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Executives

Jay Chang – Chairman and CEO

Leilei Wang – CFO

Analysts

Ming Zhao – SIG

Steve Chen – ROTH Capital Partners

Michael Lee – Royal Capital Management

KongZhong Corporation (KONG) Q3 2011 Earnings Call November 29, 2011 7:30 PM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2011 KongZhong Corp’s Earnings Conference Call.

At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session, at which time, if you wish to queue for a question, you will need to press star followed by 1 on your telephone keypad. I must advise that this conference is being recorded today, Wednesday, the 30th of November, 2011.

I would now like to hand the conference over to your host today, CFO, Mr. Jay Chang. Thank you. Please go ahead.

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 upon that. For additional discussions of risks and uncertainties related to the 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 as of the date of this call.

Thank you for your continued interest in KongZhong. I will first go over a review of our third quarter results before handing over the call to our CEO, Mr. Wang Leilei.

Total revenues for the third quarter of 2011 was $38.9 million, a 6% sequential decrease but a 3% increase from the same period last year. As we continue to transition our business to become a cross-platform visual entertainment company, Mobile Games made up 26% of total revenue and Internet Games contributed another 23%.

Total gross profit was $14 million compared with $17 million in the second quarter, while gross margin declined at 36% compared to 41% in 2Q, as gross profits from WVAS continued to underperform due to the ongoing challenges in the WVAS market, offset by the continued strong performance of World of Tanks. If excluding a non-cash position for impairment of goodwill and intangible assets of $20.26 million, total OpEx would have been $12 million, roughly stable from the second quarter of 2011.

Net loss in 3Q was $17.26 million compared to net profit of $4.4 million in the second quarter, with the basic net loss per ADS of $0.42 based on 41.2 million ADS. Excluding the goodwill impairments, net profit would have been $3 million. Non-GAAP net income was $4.7 million, in line with the company’s guidance range of $4 million to $5 million, while non-GAAP diluted net income per ADS was $0.11.

At the end of 3Q, the company had $143.1 million in cash and cash equivalents or $3.5 per ADS in cash and cash equivalents, compared to $134.2 million at the end of the second quarter of 2011. However, cash and cash equivalents exclude the $22 million loan to a third party. If including the value of [this renminbi/dollar] loan, which was made solely for the purposes of treasury management, total cash and third-party loans amounted to $165.1 million at the end of the third quarter, or equivalent to $4 per ADS.

Now I would like to turn to each business unit’s financial performance, namely, Internet Games, Mobile Games and WVAS.

Internet Game revenues were $8.81 million, a 15% decrease from the second quarter but almost a 200% increase compared to 3Q 2010. Internet Game revenues were drived by continued strong performance of World of Tanks which was launched commercially on March 15, 2011.

Domestic Internet Game revenues were $7.8 million, a 6% decrease from the second quarter, but a 219% increase from the same period last year, due to continued growth of the World of Tanks community, offset by a gradual decline in the older, soft-developed 3D MMORPG games.

Overseas Internet Game revenues were $1.04 million, a 50% decrease from the second quarter, but a 98% increase from the same period last year. Total overseas revenues as a percentage of total Internet Games in the third quarter was 12% compared to 20% in the second quarter.

For the third quarter three-month period, domestic Mainland Chinese Online Game operations achieved ACUs of 157,000 and aggregate paying accounts of 450,000, with quarterly average of revenue increase on our ARPU of 111 renminbi.

Internet Games gross profit in 3Q was $4.26 million, a 25% decrease from 2Q but a 99% increase from the same period last year. Third quarter Internet Game gross margins were 48% compared to 55% in the previous quarter, due to the higher revenue contribution from World of Tanks, which includes revenue share to Wargaming, our third-party game development partner for World of Tanks.

Now, turning to Mobile Games. Total Mobile Game revenues in the third quarter were $ 10mn, a 9% decrease from the second quarter and a 28% decrease from the same period last year. Revenues from downloadable mobile games were $ 9.7 million, representing an 8% decrease from the second quarter and a 26% decrease from the same period last year.

In 3Q, Mobile Games continued 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 4Q11. In 3Q11, average monthly Mobile Game subscribers were roughly 1.7 million compared to 1.7 million to 2 million in the second quarter. However, the company continues to invest in the development of smartphone game platforms, including iOS and Android, and expect to accelerate the development of these platforms in the coming quarters as the market demand develops.

Revenues from mobile multi-player online games or online mobile games were $0.31 million, a 22% decrease from the second quarter. In July, we launched Tian Jie 2, a new mobile online game, whose revenues accounted for roughly 38% of the company's Online Mobile Game revenues in 3Q11. Revenues from Tian Jie Online 1 accounted for 43% and revenues from Feng Shen accounted for the remaining 18%.

Revenues from downloadable mobile games made up 97% of total Mobile Game revenues compared to 96% in 2Q11.

Mobile Games gross profit was $3.62 million, a 12% from the second quarter and a 28% decrease compared to the same period last year as the policies from China Mobile in our mobile game monthly subscription business continued to lead to higher churn and lower profitability. Mobile Games gross margin was 36% in the third quarter compared to with 37% in the second quarter.

Turning to WVAS, WVAS revenues in the third quarter were $20.16 million, a 1% decrease from 2Q and only a 3% decrease from the same period last year. WVAS revenues were relatively stable compared to prior periods although the WVAS operating environment continues to remain difficult.

In the third quarter, 2G revenues represented 79% of total WVAS revenues, while 2.5G services made up 21% of total WVAS revenues. 2.5G services include mobile e-book revenues from our cooperation with China Mobile.

WVAS gross profit in the third quarter was $6.13 million, a 15% decrease from 2Q and a 27% decrease compared to the same period last year. 3Q11 WVAS gross margins were 30% compared to 36% in 2Q as ongoing policy measures led us to rely more on higher-cost distribution channels as a percentage of WVAS revenues compared to prior periods.

Total operating expenses included a $20.26 million provision for impairment of goodwill and intangibles. Excluding this provision, total OpEx was relatively stable at $12 million in 3Q compared to prior periods.

Product development expenses in 3Q were $3.96 million compared to $3.95million in 2Q, roughly stable sequentially.

Sales and marketing in 3Q were $5 million compared to $5.35 million in 2Q and $5.30 million in the same period last year. Sales and marketing remained stable compared to prior periods as we did not have any significant new game launches in the third quarter. However, we expect to increase marketing expenses to support the launch of the new versions of World of Tanks and Kung Fu Hero in the coming quarters.

General and administrative expenses in 3Q were $2.94 million compared to $2.96 million in 2Q. We expect G&A to be maintained at 3Q levels in the coming periods.

In terms of company's total headcount in the third quarter, we exited the quarter with roughly 1,011 staff compared to 1,048 staff at the end of 2Q.

Now, turning to fourth quarter 2011 guidance, we expect total revenues for the fourth quarter to be within the range of 38% to 40%, with business unit revenues at the midpoint expected to roughly consist of $19 million of WVAS revenues, $7 million of Mobile Game revenues, and $13.5 million of Internet Game revenues.

We expect total gross profit to be within the range of $15 million to $16 million, total operating profit to be within the range of $3 million to $4 million, and non-GAAP net profit to be within the range of $5 million to $6 million.

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

Leilei Wang

Hello, everyone. Thank you for your continued interest and support of KongZhong Corporation.

As we have mentioned before, we are midway in evolving KongZhong into a leading digital entertainment company, focus our – operating high-end games accessible through both mobile and the internet platform. In line with this strategy (inaudible) will continue to contribute stable cash flow for the company to help fund future product developments and acquisitions.

For Internet Games, our strategy is to become a leading developer of high-quality 3D online games for the Chinese market and to complement our self-developed games franchise with high-quality overseas content partners like Wargaming.net. We have begun closed beta testing on Kung Fu Hero, our self-developed martial arts themed 3D MMORPG in October in Mainland China. The testing results to date, such as user retention and the [paying user] ratios are all above our expectations and exceeded similar ratios on long periods game during its initial testing phase.

In addition, we have also given priority to open beta testing for Kung Fu Hero in Malaysia and Hong Kong before our open beta testing in China, so that we can improve upon and ensure a successful large-scale of Hero in China currently targeted for March 2012. We continue to believe Kung Fu Hero has the potential to become the permanent flagship online game for 2012 and 2013.

In the second half of 2011, we continue to grow the World of Tanks community in China, and look forward to launching version 7.0 and (inaudible) to Chinese users by the end of this year. More importantly, we continue to work in close partnership with Wargaming.net to further localize the game to Chinese user taste, and believe we’ll see strong growth of World of Tanks in 2012, in line with our fourth quarter revenue guidance for [Internet Games].

In terms of our Mobile Game business, we will continue our existing cooperation with our mobile operator partners in the Java Mobile Game business. On the other hand, we believe iPhone and Android smartphones have more market share than Java phones in the future market in China, and we will seek to accelerate the development of our iPhone and Android games business in working in technology platforms, which is – enable us to (inaudible) and deploy quality content for users in China and in overseas markets, especially for the premium space model game markets which we believe suits the China Android market well.

So, operator, I would like to open the call to questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, welcome to the question-and-answer session. To queue for a question, please press star followed by 1 now on your telephone keypad, and wait for your name to be announced.

Just another quick reminder, it’s star 1 to register for a question.

Your first question comes from the line of Ming Zhao from SIG. Go ahead, please.

Ming Zhao – SIG

Thank you for taking my question. Good morning, Leilei and Jay. So, I have two questions. First question is, if I look at your fourth quarter guidance, it seems like you’re predicting a growth in the Online Game business, a decrease in the Mobile Game business. So, Mobile Game is probably due to what you just said, due to policy change there. But can you elaborate why the Online Game business is expected to grow significantly in the fourth quarter? I heard Leilei say about the Kung Fu Hero in March launch. Is there anything you put out maybe I missed?

Jay Chang

Yes. So, as you mentioned before, the Mobile Games is really being impacted by policies, and as of today, iOS and Android revenues are very – are almost – are non-material right now. But for our Online Game guidance, the key driver there was World of Tanks. If you look at (inaudible) ranking, if you look at anywhere around kind of traditional game media, you can see the World of Tanks becoming, we believe, one of the next and one of the few big hits that’s come into the market over the past few years. And we’re driving very closely with the user community, with the developer and with our marketing teams to ensure that we can take advantage of the potential of this game, which we believe has potential to be one of the top games in China given its unique game play, team-based shooter, which doesn’t really have any competition, compared to of the other kind of content that’s out there today.

And the guidance reflects what we’re seeing in World of Tanks right now and in the fourth quarter.

Ming Zhao – SIG

Okay. Okay. Thanks for that. So, my second question is more of a strategy question here. So, I understand you are transitioning to a company that’s providing entertainment on both the mobile front and the PC internet front. So, how aggressive will you be in the upcoming years? I see that you’re doing step by step, pretty slowly, if that’s right. So, you have a game developed. Once it’s done, you release to the market. Are you going to accelerate that pace a little bit so that you're transitioning to have more revenue from the online – in the PC online side it will be bigger? So, just want to have an understanding about your overall strategy.

Jay Chang

As it stands today, if you look at our current operating plans, excluding any acquisitions or any other potential licensing deals, we would expect Online Game to be a larger and larger percentage of our business next year compared to the third quarter of 2011, based on both existing games in the pipeline that are clearly operating, as well as Kung Fu Hero.

Ming Zhao – SIG

Okay. But you won’t consider that’s a licensing – the five games altogether then launching next year, so that the process will be faster.

Jay Chang

We would obviously like to see Online Games become a larger and larger portion of our business sooner rather than later, but in terms of licensing, it does take time to find partners, negotiate with partners, and then get the government approvals. So, I think from our side, our focus is still the self-develop side. We do have other games in our pipeline which we’re still working out, which we haven’t really announced hard launch dates, which could be launched next year. And in addition to that though, I think the flipside is Mobile Games right now, I would say the fourth quarter, we hope, is kind of a low period. We do believe there’s still potential for next year to maybe stabilize or improve slightly from current levels. And then WVAS I think has room for some stabilization, maybe some improvement in the back half of 2012. But I think for right now, our focus is to grow, and what we can control is the Online Games side.

Ming Zhao – SIG

Okay. Thank you very much.

Leilei Wang

Thank you.

Operator

Thank you. Your next question comes from the line of Steve Chen from ROTH Capital. Go ahead, please.

Steve Chen – ROTH Capital Partners

Thank you for taking my call. So, within your Q4 online gaming revenue guidance, so, what percentage of the revenue do we expect to come from overseas market, especially given the so-called [introductions] of Kung Fu Hero and some of those in this market?

Jay Chang

We would expect overseas revenues in the fourth quarter to be lower than the third quarter. So, the majority will be coming from World of Tanks in China. And Kung Fu Hero overseas contribution won’t be coming until really sometime after we launch the game in China. So we are actually accruing some revenues right now, but they’re not that material, both overseas and in China as well, but (inaudible) but they’re not material.

So, really our guidance is really driven by what we’re seeing in World of Tanks, we believe it’s becoming a hit game.

Steve Chen – ROTH Capital Partners

Previously, actually you mentioned you partner with Wargaming to do some localization work. So, you started, that collaboration has largely been completed following the version 6.0 and the (inaudible) launch?

Jay Chang

No. I think this is just some of the things. As you know, as the people on the call know, Crossfire is a game that’s been out three, four years, and has been constantly evolving based on the operation team, the community and the developer. And that’s the relationship which we would like to replicate some of the [excess of] that game with World of Tanks, and we’re constantly in dialogue with Wargaming to improve the game (inaudible) but at the same time, they also want to have some balance in terms of maintaining a consistent global product development roadmap as well. But as I understand right now, I believe the game is the number one game in Russia, and they would have ambition to hope to see similar success in China, but I think we’re taking it day by day. So far I think, in the fourth quarter, the game is doing well.

Steve Chen – ROTH Capital Partners

Okay. So my next question is regarding your Mobile Games. How many games you have already launched on iOS or Android platform, and what’s the pipeline for the next year?

Jay Chang

In terms of the iOS games, you can go on the App Store right now and search on KongZhong, and I believe there’s maybe like 10 or so unique content. I think over the next quarter or two quarters, you’ll see some more specific information from us on how we plan to leverage technology platform to address the overseas iOS/Android space as well as the Chinese iOS/Android space. But at this current point in time, I think the best I can just point you is what you see on the App Store today is not what we will see hopefully in the next six months or so.

Steve Chen – ROTH Capital Partners

Okay. So, my last question is, regarding your use of cash. Actually, we noticed you still generated positive cash flow within the quarter and you have already started a buyback program starting from the end of September. So, beyond that, are you still considering some cash dividend opportunities especially given the current relatively low liquidity?

Jay Chang

Our board is always actively considering ways to enhance shareholder value. Currently today, our view is we’d like to focus on generating cash flows, to look for additional acquisitions which may enhance long-term value for the company, and as we’ve stated before, we want to become a leading digital entertainment firm in China. And if you look at the market caps of the leaders, we’re very far away from that right now. So we have a lot of work to do, and we believe having the current cash balance as it stands is useful to address that strategy.

Steve Chen – ROTH Capital Partners

Okay. Thank you.

Leilei Wang

Thank you.

Operator

Ladies and gentlemen, just a reminder, to queue for a question, it’s star followed by 1 on your telephone keypad.

Your next question is from the line of Michael Lee from Royal Capital. Go ahead please.

Michael Lee – Royal Capital Management

Hi, Jay. Thanks for taking my question.

Just to follow up on the last question, are you trying to say that we shouldn’t expect buybacks to continue into the fourth quarter?

Jay Chang

No. The buyback that’s in place right now is automated. So, it’s continuing as per the payment structure, the plan we had as of September 30.

Michael Lee – Royal Capital Management

Okay. And then just on World of Tanks, can you remind us again, when did the new localization enhancements go into effect?

Jay Chang

They’re going in effect every time we launch a new version update or a patch. I mean, as you know, the Online Game business is a service. It’s not just the packaged software business. And I don’t want to go into kind of the details, things are changing, but a lot of it, some of it’s on the back end, some of it’s related to, for example, I think during October holiday we launched the Chinese Tanks [computer games] which is part of the reason now you're seeing a lot more revenue growth, but we’re focusing also on growing the community and the ACUs and PCUs as well. So, there’s lots of operational details around that which we’re working on closely with our fellow Russian partners. I was actually in Minsk myself in September. So we’re working very closely well together.

But there’s still a lot to achieve, a lot to do. It’s still very early days; the game has been in the market less than a year right now. And I think as you see 7.0 and Clan Wars, and hopefully 7.1, over the next two or three months, that we can see continued growth in. Primarily, our goal is to grow the World of Tanks community, which will then translate hopefully into better, improved financial performance.

Michael Lee – Royal Capital Management

That’s great. Thanks. That’s all I have.

Leilei Wang

Okay. Thank you.

Operator

Ladies and gentlemen, this is the final reminder call for questions. It’s star followed by 1.

As we have no further questions at this time, I’ll hand back to Mr. Chang for closing.

Jay Chang

Thank you very much for your continued interest in KongZhong, and myself and Leilie look forward to speaking to you in the next weeks and months and quarters ahead. Thank you very much.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for your attendance. You may all now disconnect.

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