KongZhong (KZ, profile) reported a disappointing Q3 in late November, and the stock has since dropped as much as 15% from pre-announcement levels. Quarterly results missed management's own guidance (ouch) and offered bears plenty to chew on through lackluster performance of key new releases which originally came with high hopes.
We had previously written a note exploring why we thought the stock was compelling and wanted to provide an update to further discussion.
In the earlier article, we identified new game launches Guild Wars 2 and World of Warplanes as potential near-term catalysts, with progress in Mobile providing additional possible upside.
Unfortunately, the launch of both GW2 and World of Warplanes haven't gone off as well as hoped, illustrated in the drop of Monthly Active Users QoQ (here are the stats). After speaking with management, it seems that the fates of the two games will likely be different. There is more to the story of Guild Wars 2 (apologies for the pun), but it seems that World of Warplanes is likely to remain a minor contributor.
Turning to Mobile, the story is more positive. One of the reasons for the Q3 miss was the slipped launch date of some mobile titles. After checking App Annie, an app tracking website, it seems that KongZhong's recently launched titles My Princess is Cutest ("我家公主最可爱") and Rush! Three Kingdoms ("进击！三国") have both fared reasonably well since launch. (Here's the App Annie page for Princess, and here's the page for Rush! Three Kingdoms.)
On the Q3 call, management reaffirmed its plans to launch 1-2 mobile titles per quarter, however it remains to be seen if there might be some 'catch-up' in Q4. We think that additional releases in Q4 would be positive, but a lack thereof wouldn't pose concerns. Instead, we favor a release schedule driven by game quality instead of fixed calendar dates. As we've noted in the past, success in China's competitive mobile game market can involve a bit of luck (players' tastes can change quickly, and drastically), but focusing on quality can help offset the luck factor to some extent.
Given what appears to be reasonable performance for mobile titles launched thus far in Q4, we think that performance in that segment will be back on track, and resume YoY revenue growth in the 20% range.
Now back to PC games. Because World of Tanks is a somewhat established title, growth is less likely to be as explosive as a new game, so steady performance from this game going forward is reasonable. As noted above, we think that World of Warplanes won't be a major contributor, so therefore growth in PC games comes down to Guild Wars 2. (The company does have other games in the development pipeline, but expecting a major contribution before 2H FY2015 seems overly optimistic.)
Despite the pre-launch hopes, Guild Wars 2 has been somewhat of a disappointment in China so far; management conceded post-Q3 that the game performance was beneath its expectations. But despite the lackluster progress to date, we think dismissing the game offhand is premature. The game's publisher, ArenaNet (owned by NCsoft) seems firmly committed to game, to the extent that during some recent internal restructuring, the Guild Wars team remained intact. (NCsoft specifically mentioned sales growth of GW2 in China tapering off during its Q3 call, saying that it would move aggressively to boost sales via more marketing and game updates.)
There have been plenty of rumors on the game's player forums about the game's possible future, and the developer's communication strategy may be partly to blame for rampant speculation. However, it seems that there are still plenty of engineers working on the game, which could address players' existing issues as well as make improvements going forward.
However, based on comments from KongZhong's management, there might not be any significant changes introduced in China until well into FY2015. What this could mean to investors is flat performance until then (the game does have a stable core group of players, according to the company). After such a highly-anticipated launch, waiting several more months to see if the game can live up to expectations is undoubtedly frustrating, but the company did communicate some of the risks before the launch.
The silver lining in the GW2 story is undoubtedly the game developer's attention to performance in China. Support from the team at ArenaNet could provide some notable tailwinds to KongZhong's ability to reignite player interest, key to the game's long-term success. But until there is more clarity on concrete steps to get the game back on track, assuming significant growth may be too early.
So based on our assumptions for sideways performance in PC games and some incremental growth in Mobile, we think the company's revenue guidance for Q4 is reasonable (59-60 million USD). Our assumptions include flat QoQ growth in Mobile and PC games, and some slowdown in WVAS revenues of about 10%. (Note that our WVAS revenues estimate assumes further deterioration, something which may be overly conservative considering management's comments that the environment was stabilizing somewhat.)
The company's net income guidance is for 9-10 million USD (net margin of about 16%, up vs. Q3 but lower than the 20% NPM Q4 last year). Assuming no major changes in the share count, that would translate into EPS of about $0.20 on a US-GAAP basis, up vs. earlier quarters and flattish with levels late last year.
Assuming for a moment that KongZhong could deliver quarterly EPS of about $0.20 (on par with Q1 FY2014, before the large expense run-up associated with new game launches), it could mean the full-year normalized earnings were about $0.80 (FY2015; assuming no incremental growth from new games, etc.).
If full-year EPS was about $0.80, then the current stock price implies a forward P/E multiple of about 7.5x; and P/S of about 1.2 (based on the flattish revenue assumptions above).
The stock is again trading at about $6, the similar range when we first published our view that the stock looked attractive, and although it could fall further, such a low valuation seems to be unfairly penalizing the company.
Management clearly cares about the stock price, and is trying to get investors' attention, as shown by the mid-October dividend. We think that the core story remains in place, and that the stock deserves a close look for investors with a longer-term horizon. The company is underfollowed and relatively obscure, and it might not take too much for the market to take notice of the story.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.