank you for joining our call today. This does conclude the presentation. You may now disconnect. Have a good day.

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