KongZhong Q3 2007 Earnings Call Transcript

Nov.19.07 | About: KongZhong Corporation (KZ)

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 Corporationearnings conference call. (Operator Instructions) I would now like to turn thepresentation over to your host for today’s call, Mr. Sam Sun, Chief FinancialOfficer of KongZhong. Please proceed.

Sam Sun

Thank you, Shawn. Hello, everyone. Welcome to KongZhongCorporation’s third quarter 2007 earnings conference call. You can find our Q32007 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 Chairmanand CEO; and Nick Yang, our President, on the line.

I will first go through our financial highlights. After mydiscussion, I will turn it over to Yunfan, who will then review our operationsand talk about our business outlook.

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

This is a combined result of movement of high gross marginSMS and JAVA and low gross margin IVR. We also made significant cost savingsefforts, 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 continuedits growth trend and reached $265,000 a 19% increase from Q2.

We continue our efforts in the wireless Internet business. InQ3, 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 GAAPearnings per ADS were $0.02 in Q3. Third quarter non-GAAP income was $1.37million, which excluded share-based compensation costs of $618,000 andamortization 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 hisremarks.

Yunfan Zhou

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

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

We believe we have laid a good foundation for the growth ofour wireless Internet business. Given the fact there are over 500 million cellphone users and over 140 million Internet users in China, the current about 40million 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 ourpartnership with NBA, MSN, Opera, et cetera, we are making our best efforts toincrease our brand awareness, traffic and mobile advertising revenue.

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

Sam Sun

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

Question-and-AnswerSession

Operator

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

Analyst for C. MingZhao - SIG

I have a couple of questions. Your fourth quarter guidancelooks 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 andthe 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. ForWAP 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 revenuelines will remain stable or may have very modest growth. For mobile advertisingrevenue, as I just mentioned, we should be able to see some growth also in themobile advertising area.

Analyst for C. MingZhao - SIG

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

Sam Sun

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

Analyst for C. MingZhao - SIG

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

Sam Sun

Excuse me, what’s the question?

Analyst for C. MingZhao - SIG

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

Sam Sun

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

Analyst for C. MingZhao - SIG

Why did your G&A expense decrease in this quarter? Willthis 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 toQ2. We think we already are doing pretty well in cost control so our feeling isthat in Q4, we won’t see a further decrease. At least not a significant furtherdecrease in the operating expenses.

Analyst for C. MingZhao - SIG

Given your competitors such as Hurray have done somerestructuring, 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 andthis year we are strengthening our efforts in the wireless Internet business. Wehave signed partnerships with the NBA, MSN and other partners and we believethis 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 stillthe very beginning, similar to the time that we experienced like in 2000-2001for the Internet. Still we have a pretty small user base for the wirelessInternet; however, with over 500 million cell phones, installed based in Chinawhich is still growing, we believe the wireless Internet will probably be thenext big thing in China.

Operator

Your next question comes from Mike Olson - Piper Jaffray.

Mike Olson - PiperJaffray

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 about2008 but since our opinion is the WVAS business began to stabilize in Q4, guidanceis better than Q3 actual. Right now, the feeling is that 2008, for the quarterperformance right now, the feeling is that it should be at least flat comparedto maybe Q4 levels. I mean, there is still uncertainty about the regulations. Inthe WVAS business there are always a lot of regulations from MMI and ChinaMobile and other telecom operators. We think that uncertainty is still therebut the business is should begin to pick up.

Nick Yang

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

Mike Olson - PiperJaffray

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

Nick Yang

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

Operator

Your next question comes from Lee Hong - Goldman Sachs.

Lee Hong - GoldmanSachs

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

Sam Sun

Lee, excuse me, what’s the question?

Lee Hong - GoldmanSachs

Share-based compensation, what percentage for each operatingexpenses 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 itis another $235,000.

Lee Hong - GoldmanSachs

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

Sam Sun

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

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

Lee Hong - GoldmanSachs

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

Sam Sun

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

Nick Yang

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

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

Lee Hong - GoldmanSachs

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

Nick Yang

I think right now, because I am actually spending a lot oftime in the field, there are three different types of companies working in themobile advertising. One type of company is the guys who do what we call SMSspamming here in China;messaging your phone, you always get these SMS messages about everything frompeople 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 fromcompanies who don’t care about brand at all. It’s these little mom-and-popshops who just massively spam.

This is not the area we’re working after. We’re going afterwhat 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 touse the wireless advertising medium, but they really care about the brand sothey 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 veryacceptable manner.

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

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

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

So, for an advertiser to sign a contract with KongZhong, wegive 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’swhy we believe we have a very good advantage going into 2008 in the wireless advertisingfield.

Lee Hong - GoldmanSachs

Regarding the traditional wireless value-added service ofyours, obviously the whole sector has been pretty depressed. Besides theregulation, how do you characterize the actual underlying demand from the cellphone users and how do you characterize the current overall environment? If youlook out into the next year or next several years, what’s your outlookregarding the industry?

Yunfan Zhou

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

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

Basically we believe that as we are moving into a richermedia area, that we definitely will be able to provide more content to users. Regulationis definitely one of the major concerns we have, because when a regulationschanges, definitely it will hit the revenues. However, if we don’t pay muchattention to that for now, we can be able to focus on the customer demand. Webelieve that there is still growing demand for users of every single type ofaccounts including MMS, including WAP, including IVR; all of these platformsand 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. MingZhao - 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 a10% 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 theearnings release, that is still the result of the continuing effects of ChinaMobile policies since May 2007. We believe in Q3 the effect has been fullyabsorbed. So in Q4, since the result has been fully absorbed and also withChina Mobile’s grading systems starting to take place in Q3 and Q4, we thinksince we have done pretty well in the grading system, we’ve got pretty goodresults from the grading and we can enjoy some of the preferential treatmentfrom 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 totalking with you again next quarter. Thank you.

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