KongZhong Q3 2007 Earnings Call Transcript

KongZhong Corporation (KONG)

Q3 2007 Earnings Call

November 19, 2007 7:30 pm ET

Executives

Yunfan Zhou - Chairman of the Board, Chief Executive Officer

Nick Yang - President, Chief Technology Officer, Director

Hanhui (Sam) Sun - CFO

Analysts

Mike Olson - Piper Jaffray

Analyst for C. Ming Zhao - SIG

Lee Hong - Goldman Sachs

Presentation

Operator

Welcome to the third quarter 2007 KongZhong Corporation earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Sam Sun, Chief Financial Officer of KongZhong. Please proceed.

Sam Sun

Thank you, Shawn. Hello, everyone. Welcome to KongZhong Corporation’s third quarter 2007 earnings conference call. You can find our Q3 2007 earnings press release at our website ir.kongzhong.com. 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, who will then review our operations and talk about our business outlook.

Overall, our Q3 financial results are in line with what we expected in August. Our Q3 total revenues were $17.12 million, in line with our guidance of $16.5 million to $17.5 million. Our wireless value-added service revenues increased in the areas of SMS, JAVA, and IVR while MMS revenues decreased by 23%. Our WVAS gross margin in Q3 was 52%, about 3 percentage points higher than the previous quarter.

This is a combined result of movement of high gross margin SMS and JAVA and low gross margin IVR. We also made significant cost savings efforts, which also help improve gross margin.

Total WVAS operating expenses in Q3 2007 were $6.57 million, a similar level as those of Q2. In Q3, our mobile advertising revenue continued its growth trend and reached $265,000 a 19% increase from Q2.

We continue our efforts in the wireless Internet business. In Q3, we spent $2.60 million relating to our wireless Internet sites, about 9% higher than Q2. We expect a similar level of spending in Q4.

Our US GAAP net income was $544,000 in Q3. Diluted US GAAP earnings per ADS were $0.02 in Q3. Third quarter non-GAAP income was $1.37 million, which excluded share-based compensation costs of $618,000 and amortization of intangibles of $211,000. Diluted non-GAAP income per ADS was $0.04.

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

Yunfan Zhou

Thank you, Sam. We are doing better in Q3 than Q2 in terms of both revenues and net income, thanks to the continuous efforts of our mobile advertising revenues and our cost-controlling efforts. Our Q3 revenue reached $17.12 million and met our guidance. Based on information available today, we expect our Q4 revenues to be between $17.5 million and $18.5 million.

In addition to our stabilized WVAS business, we are also pleased about our good progress in the wireless Internet business. We are happy to announce our mobile advertising revenues in Q3 increased 19% sequentially to $265,000. Also in this Q3 we launched the official Chinese NBA mobile website which will be one of the major drivers to increase our traffic and user base of the wireless Internet sites we have and our mobile advertising revenues.

We believe we have laid a good foundation for the growth of our wireless Internet business. Given the fact there are over 500 million cell phone users and over 140 million Internet users in China, the current about 40 million WAP user base has a big growth potential in the next few years. Thus, we are confident about the future of our wireless Internet business with our partnership with NBA, MSN, Opera, et cetera, we are making our best efforts to increase our brand awareness, traffic and mobile advertising revenue.

To summarize, although we are facing continuous challenges in wireless VAS, KongZhong’s management believes that our WVAS business has begun to stabilize. Our investment in the wireless Internet business is the right strategy for us to achieve our vision, which is to build KongZhong.net to be the largest wireless Internet portal in China. Thank you.

Sam Sun

Thank you. Operator, let’s open the lines for questions and answers please.

Question-and-Answer Session

Operator

Your first question comes from the line of [C. Ming Zhao] - SIG.

Analyst for C. Ming Zhao - SIG

I have a couple of questions. Your fourth quarter guidance looks like it implies modest growth. May we know where this growth is from?

Sam Sun

We think the growth will mainly come from the IVR side and the WAP side. Of course, the mobile advertising revenue should also see growth. For IVR, we think we will have a growth of about 30% quarter over quarter. For WAP revenue, we think we probably will have about a 10% increase quarter over quarter. For other revenue lines such SMS, MMS, JAVA and IVR, we think those revenue lines will remain stable or may have very modest growth. For mobile advertising revenue, as I just mentioned, we should be able to see some growth also in the mobile advertising area.

Analyst for C. Ming Zhao - SIG

Does this mean you think the wireless sector has already hit the bottom?

Sam Sun

As Yunfan just mentioned, we think that WVAS business has begun to stabilize, so that’s the reason why we think our Q4 guidance can be higher than Q3.

Analyst for C. Ming Zhao - SIG

What’s the expense related to your WAP service in the third quarter? Why did the G&A expense decrease in this quarter? Will this trend down?

Sam Sun

Excuse me, what’s the question?

Analyst for C. Ming Zhao - SIG

What’s the expense related to your WAP service in the third quarter? The mobile wireless service, the related expense?

Sam Sun

Our wireless Internet expense in Q3, the operating expenses for Q3 is $2.6 million.

Analyst for C. Ming Zhao - SIG

Why did your G&A expense decrease in this quarter? Will this trend down? Will this margin keep going, stable?

Sam Sun

In Q3 we also took significant efforts to control the costs. We believe that’s the major reason why G&A expenses decreased compared to Q2. We think we already are doing pretty well in cost control so our feeling is that in Q4, we won’t see a further decrease. At least not a significant further decrease in the operating expenses.

Analyst for C. Ming Zhao - SIG

Given your competitors such as Hurray have done some restructuring, will KongZhong also make some strategic changes in the near term?

Yunfan Zhou

We saw that Hurray announced a merger yesterday. Actually, we have really been able to focus on the wireless for the past few years and this year we are strengthening our efforts in the wireless Internet business. We have signed partnerships with the NBA, MSN and other partners and we believe this is the right strategy we have, which is to focus on the wireless sector, including wireless value-added services and wireless Internet.

Especially for the wireless Internet, we believe it’s still the very beginning, similar to the time that we experienced like in 2000-2001 for the Internet. Still we have a pretty small user base for the wireless Internet; however, with over 500 million cell phones, installed based in China which is still growing, we believe the wireless Internet will probably be the next big thing in China.

Operator

Your next question comes from Mike Olson - Piper Jaffray.

Mike Olson - Piper Jaffray

It seems like WVAS stabilized somewhat. Is it possible with WVAS, that we could see growth in that business in ‘08?

Sam Sun

Right now, maybe it’s a little bit too early to talk about 2008 but since our opinion is the WVAS business began to stabilize in Q4, guidance is better than Q3 actual. Right now, the feeling is that 2008, for the quarter performance right now, the feeling is that it should be at least flat compared to maybe Q4 levels. I mean, there is still uncertainty about the regulations. In the WVAS business there are always a lot of regulations from MMI and China Mobile and other telecom operators. We think that uncertainty is still there but the business is should begin to pick up.

Nick Yang

As you can see, more and more bigger players are approaching other strategies such as Hurray is going to other strategies of their own that I think for 2008 we should see that KongZhong is still having a very strong focus in the wireless areas such as wireless VAS and wireless Internet. With the Olympics coming in 2008, I think for wireless VAS we are optimistic about it.

Mike Olson - Piper Jaffray

I think on the last call you had said that it is possible that by 2010 advertising revenue from Kong.net could be equally important as WVAS. Do you still feel that’s true?

Nick Yang

We still feel that it will take three to five years for us to grow the wireless Internet business to be a self-sustainable business, to be an important business segment to KongZhong. That’s still our belief.

Operator

Your next question comes from Lee Hong - Goldman Sachs.

Lee Hong - Goldman Sachs

Can you break down the share-based compensation into the different operating expense lines, please?

Sam Sun

Lee, excuse me, what’s the question?

Lee Hong - Goldman Sachs

Share-based compensation, what percentage for each operating expenses line -- R&D, SG&A -- can you break them down please?

Sam Sun

For selling expenses the share-based cost is about $119,000. For product development it is also about $119,000. For the G&A expense it is another $235,000.

Lee Hong - Goldman Sachs

My next question is regarding your mobile advertising business. Can you talk about the major advertisers for the mobile advertising business during the quarter? Also, who do you see as other active players within the space?

Sam Sun

In Q3 our major advertisers include Nike from the sport field; we have Red Bull; we also have Blackberry; we have Motorola and Nokia; we have BMW. So these are the major advertisers in Q3. Going forward, we believe all the brand names from various industries will all be interested, and especially the fast-moving consumer goods products, they will all be interested in the wireless mobile advertising on the wireless Internet.

There is also many NBA marketing partners that are also very interested in putting advertisements on the official NBA website as well as Kong.net. We believe we can have more advertisers from them.

Lee Hong - Goldman Sachs

How do you break down the number of advertiser growth versus the spending per account? I know all these spendings are more trial spending for now, but do you see any quarterly growth trends? How do you characterize it?

Sam Sun

It’s still in the trial stage. For example, we’ve seen Red Bull and Blackberry as new advertisers this quarter. For advertisers like Nike or Motorola, they have been spending advertising dollars on Kong.net for several quarters and we have seen the trend and they increased their spending little by little. They also increased the time period. For example, in the past they may just assign a contract for one week/two weeks now they are extending the contract period to set up a longer relationship with KongZhong. I think all these are good signs.

Nick Yang

Right now I’m spending a lot of my time traveling to meet customers and advertisers and what we have seen is that, for example, a company like Nike, initially they spent very little, like maybe RMB 20,000 to advertise on our sites. Then they move into to hundreds of thousands of RMB and right now I’m talking to, including them and other advertisers, for the advertising for the whole year for 2008 for the bigger contracts.

I’m seeing more and more interest in the advertisers to the wireless Internet and mobile advertising in general. They are much more interested because everyone is looking for new ways to market and advertise. A lot of those companies are very interested, so I’m fairly optimistic about next year.

Lee Hong - Goldman Sachs

Who do you see as other players that also are starting to get into more active in the mobile advertising space?

Nick Yang

I think right now, because I am actually spending a lot of time in the field, there are three different types of companies working in the mobile advertising. One type of company is the guys who do what we call SMS spamming here in China; messaging your phone, you always get these SMS messages about everything from people selling their houses to buying new cars or some sauna place or whatever. So you get a lot of these short message spam. This kind of advertising is from companies who don’t care about brand at all. It’s these little mom-and-pop shops who just massively spam.

This is not the area we’re working after. We’re going after what we call the brand conscious companies; guys like Nike, guys like Blackberry, guys like BMW. These are the guys who we are going after because they want to use the wireless advertising medium, but they really care about the brand so they will never spam customers. This is what our value proposition to them is, that we provide a very good way for them to reach the customers in a very acceptable manner.

The third type of advertisers, besides the spammers and us, is the guys who are the traditional PC Internet players. They are also working in the wireless Internet area, but wireless Internet advertising is only a small faction for them, so they don’t spend that much efforts into post advertising customer work.

For example, some of the companies, we talked with some advertisers they’ve said the big portals, the PC portals give them some of the wireless advertising on their wireless portal, but they don’t even give them a good report. They don’t have customer service.

So that’s why they come to us; they come to KongZhong because we have a very professional pre-sales, sales execution, and the post sales reporting and customer service work. Also for KongZhong, one of the advantages we have is that we are a very complete wireless advertising platform compared to some of the WAP-only sites. For example, the free WAP sites you are probably aware of, those sites only have WAP advertising, but for KongZhong because we are a big MMS provider, because we are a big IVR provider, a big caller ringback tone provider, SMS provider, what we give to the customer is the full solution to all of the areas of wireless advertising.

So, for an advertiser to sign a contract with KongZhong, we give them besides advertising on our WAP portal we have MMS advertising, IVR, caller ringback tones, SMS as well as a community website, so for us, that’s why we believe we have a very good advantage going into 2008 in the wireless advertising field.

Lee Hong - Goldman Sachs

Regarding the traditional wireless value-added service of yours, obviously the whole sector has been pretty depressed. Besides the regulation, how do you characterize the actual underlying demand from the cell phone users and how do you characterize the current overall environment? If you look out into the next year or next several years, what’s your outlook regarding the industry?

Yunfan Zhou

I think basically there are two things we have really seen. One is that the growth of the mobile users is still growing pretty fast. In the past few years China adds about 50 million to 60 million new cell phone users each year and it seems that the trend is still continuing.

Secondly, people are changing their phones probably every 12 to 18 months here in China. So when they have the new phones, they need to have some personalized content. We feel that there is a continuous demand for the wireless value-added services for both the new users and the current users with new phones.

Basically we believe that as we are moving into a richer media area, that we definitely will be able to provide more content to users. Regulation is definitely one of the major concerns we have, because when a regulations changes, definitely it will hit the revenues. However, if we don’t pay much attention to that for now, we can be able to focus on the customer demand. We believe that there is still growing demand for users of every single type of accounts including MMS, including WAP, including IVR; all of these platforms and also JAVA games. We are pretty sure that this demand is still growing.

Operator

Your next question comes from Analyst for C. Ming Zhao – SIG.

Analyst for C. Ming Zhao - SIG

For your WAP, in the third quarter we saw there was a 6% sequential decrease. However, in your fourth quarter guidance, there will be a 10% increase. What’s the major driver for the WAP growth in the first quarter?

Sam Sun

The 6% decrease in WAP revenue in Q3, as we described in the earnings release, that is still the result of the continuing effects of China Mobile policies since May 2007. We believe in Q3 the effect has been fully absorbed. So in Q4, since the result has been fully absorbed and also with China Mobile’s grading systems starting to take place in Q3 and Q4, we think since we have done pretty well in the grading system, we’ve got pretty good results from the grading and we can enjoy some of the preferential treatment from China Mobile so that our WAP revenue can pick up the growth trend again.

Operator

We have no other questions at this time.

Sam Sun

Thanks to everyone for calling in, and we look forward to talking with you again next quarter. Thank you.

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