KongZhong Q2 2006 Earnings Conference Call Transcript (KONG)

| About: KongZhong Corporation (KZ)
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KongZhong Corporation (KONG)

Q2 2006 Earnings Conference Call

August, 14, 2006 8:30 pm ET

Executives

Yunfan Zhou - Chairman of the Board, Chief Executive Officer

Nick Yang - President

J.P. Gan - Chief Financial Officer

Analysts

Michael Zhang - ThinkEquity Partners

William Bing - Deutsche Bank

Lu Sun - Lehman Brothers

Paul Bieber– Piper Jaffray

Kip Low – Goldman Sachs

Lee Pang – Pacific Crest Securities

Ming Lu –

Chang Qiu – Forun Technology Research

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2006 KongZhong Corporation earnings conference call. My name is Shamika and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference.

(Operator Instructions)

I would now like to turn the presentation over to your host for today’s call, Mr. J.P. Gan, Chief Financial Officer. Please proceed, sir.

J.P. Gan

Thank you. Hi, everyone, welcome to the KongZhong Corporation second quarter 2006 earnings conference call. You can find our second quarter earnings press release at our website, ir.kongzhong.com. Again, I am J.P. Gan, 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 second quarter financial highlights. After my discussion, I will turn the floor to Yunfan. He will review our operations and talk about our outlook.

We had another great quarter. Our second quarter total revenue increased 64% year over year, and 8% quarter over quarter to reach a new record of over $30 million. We have executed well our diversified growth strategy. Our revenue from customers of China Unicom, China Telecom, and China Netcom was about $6.9 million, accounting for 23% of total revenue, and compared to 9% in Q1.

As discussed previously, 2G business and non-China mobile business generally have lower gross margin. Despite an increase in 2G and non-China mobile revenue as a percentage of total revenue, our gross margin was 57%, only one percentage point lower than Q1.

Each of the line items in the cost of sales as a percentage of revenue was pretty much similar to Q1. In Q2, revenue sharing payments to telecom operators was about 16% of the revenue.

Payment to the handset manufacturers was about 12% of the total revenue.

Transmission fees was about 7%, and content was 5% of the total revenue.

Other expenses, including depreciation and bandwidth costs, was about 3% of total revenue.

Total operating expenses in Q2 2006 was a little over $10 million, a 9% increase sequentially. The increase in operating cost is primarily driven by a nationwide marketing campaign for our wireless Internet portal, kong.net, and the KongZhong corporate brand. The campaign was launched in late May and the first phase of the campaign will be completed later this month.

We also recorded a non-cash share-based compensation expense of $470,000 in Q2 compared to $348,000 in Q1.

Our U.S. GAAP net income was $7.6 million. Diluted U.S. GAAP earnings per ADS were $0.21 in the second quarter.

Starting in Q1 2006, we began to present you with non-GAAP income. This will give you an apples-to-apples comparison to analyze our target growth trends.

Second quarter non-GAAP income was $8.2 million, a 5% increase from the previous quarter. Diluted non-GAAP income per ADS was $0.23, up from $0.19 in Q2 2005 and up from $0.22 in Q106.

Non-GAAP income and non-GAAP earnings per ADS reached a new record again in Q2.

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

Yunfan Zhou

Thank you, J.P. First of all, we are very pleased that both our revenue and operating profit reached new records in Q2. We believe we have maintained our number two position in terms of revenue in the Chinese WVAS industry. As previously announced, we anticipate challenges in the remainder of 2006 due to policy changes at telecommunication operators in China. In response to that, we have recently completed a headcount reduction program to layoff approximately 15% of our workforce. We will continue to reduce costs and improve efficiencies, with the goal of maintaining profitability. Given our experience and strong execution capability, we are confident that we can get through this difficult time and continue to deliver returns for our shareholders.

Our Q2 revenues grew 8% sequentially to a new record of over $30 million, meeting our Q2 guidance. Our U.S. GAAP net income reached $7.6 million. Diluted earnings per ADS were $0.21, meeting our Q2 guidance.

Based on information available by now, and absent any significant changes in policies and regulations of the telecom operators and the Ministry of Information Industry, we expect our Q2 revenues to be between $23 million and $24 million.

We also revised our full-year 2006 annual guidance from previously projected of between $85 million and $105 million to between $97 million and $105 million.

In terms of revenue breakdown from different operators, our revenues from China Unicom, Telecom, and Netcom accounted for 23% of the total revenue in Q2, compared to only 9% in Q1, as the policy changes from these three operators has much less negative impact on the revenues than China Mobile’s policy changes. We expect our revenues from these three operators will continue to grow in Q3.

In the long term, we believe our diversified operator relationships will help us minimize the risks of depending on a single operator and give us more advantages in preparing for the upcoming 3G services in China.

To summarize, despite a short-term hit on revenue by policy changes, we are confident about the long-term growth of the WVAS industry in China. We believe KongZhong will continue to execute well, and gain market share in the future.

In Q2, we launched our first national marketing campaign for our wireless internet portal, kong.net. The focus of the kong.net brand and the wireless Internet concept, we spent about $1.5 million in this marketing campaign in Q2. We put ads on China’s central television, LCD office buildings, radio, billboards, buses, subways, in Beijing, Shanghai, Guangdong, and other major cities in China. We believe this campaign is very successful, by significantly increasing our brand awareness as well as traffic.

In Q3 and Q4, we will continue to invest in kong.net. Although we are facing a difficult time in WVAS, KongZhong’s management firmly believes that continuous spending on marketing dollars on kong.net is the right strategy for us to achieve our vision, which is to build kong.net to be the largest wireless Internet portal in China. We are making our best efforts to balance making such investments in our brand while maintaining profitability.

To summarize, the two strategic business lines we have, WVAS and wireless Internet portal, are equally important for us. We believe we have maintained the number two player in the overall WVAS industry in China, and we are closing in the gap from the top player.

Wireless Internet portal is currently in the investment stage, but we believe it will be an important revenue and profit driver in less than two years time. The kong.net brand will become our core asset, which will have long-lasting value. Thank you.

J.P. Gan

Thank you, Yunfan. Operator, can you please open the line for questions?

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Michael Zhang with ThinkEquity Partners. Please proceed.

Michael Zhang - ThinkEquity Partners

Good morning. Great quarter. Two questions. The first one is about your guidance. It has several parts. It looks like the situation is not as bad as previously anticipated, so you narrowed the guidance range. My question is which part of the business is declining less than you thought, so you increased the lower end of guidance?

Also, I do not know if you can comment on the bottom line. Previously you mentioned $27 million to $32 million. At this point, I think it is outdated. Maybe you can briefly comment again your take for 2007.

Yunfan Zhou

Thank you for the question. I think for the first one, basically when we gave the first revised guidance for the full year 2006 in early July, after we heard the news of China Mobile’s policy changes, we did not have a very clear visibility of Q3 and Q4, so we gave a pretty broad range, from $85 million to $105 million. The low side was pretty conservative at that time. However, after probably about a half-month, we have a pretty clear look at Q3 and a better look at Q4 today, so we revised up the bottom part of the guidance while maintaining the upper side of $105 million.

In terms of business lines, I think the new policies which basically are two big ones. It is a free trail period extension from three days to a month. The second one is sending SMS notification to all the existing WVAS subscribers in August and September to remind them of their subscriptions of all the services from all the service providers.

These two major policies will actually hit our China Mobile’s SMS and MMS most. Both of these business lines we expect to have probably around 40% to 50% decline in Q3 over Q2 due to these two policies. It is pretty hard to really tell which one gives how much because they are happening together. However, we actually anticipate much less declining SMS due to our SMS business from Unicom, Telecom, and Netcom, and we still have growth out there. The whole SMS business, we expect to have 10% to 15% declines in Q3 over Q2. For that, we expect to have about 25% to 30% decline in Q3 over Q2, due to these policies.

Also, there is another policy for WAP, which is China Mobile will begin to cancel existing WAP subscriptions that have not been active for more than four months. The previous policy in Q1 was to cancel for eight months inactive users. In Q2, it started to cancel for six months, and right now it is four months, so that will also hit that.

For other business, like IVR, it is probably a little bit declined from Q2, while we still expect growth in the color ring back tone because it is not much affected by these policies.

So after all these calculations, we gave the number of $23 million to $24 million for Q3, and then we also gave a range for the whole year for the rest of 2006, which adds up to $97 million to $105 million.

J.P. Gan

Michael, let me comment on the second question, in terms of profitability. We are looking at Q3, as Yunfan mentioned, our revenue is going to be somewhere between $23 million and $24 million. As you know, a portion of our cost of sales is fixed costs, such as depreciation, bandwidth, and some of the content costs. We estimate about $1.2 million of our cost of sales is fixed over this time.

The rest of our cost of sales is actually all variable, such as the payment to handset manufacturers, revenue sharing payment to telecommunication operators. In Q3, as was Q4, the proportional revenue from 2G and also revenue from China Telecom, China Netcom, and China Unicom, is going to be much larger. The gross margin from those two business lines is going to be a little bit lower.

We think in Q3 our gross margin is going to be somewhere between 51% and 52%.

In terms of our total operating costs, given that the new policy changes at China Mobile do not come into effect until -- it was not announced until early July, so we are not able to dramatically change our cost basis. We did the 15% headcount reduction but we will see the benefit from that in Q4 rather than Q3. We believe the Q3 total operating cost is going to be similar to Q2. We will try our best to squeeze out about $0.5 million out of Q3.

So we are looking at our operating margin at somewhere between 11% and 12%, and our net margin with the interest income is going to be a full percentage point higher than our operating margin.

Michael Zhang - ThinkEquity Partners

What do you think about 2007? Do you think Q4 will be the worst for Kong, or are you uncertain at this point?

Yunfan Zhou

I think Q4, we still expect more impacts from these policies because the estimates reminders will be sent out in August and September, so hopefully we can recover in Q107. Right now, our expectation is to do our best to reduce cost and also improve operational efficiency, trying to offset some of these impacts from the policy changes.

J.P. Gan

Let me just quickly add on to that. We revised up the low end of our 2006 revenue guidance from $85 million to $97 million. If we meet our Q3 guidance of $23 million to $24 million, it will basically impart our Q4 revenue would be somewhere between $16 million and $24 million.

Currently, the visibility for Q4 is still relatively low. China Mobile’s provincial subsidiary just started to send out subscription notice to our subscribers, so it is still not clear how many of their subscribers will cancel their subscription as a result of those notices.

However, given the industry dynamics, we believe without any significant changes as the other telecommunication operators, as well as China Mobile, Q4 hopefully will be the bottom of the [inaudible], and we will resume growth in Q1 2007.

Michael Zhang - ThinkEquity Partners

Okay, that is great. The second part of my question is about your WIP business. Could you provide some general update on that part of the business, including some of the co-branding partners? I think you mentioned that before. When do you plan for the next round of the campaign, marketing campaign?

The last part is I think the speculations on China Mobile’s next move that will charge for the different rates for WAP users visiting [Mountain App] and other WAP sites, how likely it would happen and if it happens, what kind of impact does it have on your WIP strategy? Thank you.

Nick Yang

A little bit of an update on the wireless Internet portal business, recently we have just completed a campaign during the World Cup event in the summer, and that has been very, very successful. If you look at the numbers of the page views, we have not mentioned before -- before the campaign, we had about 20 million page views per day. Right now, we are close to 30 million page views per day. You can see in many aspects of our wireless Internet portal business has improved quite a bit in terms of user traffic and user activity on our site.

About the partnerships, we have partnered with many of the handset manufacturers in promotion and other areas of cooperation with the wireless Internet portal. I believe it is definitely a strategic direction for the company to go, to invest more into this area.

As far as you mentioned the policy involving the wireless Internet portal business, or this free WAP model, is that although there are many different things in the market about the potential policies from China Mobile, I believe it is to the user’s best interest to use the wireless Internet portal, as with the Internet model.

I believe in the long-term, the policies will not be good for the industry. As far as the temporary industry policies, we will have to wait and see.

Yunfan Zhou

I will just add on, for the co-marketing partners, right now we are completing the first phase of the campaign and also starting to do more co-marketing events.

For example, we are doing co-marketing with Motorola, Samsung, and Sony Ericcson to put out their new cell phone models on our auto-adds, and they give us many cell phones in exchange for us to use for promotion of the wireless portal.

For the policy side, I think right now, a lot of people expect that China will give 3G licenses, either later this year or early next year, because the Beijing Olympics will be coming up in just two years time.

We believe that there will be at least two to three 3G licenses given to the operators in China. At that time, the competition in the wireless Internet, in the beta services, will be intensified. We believe that during the brand early on, the kong.net is very important for us.

The other policies are relatively less important because when we have 3G licenses, several competitors in the market, we believe they will issue new regulations and policies with the competition, so it is in the user’s best interest to choose the one that is highest brand name awareness and also the highest convenience to use.

One thing for sure is that we are going to provide kong.net service with every single operator that will have the 3G licenses.

Right now, whatever the policy will be, although we have not seen any new policies from China Mobile as you have mentioned, either the price difference or other policies. Whatever the new policies will be, we believe it will probably be in the short-term, feeling that it is only one operator has the dominant position here in China.

Michael Zhang - ThinkEquity Partners

When do you expect the next round of marketing campaign?

Yunfan Zhou

We already started it. We already started it. We are adding a lot of new buses here in Beijing and Shanghai, so this is probably the extension to the first phase, which will definitely end in late August. As Q3 is already half past, we believe that in Q4, there will be another new content out there for the kong.net.

According to our internal estimates, and we are also doing marketing analysis right now, we believe that this campaign had been a great help to our brand awareness in these big cities, so we believe this is very important for building the Internet asset.

Operator

Your next question comes from the line of William Bing of Deutsche Bank. Please proceed.

William Bing - Deutsche Bank

Just a couple of questions. Where are you seeing the cuts on the employee side? Is it across the board or in a particular area?

J.P. Gan

Yes, I think overall, it is across the board. We reduced headcount in pretty much all the departments.

William Bing - Deutsche Bank

In terms of the policies, the new policies that [inaudible], have they been uniformly rolled out across the provinces?

Yunfan Zhou

I think so, because the activate notifications and also the free trial period is uniformly enforced. However, as we mentioned in our earlier release, that some towns and local provinces, they are enforcing a [inaudible]. For example, the Guangdong and some other provinces, they give double confirmation to all the new users of SMS and NMS.

William Bing - Deutsche Bank

Okay. In terms of the traction that you are getting outside of China Mobile, can you just give us a little bit of color within each operator where you are seeing the most success?

J.P. Gan

I think right now, for Q2, China Mobile is about 77%. Unicom, we have about 12%, and telecom right now is about 8% and Netcom is about 3% of our revenue coming from these three outfitters.

William Bing - Deutsche Bank

Is it SMS or WAP or -- where are you seeing the strength within China Unicom, China Telecom, China Netcom?

J.P. Gan

Right now, from these three outfitters, since most of their service is offered in the 2G platform, right now the majority is still SMS and IVR and the color ring back tone. SMS is probably more than half of that, followed by the IVR and the color ring back tone.

William Bing - Deutsche Bank

Thank you.

Operator

Your next question comes from the line of Lu Sun of Lehman Brothers. Please proceed.

Lu Sun - Lehman Brothers

Thank you. Good morning, gentlemen. I have three questions. Number one is how much did Sharp Edge contribute to your second quarter ’06 revenue and profit? Thank you.

J.P. Gan

Sharp Edge contributed about $3.7 million in revenue, and $1.3 million operating income.

Lu Sun - Lehman Brothers

In terms of profit, in terms of their revenue outlook and older product mix in comparison to KongZhong’s traditional business, are there any differences? Are they more download base, usage base versus the original subscription-based model that you are [explaining]? Why do you have so much confidence that their business will continue to grow?

J.P. Gan

In Q3, we think Share Edge revenue is going to be about $5 million, and the operating profit is going to be about $1.8 million.

As Yunfan mentioned, the policy changes at the China Unicom, China Telecom, and China Netcom, are not as severe as China Mobile’s. As you know, Sharp Edge business is mostly 3G business, and mostly in SMS, color ring back tone, and IVR, so they have more download type of revenue rather than subscription-based revenue.

So far, we have not seen any major changes in those telecommunication operators. That is why we think our revenue from those three operators will continue to increase as the proportion of our total revenue.

Lu Sun - Lehman Brothers

I see. My last question is on your Java business. It seems like this business line actually declined quite a bit sequentially. What is the trend going forward?

Nick Yang

As far as Java, in our conference calls, which I have said before, that I believe the biggest constraint to the Java market is the China Mobile Policy. It was never good. So as you can see, the market release didn’t take off because I believe there is a big demand for gaming on the mobile, but the policies of admitting only a certain number of mobile handset markets to get into the Java games, and also the policy of they haven’t updated the [deck] I believe in the past few months. You can even check with the sources, with the operators. So the policy is just not good at all.

So right now the shift of our strategy in the gaming department is towards the mobile online games, the business model, rather than the mobile download games. Because the mobile online games are less dependent on the operators. That is why, as you can see, our Java revenue hasn’t grown very much. The entire market for Java hasn’t been doing very well. You can check with the market as well.

Lu Sun - Lehman Brothers

Do you think the take-up for the mobile online game is now pretty good? What is your outlook for the second half of the year?

Nick Yang

Right now, because the market is still emerging in the mobile gaming market, so our games are free right now. We have to get the user used to playing with these online games before we can charge them. Typically in online games, you offer it to customers free for a while so customers get attracted to the games before you charge them. We are in that period right now. We are seeing some traction with the customers who are using our games for free.

We are offering it as part of the [phone deck] portal. On our portal, there are games which you can download, whether it is a Java online game or WAP online game, there are two different models.

Lu Sun - Lehman Brothers

Going into the second half of the year, where would you add investments? Other than WAP or portals, what are the other areas that you see very good growth potential for the long term?

JP Gan

Overall, we continue to have two major business lines. One is WAP. The second is wireless internet portal. We don’t have any plans to launch any strategic initiative. So we will continue to focus on WAP will generate cash flow and operating profit for us in the coming quarters. We will focus on building up our wireless internet portal.

In terms of the wireless games business, I will just quickly add on to what Nick just said. Right now, the visibility for the Java business is still very low. As we talked about previously, China Mobile continues to be a bottleneck for rapid growth of the overall market. At the same time, there are players coming into the single downloadable Java game business. Some of them use various techniques to promote their rankings on China Mobile’s menu. That is the one of the reasons that our Java revenues have declined.

However, with the launch of the 3G network in China, we continue to believe Java games, as well as other wireless games, will be a very important growth area for us. However, the 3G visibility is very low, as many people know, in the market.

Lu Sun - Lehman Brothers

I have one small follow-up. You have actually $120 million cash on your balance sheet. Would you consider using some of that to buy back your shares, given that it is trading at almost historically low levels?

JP Gan

Yes, we are definitely considering it. The management team and the board of directors have been in continuous discussion regarding this topic. If we do decide to do a share buyback, we will announce it in due course.

Operator

Our next question comes from Safa Rashtchy – Piper Jaffray.

Paul Bieber– Piper Jaffray

Good morning. This is Paul Bieber for Safa. I have two questions. The first question is, at what level of traffic will you begin to monetize the web portal? The second question is, can you just repeat what you said about the levels of marketing spend in the second half?

Nick Yang

I think the traffic, the more the better, the more the merrier. To the advertiser, it is a matter of getting them to understand using the mobile platform as the advertising platform. If you look at the history of Internet advertising, when the penetration level of the Internet became quite good in China, many customers, because they are not in the age group of heavy mobile online services, you really have to convince these advertisers that this is a good marketing platform.

The good thing is that there are many players in the marketplace also doing the wireless Internet business model, who are also convincing the advertisers to advertise on those platforms. So I believe that with our collective efforts, that these advertisers will recognize the platform as a good advertising place. Hopefully with our tracking numbers, with our aim of becoming the best Internet portal that hopefully we can grab the market share in the advertising business on the mobile.

Yunfan Zhou

In terms of marketing expense, for the Kong.net, we are looking at between $1 million to $1.3 million in Q3. We are looking at probably a little bit less than that in Q4 right now. As we have said before, we actually intend to invest about $10 million in Kong.net this year. In Q2, the total cost associated with Kong.net is close to $3 million. We still maintain that target right now. We are also making our best efforts to balance investing in the Kong.net brand while maintaining our profitability.

JP Gan

In terms of monetization, we actually had some early successes in terms of getting advertising revenue from the wireless Internet portal. We generate about $25,000 in advertising revenue in Q1, and approximately the same amount in Q2. We got Motorola and BMW to place ads with us. Although the amount is very small, we are very pleased to have premier advertisers on our wireless Internet portal at the current time.

We think towards the second half of 2007 we will see more meaningful advertising revenue on our portal.

Paul Bieber– Piper Jaffray

Thank you.

Operator

Our next question comes from Kip Low – Goldman Sachs.

Kip Low – Goldman Sachs

Good morning. Two quick questions. Can you give us a breakdown on the share-based compensation costs that you have slotted into the Executive Costs line, from Cost of Services all the way to G&A, please?

JP Gan

Kip, why don’t you go to the second question first. I will get an answer to you in a minute.

Kip Low – Goldman Sachs

The second question is on the WAP side. Where do you see the trend on WAP going in terms of, one of your competition’s issue was in terms of the cap, in terms of the connect on a fixed basis, are you seeing that sort of an impact going through your own system also, in terms of the revenue per subscriber coming down, or is it strictly just a [inaudible] at the moment?

Yunfan Zhou

I didn’t quite catch the question. Are you talking about the per user subscription fees versus transaction fees?

Kip Low – Goldman Sachs

Correct.

Yunfan Zhou

I think due to the new policy, during the free trial period, I think most of the players in the market including ourselves are switching from the subscription model to promoting the transaction-based services. Right now, starting in July, we are starting to promote all of the transaction-based services.

Before that, our average length per subscription is about three months, and the ARPU from that is about RMB5 to RMB6. However, the free trial period actually limits a lot of subscriptions. That is why we are switching to the transaction model.

Right now, ARPU is probably about RMB6 per user, per use. They do about three downloads per use.

Kip Low – Goldman Sachs

So your ARPU is basically going to be flat by switching?

Yunfan Zhou

Yes, that is correct. However, there is no subscription base, so that means we have to accumulate from zero again for the next month. That is the way it will probably impact revenue.

Kip Low – Goldman Sachs

So we should expect WAP to continue to go down, and we can focus strictly on a volume basis, not so much on ARPU for the time-being?

Yunfan Zhou

Yes, you are correct. We continue to expect WAP to go down in Q3.

JP Gan

Kip, to your first question, we recorded the 470,000 in non-cash share-based compensation. Approximately 30% is in product development, 25% in sales and marketing and about 45% in G&A.

Operator

Our next question comes from Lee Pang – Pacific Crest Securities.

Lee Pang – Pacific Crest Securities

Your WAP revenue declined 26% in Q2 sequentially. Was that mostly driven by the competition from free WAP portals?

Nick Yang

I think there are two reasons. One is the competition, not just from the free WAP side, but also from the internal sites due to different players fighting for positions. Each position actually generates less revenue than before due to the competition of the free WAP sites. There is more competition on these conditions. So that is one thing.

Another impact is from the clean-out of the inactive users. China Mobile started cleaning out the inactive users for four months rather than six months in Q2, so that also hits the revenue. So it is these two reasons that caused us declining WAP.

JP Gan

Let me just quickly add on to that. Overall, we still think we are either the number one or number two player in WAP in China in Q2. We think, given all of the policy changes at China Mobile, actually the overall WAP market is going to decline in the next two quarters. Our goal is to continue to maintain our number one position in WAP.

Nick Yang

We are still a clear number one in WAP in China Mobile today.

Lee Pang – Pacific Crest Securities

A second question is, since China Mobile or China Unicom launched their own mobile advertisement initiative recently, do you expect that to compete with you regarding the ad dollars going forward?

Yunfan Zhou

I think in the early stage it is very helpful for us as well, because they also go out to educate the market. Right now, as Nick said before, the most important and biggest feature for the advertisers is that most of them don’t understand how it works. The advertisers themselves, they weren’t used to monitor the Internet before, so they don’t have the idea of what this is. So I think China Mobile and China Unicom going out to the market, advertising their portal is very helpful for the market, for the customers, to really understand what wireless Internet is.

So we believe that at the early stage, it is very helpful for the whole market and it is also good for us. When we go out to the customers it is easier for us to persuade them.

Lee Pang – Pacific Crest Securities

So you are saying the market is early enough, big enough, to accommodate multiple players at this stage?

Nick Yang

I think right now the advertising on the wireless Internet is very small, so it really doesn’t matter if there are five or ten players. What really matters is two years from now the line that has the biggest traffic and brand name awareness will attract – the top two players, probably. Companies here in the Internet in China will probably get more than half of the market share.

Lee Pang – Pacific Crest Securities

Looking out longer term, it seems like the operator is trying to push the SPs into more like content providers. Do you think in the long run, you will consider vertically integrating into the content ownership, maybe own some of the content providers?

Nick Yang

Yes, I think that is definitely one option for us, to own some of the content providers. However, we believe that even in the longer term there will still be many service providers delisting and partnering with the operators. The operators are doing some of the content themselves. However, we believe that it is not to their best interest to really become service providers, replacing the thousands of service providers out here today in China.

For the large service providers, like KongZhong, I think we are in a very good position to have a long-term partnership with China Mobile. They need a service provider like us, 800 people working on the content and services and working on the different mechanisms than if they own carriers. Their focus, the majority of their revenue is still coming from voice. Even if they do data, they need partners rather than just doing it themselves.

Operator

Our next question comes from Ming Lu – .

Ming Lu –

I have two questions. First, KongZhong announced a layoff recently. IN which departments or functions were the layoffs implemented? Are there any other ways to cut down expenses in Q3 and Q4?

Yunfan Zhou

The layoffs are across the board. So pretty much all of the departments have reduced their headcount. In terms of cost reduction, for Q3, given that we are already half into the quarter, it is very difficult to further reduce costs. As I mentioned in our prepared remarks, our Q3 operating expense is going to be $0.5 million less than in Q2. In Q4, you are getting to the layoffs, there are cost reductions associated to headcount reduction, such as rent and computer equipment. We are working very hard to reduce costs and improve efficiency and hopefully we can squeeze out more in cost reduction in Q4.

Ming Lu –

The Minister of Information and Industry announced two black lists. Do you think those companies on the list will leave market share for other SPs? Or does the market share just disappear, as they are illegal? Thank you.

Nick Yang

Well I think very fortunately that we are not on any of those black lists. There are, I believe, about 102 SPs on one of those lists. Yes, we think the WAP market will continue to consolidate. Many small to medium sized companies will leave the WAP industry, close doors or shift their focus to something else.

In addition to that, we think some foreign players who have come into the market by acquisitions in the last 12 to 24 months may also hesitate to further expand their business here in China and even possibly, leave the market.

Ming Lu –

Is that good news for KongZhong, that the market just disappear?

Nick Yang

I don’t think it will disappear. As you know, there are thousands of service providers out there, so it really doesn’t have much impact on us, those in the black list. However, as JP explained before, if there are 100 players that can now do certain things, that will leave space for other players. As the second-largest service provider in China, we definitely can get a little bit more market share from that, and as you will see the numbers for us and the competitors, we are actually gaining some market share, and we are still doing that.

Ming Lu –

Thank you.

Operator

Our next question comes from Chang Qiu – Forun Technology Research.

Chang Qiu – Forun Technology Research

Good morning. Regarding your wireless ads, you mentioned Motorola and BMW placed ads with your Kong.net platform. I just wonder, maybe you can give us some education here too. If the ads are text-based or image-based or what it looks like?

Nick Yang

Those two ads are both banner ads, so it is similar to what you see on the Internet, except it is basically between text-based articles. We insert a link. If the user is interested in a new BMW product, they will click on the link and that will take them to an image of a fancy car.

Chang Qiu – Forun Technology Research

Okay. So if the 3G license is delayed, say maybe not in this year, maybe not in early next year – so maybe, say later next year. What would be the impact to your strategy? What would you change in terms of your marketing campaign?

Yunfan Zhou

I don’t think we will change our marketing campaign, because we believe that whatever the platform is, the most important thing is to let the users know when they get online with their cell phones, they choose KongZhong. So whatever platform it is, whether it is WAP or 3G platforms.

So what we are doing today is to let people know that KongZhong is the largest, the number one, is the best player out there in the wireless Internet. So even if 3G is delayed, I don’t think it will affect our marketing campaigns that much.

However, we do welcome the early arrival of the 3G in China.

Chang Qiu – Forun Technology Research

Well maybe I should understand it this way: because the text links are part of the mobile advertisement JP mentioned earlier, the ad part does not really depend on 3G. The mobile, even 2G or 2.5G bandwidth is already good enough, right?

Nick Yang

Absolutely. I think right now in GPRS or CDMA 1X environment, it is in general, fast enough for most people to browse the Internet using the mobile phone. With 3G, all it does is it will increase the bandwidth and also download speed. So it will just make the user experience much more comfortable and more interesting. But right now, in the current environment, it is still okay for most people to browse the Internet using their mobile phone.

Chang Qiu – Forun Technology Research

Another question regarding IVR and also caller ringback tones. On the IVR front, some of your peers guide to a much better quarter, but others guide to a much worse quarter. You guide, it looks like slightly down for IVR. Can you clarify this? What you see? Why the difference?

Nick Yang

I don’t know why the peers guided differently. However, for us, our IVR revenue grew 85% quarter-on-quarter in the second quarter, mostly because of the acquisition of SharpEdge we got a lot of IVR revenue from SharpEdge’s China Telecom and Netcom offerings. So for Q3, I think one thing that really impacts IVR is that we need to do a lot of promotion for the IVR, because most of the IVR is transaction-based services.

So I think the amount and the weight of doing promotions for IVR is actually affecting how much revenue we can get from IVR. Right now for us, it is quite steady in Q3. So we guided it to slightly down for Q3.

Chang Qiu – Forun Technology Research

Maybe in the same line, earlier you mentioned that SharpEdge contributed $3.7 million in revenue. Can you split that out into how much of that is SMS revenue, how much of that is IVR and others?

Chang Qiu – Forun Technology Research

Let us check, hang on.

JP Gan

About 40% of SharpEdge revenue is in SMS. IVR and ringback tones is about 30% each.

Chang Qiu – Forun Technology Research

Thank you.

Operator

There are no further questions in the queue. I would like to turn the call back over to management for closing remarks.

Yunfan Zhou

Thank you everybody for dialing in today. Again, we are very pleased with our second quarter results and we look forward to talking to you again in three months. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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