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AsiaInfo Holdings, Inc. (NASDAQ:ASIA)

Q3 2012 Earnings Call

October 31, 2012 8:00 p.m. EDT

Executives

Jimmy Xia – Head of IR

Steve Zhang – President and CEO

Michael Wu – CFO

Analysts

Sam Li – Goldman Sachs

Qin Zhang – J.P. Morgan

Clara Fan – Jefferies & Co.

Leping Huang – Nomura

James Friedman – SIG

Steven Liu – Standard Chartered Bank

Mars Cao – UBS

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Q3 2012 AsiaInfo-Linkage earnings conference call.

[Operator Instructions]. I must advise you that this conference is being recorded today, Thursday, the 1st of November, 2012.

I would now like to hand the conference over to your first speaker for today, Mr. Jimmy Xia, Head of IR for AsiaInfo-Linkage. Thank you. Please go ahead.

Jimmy Xia

Thank you. Hello everyone and welcome to AsiaInfo-Linkage’s third quarter 2012 earnings conference call. Today, Steve Zhang, AsiaInfo-Linkage’s President and CEO, will review business highlights from the quarter and discuss the company strategy. Our Chief Financial Officer, Michael Wu, will discuss financial results for the third quarter 2012 and give guidance for the fourth quarter.

Before we continue, please allow me to read you AsiaInfo-Linkage’s Safe Harbor Statement. Information discussed during this conference call might be forward-looking in nature and therefore subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. To understand the factors that could cause results to materially differ from those in the forward-looking statements, please refer to our annual report on Form 10-K for the fiscal year ended December 31, 2011 and reports subsequently filed with the SEC.

Please note that some of the information to be discussed today includes non-GAAP financial measures as defined in Regulation G. The most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to AsiaInfo-Linkage’s financial results prepared in accordance with GAAP are included in our earnings release which has been posted under IR section of the company's website.

Also please note the company will not comment on the "Going Private" transaction while the process is ongoing, and the company will disclose these developments when appropriate. A special committee continues to work with both its legal and financial advisers in taking the best course of action for our investor base. As previously noted, there can be no assurance that any definitive offer will be made, that any agreement will be executed, or that this or any other transaction will be approved or consummated.

Finally, please note that, unless otherwise stated, all figures mentioned during this conference call are in US dollars.

I will now turn the call over to AsiaInfo-Linkage's President and CEO, Steve Zhang. Please go ahead, Steve.

Steve Zhang

Hello everyone, and thanks for joining us today. In the third quarter of 2012, we met both our top line and non-GAAP EPS guidance, recording net revenue of $129 million and non-GAAP EPS guidance of $0.24. Demand for our services remained strong as developments in 3G and broadband continue to drive investment in the IT service sector. China's carriers remain focused on developing ways to monetize our massive amount of data traffic. We are well-positioned to continue to benefit from this underlying trend.

Turning to our three main customer accounts, and starting with China Mobile. We signed all of our remaining NG BOSS 3.5 contracts with the carrier in the third quarter. We are also following up on a few remaining NG BASS 3.5 or BI software upgrade, which will likely be completed by yearend. The specifications for NG BOSS 4.0 and NG BASS 4.0 have been completed. It will take another year to sign all of the upgrade contracts, and we are hopeful to start a number of them by yearend. As I noted last quarter, the NG BOSS 4.0 system has unique functionality that will enable the carrier to run more efficient retail business with real-time user notification capability.

As mentioned previously, we started working on our new solution for China Mobile called Data Traffic Monetization, essentially allows the carriers to monitor data traffic usage across its 2G, 3G and wireless LAN networks, as well as upcoming LTE networks. The product provides a detailed picture of how customers are using the network, either gaming, texting, microblogging, and so on. This solution is made possible through our existing Business Intelligence solution base as well as our newly-developed solution, which provides additional customer usage data and will likely be a focus area for China Mobile.

Cloud-based technology also remains an area in which we are exploring more projects. We have already delivered one solution for China Mobile called [inaudible]. Basically it allows subscribers to view their account records on their web applications, their smartphones or in retail shops. The concept is not new, but our architecture significantly reduced the cost for this type of functionality, making it more widely available. We're excited about the potential application.

For our China Unicom account, our products for all six northern provinces convergence software upgrades have signed -- our products for all six northern provinces software upgrades have signed the second phase of the software and license contracts, and also signed two provincial contracts for software implementation and maintenance. And we expect to sign four more in the near future. We anticipate those provinces will follow the usual maintenance and upgrade cycle, including periodic mandatory upgrades as set by the carrier's central headquarters.

The e-channel system that we built for the carrier has been performing well. In fact, China Unicom executed a nationwide marketing campaign through this system this past summer. And the results were fantastic, with over 300,000 promotional 3G subscription sold. Also we continue to develop an OSS system for China Unicom that is currently in trial phase. This new system will ultimately support broadband and fixed-line services.

Our China Telecom business is stable and we are executing according to our long-term plan. To refresh your memory from last quarter, by the end of the third quarter we signed Billing 2.8 and the CRM 2.0 contracts with the majority of our provincial network customers. The remaining provinces I expect to sign soon.

We are seeing more Business Intelligence related opportunities which China Telecom refers to as data domain application. We are increasingly engaged at the headquarter level as opposed to the provincial and the operational levels, which helps to make our planned implementation more streamlined and efficient. The overall goal is to collect data and build robust [analytical] system across the entire group so the carrier can launch more effective marketing campaigns. As you can see, this continues to be a common theme with all three carriers.

With that, I will ask Michael to discuss our financial results in greater detail. Michael?

Michael Wu

Thank you, Steve, and hello to everyone on the call. Please note that all numbers I will discuss today are in US dollars unless otherwise noted.

Total revenue for the third quarter of 2012 were $132 million, an increase of 11% year-over-year and an increase of 5% sequentially. Net revenue, non-GAAP, for the third quarter of 2012 was $129 million, an increase of 10% year-over-year and an increase of 4% sequentially. The

year-over-year increase was primarily the result of continued investment in vital software and services by China telecommunications carriers and their provincial-level entities.

Gross margin for the third quarter was 37% compared to 44% in the year-ago period and 39% in the previous quarter. Gross margin of net revenue, non-GAAP, was 43% in the third quarter of

2012 compared to 49% in the year-ago period and 44% in the previous quarter. The year-over-year decrease in gross margin was primarily attributable to an increase in employee compensation, which was mainly due to the hiring of approximately 970 additional implementation engineers and overall wage inflation. The year-over-year decrease in gross margin, non-GAAP, was mainly attributable to an increase in the number of implementation engineers and wage inflation. And the slight sequential decrease in both gross margin and gross margin on non-GAAP basis was primarily due to an increase of approximately 300 implementation engineers for the current and anticipated contracts.

Total operating expenses in the third quarter of 2012 increased 27% year-over-year and 1% sequentially to $47 million. The year-over-year increase was primarily attributable to an increase

in G&A expenses, as well as increase in sales and marketing expenses and R&D expenses to develop products for anticipated contract opportunities, to support overall product standardization, and to enhance delivery. The sequential increase in operating expenses was primarily attributable to an increase in sales and marketing expenses, which was partially offset by a decrease in G&A expenses.

Sales and marketing expenses in the third quarter of 2012 increased 23% year over year and 9% sequentially to $20 million. The year-over-year increase in sales and marketing expenses was the result of international market expansion and general wage inflation. The sequential increase was mainly due to a greater number of customer workshops and meetings related expenses in this quarter.

G&A expenses for the third quarter of 2012 were $6 million, representing a year-over-year increase of 182% and a sequential decrease of 20%. The year-over-year increase was mainly attributable to an increase in wage inflation along with the raise in headcount, as well as a $1 million reversal of doubtful accounts in the third quarter of 2011. The sequential decrease in G&A expenses was mainly the result of enhanced cost controls.

R&D expenses for the third quarter of 2012 increased 12% year over year and increased 2% sequentially to $21 million. The year-over-year increase in R&D expenses reflected an increase in total compensation as a result of wage inflation plus the hiring of approximately 160 R&D engineers. The sequential increase in R&D expenses was primarily due to the hiring of approximately 100 additional R&D engineers in this quarter.

Income from operations for the third quarter of 2012 was $2 million, representing a year-over-year decrease of 86% and a sequential increase of 11%.

Operating margin of total revenue was 2% for the third quarter of 2012 compared to 13% in the year-ago period and 2% in the previous quarter. Operating margin of net revenue, non-GAAP, for the third quarter of 2012 was 12%, compared to 24% in the year-ago period and 12% in the previous quarter. The year-over-year decrease in operating margin of net revenue, non-GAAP, was mainly attributable to the increases in employee headcount and wage inflation, which led to the increase in cost of sales and R&D expenses. The sequential decrease was primarily due to an increase in the number of implementation and R&D engineers.

Other income for the third quarter of 2012 was $2 million compared to $1 million in the year-ago period and $4 million in the previous quarter. The year-over-year increase was primarily due to the improved returns from bank deposits and a $1 million impairment loss on short-term and long-term investments in the third quarter of 2011. And the sequential decrease reflects a $1 million gain from sales of investment products in the second quarter.

In the third quarter of 2012, the company recorded net income attributable to AsiaInfo-Linkage, Inc. of $5 million or $0.06 per basic share, compared to $13 million or $0.18 per basic share in the year-ago period, and $6 million or $0.09 per basic share in the previous quarter. In the third quarter of 2012, net income attributable to AsiaInfo-Linkage, Inc., non-GAAP, was $17 million or $0.24 per basic share. Net income attributable to AsiaInfo-Linkage, Inc., non-GAAP, in the year-ago period was $27 million or $0.37 per basic share. Net income attributable to AsiaInfo-Linkage, Inc., non-GAAP, in the previous quarter was $19 million or $0.26 per basic share. Net income attributable to AsiaInfo-Linkage, Inc., non-GAAP, decreased 35% year over year and 7% sequentially due to the factors already discussed.

As of September 30, 2012, AsiaInfo-Linkage had cash and cash equivalents and restricted cash totaling $256 million and a short-term investment totaling $39 million. Operating cash flow in the third quarter of 2012 was a net inflow of $9 million. As of September 30, 2012, AsiaInfo-Linkage had gross accounts receivable of $282 million compared to $307 million as of June 30, 2012 and $292 million as of September 30, 2011.

Gross AR includes agent agreements with IBM or its distributors, as well as a few other hardware companies. Since these agreements typically consist of back-to-back payment terms for certain products sold to AsiaInfo-Linkage customers, there is no impact on company’s cash flow or DSO. Net AR, which excludes IBM-type arrangements, was $222 million as of September 30, 2012, compared to $223 million as of June 30, 2012 and $224 million as of September 30, 2011. The combined effect of revenue and the AR trends, including our focus on the collections process and the business trends, resulted in the company’s DSO being 151 days as of September 30, 2012, compared to 154 days as of June 30, 2012 and 159 days as of September 30, 2011.

AsiaInfo-Linkage expects fourth quarter 2012 net revenue, non-GAAP, to be in the range of $152 million to $156 million. And the company expects fourth quarter 2012 net income attributable to AsiaInfo-Linkage per basic share, non-GAAP, to be in the range of $0.40 to $0.43.

As a reminder, we'll not comment on privatization proposal or any other potential transactions involved with the company at this time. I will also not be able to comment on projections or financials beyond the fourth quarter.

So we'll now open to the questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions].

Your first question today comes from the line of Sam Li from Goldman Sachs. Sam, please go ahead.

Sam Li – Goldman Sachs

Hi, Steve and Michael. Thanks for taking my questions. My first question is about the 4Q guidance, since it implies over 20% year-on-year revenue growth, that will be surprisingly strong compared with the low double-digit growth in the previous three quarters. So, could you give a little bit more color on the reasons behind that strong growth? Thanks.

Michael Wu

Sam, this is Michael. There are main reasons for the stronger guidance for Q4. First of all, the system fluctuation of our business typically resulted in a stronger fourth quarter each year due to the increased spending from our telecommunication carrier customers. Secondly, as we have been -- project some delayed contracts during the first nine months of the year and as we communicated previously, those delayed contracts will be realized or be signed in the fourth quarter, which will result in stronger year-over-year growth rate in the quarter.

Sam Li – Goldman Sachs

Okay. So that's mostly happening with the domestic three telcos, right?

Michael Wu

That's correct.

Sam Li – Goldman Sachs

Okay. Thank you. My second question is that we hired close to 500 new engineers in the third quarter. I'm wondering what business or project that we are having them for. Is it domestic business or overseas business? And if it's domestic, would it be China Mobile, Unicom or Telecom? Thanks.

Michael Wu

In the Q3 we hired approximately 400 people, out of which 300 people are delivery engineers and 100 people are R&D engineers. So those additional hirings are part of the execution of growth strategy, including the product standardization, overseas expansion, and also mainly to support the realization of the existing and anticipated contract in Q4. So in short, the people we add in is to generate revenue and contract in Q4.

Sam Li – Goldman Sachs

Okay. Thank you.

Operator

Your next question today comes from the line of Qin Zhang from J.P. Morgan. Qin, please go ahead.

Qin Zhang – J.P. Morgan

Hi. Good morning. I have three questions. The first is that, we understand that the China Mobile will accelerate the TD-LTE deployment starting in 2013. So, could you share some of your insights into how would this development impact AsiaInfo's business prospect in the next, let's say, one to two years?

Steve Zhang

Qin, this is Steve. As you mentioned, there is a plan from China Mobile for the trial of TD-LTE network in several major cities. And we do see there will be increasingly new demand on their IT system to support this LTE network deployment. For example, we have already been involved in Shanghai and Tianjin to do the trial for a system called PCC, it's called Policy Control Point. It's a solution that will enable the network to be able to set up the rules to monitor the data traffic as well as in real-time to execute those rules based on the traffic in the network. So we do see those potential new requirements to support the eventual launch of China Mobile's TD-LTE network.

Qin Zhang – J.P. Morgan

I see. But do we expect that the demand, the IT system upgrade demand to pick up starting 2013 or it's most likely to be in 2014?

Steve Zhang

As Michael mentioned, we are not commenting on any financial projection beyond the fourth quarter.

Qin Zhang – J.P. Morgan

Okay. Sure. Yeah. And another question is relating to our gross margin. Basically in the first nine months of this year we've seen a decreasing gross margin compared with the previous year. And my understanding is that this is basically due to cost cutting efforts at carriers, particular at China Mobile. So when we look at -- I understand we do not give financial forecast before the next one to two years, but just that I'm wondering in terms of the overall trend, do we expect in the next couple of quarters, do we expect gross margin to be largely stable or there's further room for gross margin to fall?

Michael Wu

Qin, as the privatization process going on, so we're not really able to comment on any financial forecast or expectation beyond Q4.

Qin Zhang – J.P. Morgan

Okay. Okay, understand. Yeah. And my last question is relating to our business development in overseas, both in Southeast Asia and also in Europe. Do we have any update?

Steve Zhang

Not really much update. We're just very busy in trying to deliver the three projects we already signed in Southeast Asia. We already have the system in production for U Mobile. And there's also a milestone we need to meet in December for our Nepal contract. And I think we are making good progress.

And for Europe, we just recently started trying to hire people, looking at the market. So there's really not much activity to be commented on.

Qin Zhang – J.P. Morgan

Okay. Thank you. That's all for me.

Steve Zhang

Okay.

Operator

[Operator Instructions]. Your next question comes from the line of Clara Fan from Jefferies. Clara, please go ahead.

Clara Fan – Jefferies & Co.

Hi. I've got two questions. Firstly, you previously guided that AsiaInfo will be hiring 500 staff for the year, and since March up to third quarter we've already hired 500 staff. Do we expect to hire more in the fourth quarter? And what is average salary increase for this year? Thank you.

Michael Wu

We have the plan to recruit approximately another 400 people in Q4, and the previous communication for the projection of additional headcount in the full year is the average headcount. So, 400 Q3, 400 Q4, so which will lead to the average 400 to 500 people in full year.

In terms of wage inflation and salary increase, we made an overall company wage inflation or salary increase July 1, which should range 8% to 8.5%, is the wage inflation rate.

Clara Fan – Jefferies & Co.

Okay. Thank you. Also, do we have a revenue breakdown by three telcos? And which carrier has the highest revenue booked this quarter? Thank you.

Michael Wu

The revenue breakdown by customer is approximately 52% contributed from China Mobile and 26% from China Unicom, 18% from China Telecom. And the rest from our cable and overseas business.

Clara Fan – Jefferies & Co.

Okay. Thank you.

Operator

Your next question today comes from the line of Leping Huang from Nomura. Leping, please go ahead.

Leping Huang – Nomura

Okay. Thank you, management. I have one question. So, from the hardware, telecom hardware vendors, we heard the delay in the CapEx. Do you see -- I see this quarter result is 10% growth year to year. Do you see any delay in the CapEx or do you see any change on operator payment cycle which will affect your balance sheet? Yeah. Thank you.

Steve Zhang

This is Steve. We are not seeing much impact for our business because we still think the competition among the carriers are driving a lot of more demand for sophisticated IT solutions. We are also not seeing much change in their payment cycle.

Leping Huang – Nomura

Okay, yeah.

Operator

Your next question today comes from the line of James Friedman from SIG. James, please go ahead.

James Friedman – SIG

Hi. Thanks for taking my question. My first question, Steve, was I was wondering if the proposed privatization has impacted the demand for the company either favorably or otherwise.

Steve Zhang

You mean from the customer?

James Friedman – SIG

Yeah, I'm sorry, from your customers' perspective.

Steve Zhang

No. It doesn’t have any impact either positively or negatively.

James Friedman – SIG

Steve, is it something that your customers are aware or, you said not even in the realm of conversation?

Steve Zhang

They are aware of this proposed transaction as it's already in the public domain.

James Friedman – SIG

Okay. But from your perspective, it doesn’t seem to be impacting customer level demand?

Steve Zhang

No.

James Friedman – SIG

Okay. And then my other question was, with regard to the cash flow, the company had a good cash flow quarter, Michael, and it's nice to see the improvement on your DSOs. Do you think that, I realize you'll not give long-term targets, but in your Q4 projections, do you anticipate that that trend which has some seasonality will continue?

Michael Wu

Yeah, I see the DSO will continue to improve in Q4 given Q4 is typically the strongest quarter of customer spending behavior. I think that pattern will be continued.

James Friedman – SIG

Okay. And then the last thing for me, I know others have asked you about this already on the Q&A, but the Q4 guidance does seem particularly robust and I've gotten some emails from clients asking about that. Could you comment on your visibility with regard to the Q4 given that the guidance seems to have an upward bias?

Michael Wu

As I mentioned earlier, the strongest quarter in Q4 is mainly due to the realized booking of some of the delayed contracts on the first nine months this year. And the cost delivery and implementation cost associated with those delayed contracts has been already booked in the historical quarters in the year. So that two factors will make our guidance look stronger.

James Friedman – SIG

Yeah, makes sense. Okay. Thank you very much.

Michael Wu

Sure.

Operator

[Operator Instructions]. Your next question comes from the line of Steven Liu from Standard Chartered Bank. Steven, please go ahead.

Steven Liu – Standard Chartered Bank

Thank you, Michael and Steve. I have two questions. One is regarding the revenue breakdown. After taking off the China Mobile, Telecom, Unicom, you implied very strong growth on Q-on-Q in the past three quarters, I mean revenue from cable and overseas. I mean, is the strong revenue really from cable or overseas, I mean just some color on that?

Steve Zhang

I think the growth are across all our customer segments. It's not particularly from one group of customers.

Steven Liu – Standard Chartered Bank

Yeah. So I mean, between cable and overseas, which segment grows much stronger, I mean?

Michael Wu

Steve, this is Michael. The cable and overseas today are still a small piece of total revenue. The overseas in total represent roughly 1.5% of total revenue and the cable is 1.2%, 1.3% of total revenue. So it's still a small piece of business.

Steven Liu – Standard Chartered Bank

Okay, thank you. And regarding the strong fourth quarter, if you take off the impact from the delayed project booking on the cost, what kind of Q-on-Q momentum in the revenue and recurring net profit, still flat if you take off the impact from the delayed contract, the [recognization], what the Q-on-Q performance relatively, also was it strong or just flat?

Steve Zhang

I don’t understand your question.

Steven Liu – Standard Chartered Bank

I mean your strong fourth quarter guidance is based on -- due to some booking of delayed projects in previous quarters. I mean if you take off the impact of the delayed project, I mean what kind of growth for the fourth quarter compared with third quarter and second quarter.

Michael Wu

Steve, I think if you look at the full year forecast, given the Q4 guidance already provided, which will give you a kind of a normalized projection across the quarter, so the full year, the revenue growth will be in the range 13% to 14% -- over 14%. And the operating margin on non-GAAP base will be approximately 14-plus percent. So that will be kind of a normalized forecast for the year.

Steven Liu – Standard Chartered Bank

Yeah. Okay. Maybe -- I mean the fourth quarter revenue is a very big growth Q-on-Q, maybe some one-off items. I mean, does that mean after the recognition of delayed projects, the revenue will come down again starting from first quarter next year? I know you don't give guidance, but any color on that? Is it recurring or just one-off item boosting the fourth quarter results on the revenue side?

Michael Wu

The delayed contracts in Q4 will be a one-off, but the pre-contract services, that is a common practice in our business, that will be continuing. And next year, the seasonality, because you understand our business typically in seasonality, typically Q4 is a stronger quarter and the first half of the year may be slower. So that seasonality will be continued next year.

Steven Liu – Standard Chartered Bank

Okay. Thank you.

Operator

Your next question today comes from the line of Mars Cao from UBS. Mars, please go ahead.

Mars Cao – UBS

Good morning, Steve; good morning, Michael. Yeah, I have a question, like what has been discussed, this year Unicom has delayed some of its project. Some other vendors stating that some provincial contracts now have to be signed, approved by the headquarters. Do you associate the same situation from our company, and do we forecast that such a situation will continue into the next year? And how about the situation of the other two companies, China Mobile and China Telecom? Thank you. That's my question.

Steve Zhang

I think for China Unicom it has always been the case where most of the majority contracts need to be approved at the headquarter level. And once some of the IT budget are allocated to the provincial level, the province is assigned the maintenance service contracts at the provincial level. So we don't see much change in terms of sales contract signing or approval process at Unicom.

Mars Cao – UBS

Okay. So this has not -- may change much next year, so --

Steve Zhang

We do see some signing process is getting longer because it involves more people putting their signatures on the contracts.

Mars Cao – UBS

So the delay will be normalized in the following --

Steve Zhang

I think it will become a normal process, because it is getting more complicated and the process getting a contract into the final signature is getting longer than before.

Mars Cao – UBS

So this means that in the following years Q4 will be a more heavy season, so the seasonality will be more significant going forward, can I understand that?

Steve Zhang

It's always the case that Q4 is a strong one, Q1 tends to be a weak one. I mean that's also the case in the last five, six years, if you look back -- look back at our historical financials. So next year probably won't be much different.

Mars Cao – UBS

Okay, understand. Thank you. That's all.

Steve Zhang

Okay.

Operator

Ladies and gentlemen, there are no further questions on the line today. I would now like to hand the call back to your presenters. Please continue.

Jimmy Xia

Thank you very much, everyone, for joining the call today. If you have any additional questions, please reach out to us. Have a good evening or have a good morning. Thank you. Bye-bye.

Operator

Ladies and gentlemen, that does conclude the conference for today. Thank you all for your participation. You may all disconnect.

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