The New Hurray! Deserves a Second Chance

Includes: HRAY, KZ, LTON
by: Ohad Hammer

The performance of Hurray!’s (HRAY) share price is the clearest evidence of the negative sentiment towards the Chinese WVAS (wireless value added services) segment. The market has been rightfully bearish on WVAS providers like Hurray!, Linktone (NASDAQ:LTON) and Kongzhong (KONG), all of which are traded close to their book value. During recent years, these companies have been trapped in a challenging business environment, which resulted in deteriorating gross margins and lack of organic growth, in the face of an ever growing addressable market.

Hurray! operates in one of the fastest growing telecommunication markets on earth. The number of mobile users in china is steadily growing, recently passing the unconceivable 500 million mark, and expected to steadily climb to over 700 million by 2010. Chinese mobile subscribers are heavy consumers of WVAS, a term that includes mobile games, ringtones, video downloads and wireless Internet. In fact, since mobile phones are more popular than PCs in China, cell phones are often the primary means of communication, in contrast to the US and Europe.

Despite the sheer size of the market, WVAS providers have been facing some serious challenges. The mobile market in China is dominated by China mobile (NYSE:CHL) and China Unicom (NYSE:CHU), who have very strong negotiating leverage. Traditionally, the WVAS companies and the carriers jointly promote and provide their services through the mobile operators’ channels. Obviously, there is no such thing as a free lunch, especially in china, so the operators collected their share from the WVAS players in the form of fees. The fees’ size increased with time, rising up to 50% of total WVAS sales, turning this business model from margin heaven into margin hell. In addition, Hurray! used to license content from 3rd parties like record labels and film studios, paying them around 50% of gross sales after deducting service and network fees

Another area where Hurray! and its peers have been badly beaten was regulations and policy changes, as the Chinese government, in cooperation with the mobile carriers, started enforcing strict policies, cutting into revenues and earnings of WVAS players. For example, according to a regulation issued last year, WVAS providers must get a double confirmation from their subscribers, before billing them. Furthermore, subscribers must get a free trial period, which was originally set at one month but lowered to several days soon afterwards.

Although these regulations were sometimes justified with the purpose of protecting customers (dealing with issues like over-billing and inappropriate promotion of WVAS), their impact on the WVAS companies was overwhelming. Mobile operators didn’t hesitate to punish WVAS providers for misconduct by all sorts of sanctions, like postponing the provider’s participation in several joint promotion channels. The latest policy change occurred during the 2nd Q was China Mobile’s decision to show a warning message every time a user tries to load a WAP service operated by from a third-party like Hurray!. This new regulation is expected to decrease WAP related revenues, at least in the near future.

Like all that wasn’t enough, China Mobile and China Unicom started offering their own WVAS, going directly to the content providers like record companies, TV shows and film studios. This has put the mobile operators and WVAS providers in direct competition, although in many cases the mobile operators still offer 3rd party WVAS to their subscriber base. Needless to say, the mobile operators will be happy to get rid of the middleman and become the content aggregator for the WVAS market.

However, it is still not clear how far the operators are willing to go further away from being “dumb pipes”, towards content aggregation, since it is not their core business. In order to have a truly comprehensive WVAS offering, the mobile operators are still likely to use 3rd party services they cannot or won’t develop in-house. The best way to assure that service providers will eventually choose to promote 3rd party services instead of promoting in-house services is simply to create unique and attractive services that cannot be displaced. Anyone can offer primitive services like SMS based products, but the more complex, innovative services have higher entry barriers.

So how did Hurray! deal with the tough environment? It adapted.

In reaction to mobile service providers going directly to the content owners, Hurray! decided to become the content owner itself. That way, Hurray! became a licensor instead of a licensee, a content provider instead of a content aggregator, leaving China Mobile and China Unicom no choice but to pay Hurray! its royalties when using Hurray!’s music. Since 2005, Hurray! has been buying its way into the music business by becoming a major stakeholder in several independent record labels such as Huayi Brothers and Freeland. Shifting the focus towards music and music related products looks like a smart move in general since the music’s share in the WVAS market is constantly growing. The potential in becoming a music-related content owner is threefold. First, Hurray! gets the traditional sales generated by selling records, concert tickets and other merchandise. Second, Hurray! has the unlimited possibility to develop various kinds of services based on its own music content. That way, it doesn’t have to pay royalties to content owners. Third, Hurray! may license its content to other WVAS providers or to the mobile operators themselves and get 50% of royalties.

Another clear trend is moving towards more sophisticated services like Java games. As mobile networks become more advanced and enable higher bandwidth transmission, the bandwidth hungry services like mobile games are expected to become dominant. The much-anticipated 3G launch in china later this year will surely be a catalyst in that direction. Bearing it in mind, Hurray! acquired Shanghai Magma, a top tier Java game developer and publisher in China. This acquisition has positioned Hurray! as one of the leaders in in the growing Java game market in China, with more than 10% of the local market.

Understanding the problem in depending solely on the mobile operators for WVAS promotion, Hurray! started to pursue what it calls “operator-independent channels”.

Hurray! started marketing its services directly to consumers, in addition to joint promotions with the mobile operators. The new marketing channels include direct media advertisement, marketing alliances with TV channels, like MTV China, partnerships with popular sites like and handset vendor partnerships. This kind of promotion activity is certainly associated with higher costs, but it has a better growth potential and favorable revenue sharing model. Most importantly, it minimizes the exposure to the operators’ caprices and gives Hurray! a better grip on its business.

The fact that WVAS providers like Hurray! are always subject to sudden policy changes deters investors, but the fear seems to be overblown. There is always a new reform taking place in the Chinese market, but it is unlikely we will see additional policy changes and sanctions in the scope we’ve seen during recent years. The recent round of regulation might even prevent the need for substantial policy changes in the future, as one cannot ignore the fact that these policy changes and sanctions, even if somewhat draconian, led to a more mature and efficient market. Eventually, it will enable the Chinese WVAS industry to grow and expand, gaining more acceptance among subscribers. Furthermore, the new policies have squeezed out hundreds of smaller local WVAS players that couldn’t adapt to the new situation. As a result the bigger players like Hurray! Linktone, Ton Online and Kongzhong are left with the vast majority of the market.

Examining Hurray!’s Q1 results provides some encouraging signs. The strategic shift is in motion and the trend is clear. Music and game related revenues represented 36.0% or $6.0 million of total revenues for the quarter. Furthermore, sales generated via operator- independent marketing accounted for 40% of revs, as oppose to 29% in Q1 of 2006.

Looking into the rest of 2007, Hurray! expects business to improve but it will certainly not grow at the pace it used to. In 2008, Hurray! should benefit from numerous positive factors, Such as an ease up of policy enforcement by the government, new revenue streams generated by recently signed partnerships, overall growth in the wireless market and 3g license issuance.

Hurray!’s financial metrics are also pretty strong. Judging by the stock price, the WVAS companies are at their darkest hour. Amazingly, Hurray! is still profitable, with an EPS of 0.04$. That is an impressive demonstration of the company’s abilities. Hurray!’s cash position makes current valuation even more compelling. With 3.25$ of cash per share, most of Hurray!’s market cap is covered by cash and cash-equivalents.

In summary, Hurray!’s business model has transformed over the last 2 years. Instead of heavily depend on operators for marketing of their products and on licensors for content, Hurray! managed to develop proprietary contents and diversify its distribution channels, so it is all set for renewed growth. Evidently, such a stock is very volatile, but the strong balance sheet combined with the new sources of revenue and the huge market opportunity, imply that the best is yet to come.