The Bull Case for LinkTone: Rapid Growth, Cheap vs. Peers (LTON, TOMO, HRAY, KONG)

by: Kevin Chou

I’ve mentioned before how I’m interested in investing in a Chinese VAS (Value Added Service) company that sells ringtones, wallpapers, games, IVR (interactive voice recognition) services, and various applications. In China, there are four public companies that represent pure plays in this segment: Tom Online (TOMO), HURRAY! (HRAY), KongZhong (KONG), and LinkTone (LTON). Why is this segment interesting? Consider the market:

* There are 363 million cell phone users in China, which is the largest in the world (according to MLL, June 2005)
* China’s mobile phone market is growing at about 5 million subscribers a month (which means about 400 million currently)
* An estimated 300 million “middle class” Chinese consumers have discretionary income
* People in China can’t afford computers, so the cell phone is the primary platform for information and digital entertainment. This is great for companies selling software and media to consumers on the mobile platform.

In a strange, backwards way, the US market lags Asian and European markets in the mobile space by about 12-18 months, while the United States leads other parts of the world in terms of Internet technologies. Again, it all has to do with the platform that consumers use to gather information and entertain themselves.

OK, so back to Linktone. We know the market is great. But how do we pick which of the four companies represents the BEST investment? Some investors only want to invest in the very best company, or the second best company - which is fair. After all, Cisco, Oracle, Microsoft, Dell - all market leaders that ended up crushing their competitors.

But sometimes it’s good to be in the laggards. And I’ll give you my perspective on why -- here are two big reasons:

1. A consolidating market - In a good growth market, the #1 or #2 guy is trading at a premium to their competitors, so it makes sense to buy their competition, cut costs, raise prices, and immediately get a valuation hit. Cisco wrote the book on this strategy back in the bubble days.
2. Valuations are depressed. For one reason or another, the market could unfairly punish a company that has repeatedly disappointed. This is the opposite of momentum investing. To do this right, you really have to do your homework on why a company is being punished in the stock market. Sometimes this is very dangerous, and technical investors call this 'catching a falling sword'.

Ebay is a good example of a great company that has recently seen Google start to eat its lunch. I think it’s in a falling sword pattern and greatly caution picking up EBAY stock. Those who got into EBAY in Feb after the company missed earnings and became 'cheap' were punished again in late April:

Again, back to LTON. First, I think LTON makes a great acquisition candidate by TOMO or KongZhong. But I’m not betting on that. But if they do get acquired, that’s gravy. What I like about LTON is that it is severely undervalued compared to its peers. Part of it has been that they’ve performed poorly financially. And the other part is that they’ve just finished replacing the CEO -- management change ups always worry investors, much like the star pitcher getting on the injured list. However, a lot of the restructuring is now behind the company, and management is now refocused on the business.

Here are the valuation ratios I’m looking at (from Yahoo Finance). I’m going to focus on three ratios - Enterprise Value to Revenue [EV/R], Enterprise Value to EBITDA [EV/E], and forward Price to Earnings [P/E] multiples. Someday maybe I’ll post a more detailed background into why I think these three valuation ratios are the most important. (email me at if you’d like a quick answer)

1. Tom Online (ticker: TOMO)
1. EV/R = 8.4x
2. EV/E = 29.5x
3. P/E = 22.0x
2. HURRAY! (ticker: HRAY)
1. EV/R = 2.0x
2. EV/E = 6.8x
3. P/E = 10.5x
3. Kongzhong (ticker: KONG)
1. EV/R = 4.6x
2. EV/E = 13.2x
3. P/E = 14.5x
4. Linktone (ticker: LTON)
1. EV/R = 1.6x
2. EV/E = 7.3x
3. P/E = 13.5x

LTON is clearly trading at a discount to its peers, has revenues similar to KONG, is profitable, and grew revenues by almost 50% year over year. What tech companies with 45% gross margins growing at 50% annually trades at 1.5X revenues?? Better yet, it’s trading near an all-time low since going IPO on the NASDAQ in late 2004.

Note: LTON reports earnings today.

LTON 1-yr chart:

Kevin Chou is a Venture Capitalist at Canaan Partners, a Silicon Valley venture firm that invests in high technology entrepreneurs. His specialty area is investing in digital media, communications, software and Internet companies around the world. On the side, Kevin authors FinanceHuddle, a blog about his personal investments and viewpoints on technology stocks.