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Linktone's (NASDAQ:LTON) revenue stopped decreasing in 1Q07. There are six China Service Providers listed on Nasdaq, while four of them suffered revenue declines in Q1. This year, China Mobile’s (NYSE:CHL) main activities are against MMS (Multimedia Messaging Services) and WAP (Wireless Application Protocol), while LTON’s main business line is SMS (Short Messaging Services).

We believe revenue in Q2 will decline slightly. First, Q1 is seasonally strong due to the Chinese New Year. Second, MMS and WAP will be impacted further as mentioned above. Third, ad revenue, although growing rapidly, is not significant to total revenue. LTON lost USD3.4 million in net profit, mainly due to the upfront cost for enhancing TV ad segment. Ad revenue increased 81% QOQ in 1Q07, but it accounted for merely 4% of total revenue. Management believes the ad segment will make profit in 1Q08, but they also estimate that the Company will lose another USD3 million in Q2. LTON could be an acquisition target. LTON's market price is close to book value deducting goodwill and LTON has an attractive cash balance close to 50% of total asset. We have a BUY rating on LTON.

Revenue Stable

Exhibit 1. Revenue
LTON revenue
Source: Company data and Riedel Research.

LTON’s revenue stopped decreasing in 1Q07. (Exhibit 1) The Company showed its resistance against the industry impact. There are six China SPs (Service Providers) listed on Nasdaq, while four of them suffered revenue declines in Q1. (Exhibit 2) This year, main impacts are against MMS (Multimedia Messaging Services) and WAP (Wireless Application Protocol). China Mobile upgraded platform system, so service providers [SP] lose part of their customers. China Mobile also forbade the free business model for WAP, so SPs are bearing business transformations. LTON’s main business line is SMS (Short Messaging Services), while MMS and WAP accounts for a small proportion.

Exhibit 2. SP Revenue Comparison

LTON 2

Source: Company data and Riedel Research.

We believe revenue in Q2 will decline slightly:

(1) Q1 is seasonally strong due to the Chinese New Year.
(2) MMS and WAP will be impacted further as discussed above.
(3) Ad revenue, although growing rapidly, is not significant to total revenue.

Negative Profit, Spent Much for Ad Segment

LTON lost USD4 million in EBIT and USD3.4 million in net profit. (Exhibit 3) That is mainly due to the upfront cost for enhancing the ad segment. So gross margin declined from 60% in 4Q06 to 43% in 1Q07 and operating expenses increased by 18% QOQ. Those efforts include the exclusive ad agent for Qinghai Satellite Television and acquisition costs for Shanghai Dong Fang Long New Media Co. Ltd. It is encouraging that the ad revenue increased 81% QOQ in 1Q07, although it accounted for merely 4% of total revenue

Exhibit 3. EBIT and Net Profit (USD million)
LTON 3
Source: Company data and Riedel Research.

Management estimated that WVAS gross margin will be 55%-60%, while ad gross margin will be 40%-45% in long term. Management also believe the ad segment will make profit in 1Q08.

Accordingly, gross margin should improve in the following quarters. But management also estimates that the Company will lose another USD3 million in Q2.

Risks

There are only four telecom operators in China, and China Mobile occupies the largest market share in telecom operating. SPs like KONG have no market power when operating services via telecom platforms. Operators tend to share more revenue from SP, and try to operate SP businesses themselves.

LTON tries to diversify business lines from SP to ad, but the transformation may cost LTON much. LTON has a cash balance of USD46.7 million. The Company spent USD3 million for ad segment in Q1, and plan to spend the same amount in Q2. We hope the Company can breakeven before cash declines significantly.

Valuation

This time, we evaluate LTON by scenarios.

(1) Statically, LTON is fairly valued. Book value deducting goodwill is USD2.92 per share, slightly below the market price, USD2.98. Therefore, any price significantly below USD2.92, say 10%, can trigger a buy incentive.
(2) Optimistically, LTON could be an acquisition target. LTON has a low debt ratio of 11% and an attractive cash balance close to 50% of total asset. There could be a significant premium above book value when becoming an acquisition target. Furthermore, the enterprise value is merely USD34 million.
(3) Pessimistically, LTON cannot attract acquirers before management uses up cash, because sophisticated acquisition defense tricks may raise transaction costs.
(4) Additionally, we assume that the whole company could breakeven in 3Q08 and make positive operating profit in 4Q08 when ad revenue accounts for 30% of total revenue as management expects. Under these assumptions, we project a target price of USD3.57, 20% higher than the current market price.

Recommendation

LTON lost USD3.4 million in 1Q07, but the market price is close to book value deducting goodwill. Taking the cash position into consideration, the company could be an acquisition target. BUY.

Appendices

Appendix 1. Income Statement (USD’000)
LTON 4
LTON 5

Source: Linktone Losses Overshadowed By Attractive Cash Position