Description

KongZhong (KONG) is the leader in a growing market and trades at a 16% forward earnings yield (6x forward earnings, net of cash).

As you may imagine, China leads the world in the number of mobile subscribers (over 350 million). Mobile phone users are about 25% of the Chinese population and could grow around 10+% a year to around 540 million in 2008 (which would imply ~35-40% penetration). With the relatively high cost of a PC (the installed base of PCs in China is only around 50 million), many Chinese rely on their phones (not PCs, like most of the rest of the world) for access to information and for communicating with others. In fact, the mobile phone to Internet penetration ratio in China is about four to one. The size and growth of the wireless market in China has led to a robust market for WVAS (wireless value-added services).

KONG is a top-three provider (by revenue) of WVAS for wireless carriers in China and currently the leading provider of WVAS for 2.5G networks.

First, is KONG cheap?

At $11, KONG is trading at a 16% forward earnings yield (based on 2006 ending cash), using Street estimates for F06. If F06 is unexpectedly flat with F05, KONG would still trade at a 10% earnings yield (based on 2006 ending cash).

Price (12/9/05) $11
F05E EBIT $25 m
F06E EBIT $37 m

Cash at 3Q05 $112 m ($3.1 per share)
Cash at YE06E $153 m ($4.3 per share)
Debt None

FDS 35.6 m
MC $392 m
EV at 3Q05 $280 m
EV at YE06E $239 m

F05E EBIT/ EV 8.9%
F06E EBIT/ EV 13.2%

F05E EBIT/ EV06E 10.1%
F06E EBIT/ EV06E 15.5% (6x forward earnings, net of cash)

Second, does KONG have a good business?

KONG’s return on capital is around +180% for 2005. KONG’s EBIT margins are typically in the range of 30-33%. The high EBIT margin is consistent with many Chinese Internet companies, which have considerably lower labor costs relative to their U.S. peers. G&A is around 10% of revenue for KONG.

Since being founded, KONG has grown revenues every quarter sequentially (for 13 straight quarters). The company’s outlook is for continued growth.

Importantly, KONG has a strong and close relationship with state-owned China Mobile, which controls about two-thirds of the wireless market in China. KONG typically has placement on the front screen of China Mobile’s portal. Revenue sharing with China Mobile consists of a three-tiered system that is stable as of 2H05: (WVAS provider/ China Mobile)
• 85:15 when China Mobile only provides billing
• 70:30 when China Mobile provides billing and customer service
• 50:50 when China Mobile provides billing, customer service and marketing; WVAS provider only provides content and product integration
As a leading WVAS provider, KONG is subject to 85:15 (ie. KONG gets 85% of revenue for its applications). It is possible that over time China Mobile increases its share of revenue with WVAS providers, such as for co-marketing campaigns. However, despite the apparent urge to increase its share of revenue, wireless carriers have a major incentive to keep leading WVAS providers healthy because of the data traffic that these providers generate. For example, in Japan, which has the highest data ARPU in the world (around 30%), carriers only collect 5% of revenue from providers of content and services.

Further, unlike in the U.S. (where wireless carriers effectively operate “closed” networks), wireless carriers in China do not have full and total control over the software included on the handset. While Chinese wireless carriers typically have their own portals (and those portals are fairly similar to those of U.S. wireless carriers), WVAS providers like KONG can form agreements with handset vendors to have their icon embedded directly on the handset’s screen. With WVAS providers free to deal directly with handset manufacturers, wireless carriers in China have less ability to control the user’s data experience and hence have a weakened negotiating position. In addition, revenue collection from China Mobile was recently decentralized from the parent to the provincial subsidiaries, which also may strengthen the ability of WVAS providers to negotiate future pricing.

The China market is migrating to 2.5G, a process which should take several years and which is driving wireless content as 2.5G phones come with higher processing power and more functionality like camera, color screen and Internet capability. Currently, about 30% of the subscriber base in China has upgraded to 2.5G. With 2.5G just ramping up, wireless data applications should follow and eventually rise from under 5% of subscribers currently to a level closer to Korea (15% of subscribers) or Japan (30% of subscribers). According to iResearch, the overall China WVAS market is expected to grow from $650 m in 2004 to $1.2 B in 2007 (CAGR of 23%). The China 2.5G WVAS market is expected to grow even faster, from $150 m in 2004 to $464 m in 2007 (CAGR of 46%).

Importantly, KONG is currently the leading provider of WVAS for 2.5G networks. KONG leads with about 39% market share for 2.5G (by revenue among the top four WVAS in 3Q05). KONG focused early on its R&D for 2.5G and has become a leader in the space (with TOM Online a close second).

Within 2.5G, the primary categories are MMS (Multimedia messaging service), WAP, and mobile games:

MMS. Content includes images, graphics and audio clips that are messaged directly to subscribers. MMS revenue for KONG was $3.8 m in 3Q05.

WAP. WAP is the fastest growing area of 2.5G as customers can receive the services on-demand through a browser on the phone (instead of MMS, where the services are pushed to the user). China Mobile started operating its 2.5G network in May 2002 to offer WAP services on a trial basis, and, in 2Q05, China Mobile launched a new billing system on WAP. WAP revenue for KONG was $9.5 m in 3Q05.

Mobile games. KONG is the leader in mobile games for 2.5G. China Mobile certifies each game before it is included on its portal. About 25% of cell phones in China can play games. Java games revenue for KONG was $1.1 m in 3Q05 and overall mobile game revenue for KONG (part of which is considered WAP revenue) was $2.4 m in 3Q05.

KONG (like its WVAS peers) mostly sells its services as subscriptions (85% of revenues) with a monthly subscription averaging about $0.80 and a one-time purchase averaging about $0.20. A typical monthly subscription offers unlimited downloading from a particular category (e.g. ring tones) while mobile games are usually sold as one-time purchases.

An important differentiator for KONG is its emphasis on R&D. KONG spends roughly 10% of revenue on R&D, and about 70% of its revenue is derived from internally developed products. By comparison, KONG’s closest competitor (TOM Online) spends only about 1% of revenue on R&D. KONG expects to have a total of about 600-800 employees in R&D by early 2006, up from 320 at the end of 2004 and roughly 2-3x the number of R&D employees of its leading competitors. In addition, KONG is also seeking to use its cash balance for acquisitions to build technology, perhaps in SMS and 3G.

In addition to developing its own content, KONG is also signing up content on an exclusive basis. For example, KONG received the exclusive rights to movie “Hero” (Jet Li) and then produced ring tones, ringback tones and wallpapers based on the movie. KONG also recently signed an exclusive deal with ESPN STAR sports network. Similar to its competitors, KONG shares as much as 50% of revenue with select content providers.

RISKS

Customer concentration: 94% of revenue in 3Q05 was from China Mobile. However, KONG is making some near-term progress to increase business from China Unicom, China Telecom and China Netcom (which together represented 6% of revenues in 3Q05, up from 2% in 2Q05).

Potentially lower revenue sharing or other one-time actions by wireless carriers: Wireless carriers could gradually demand higher revenue sharing from top WVAS providers, perhaps 30% of revenue. Further, state-owned wireless carriers like China Mobile have the ability to suspend or limit the service of WVAS providers. For example, in August 2004, China Mobile notified KONG (as well as other WVAS providers) of inappropriate (ie. adult) content on its IVR (Interactive Voice Response) services, instituted numerous fines and suspended various services.

Potentially lower revenue sharing with content providers: Content providers could also gradually demand higher revenue sharing from top WVAS providers. This area becomes more problematic if copyright laws on music in China are increasingly formalized and enforced. Including various ring tone applications, music represents as much as 50% of WVAS revenue.

Potentially shortened product cycles: products cycles for both online gaming and mobile applications have been shortening due to changing technology and increased competition. Shorter product cycles mean future R&D could generate lower returns.

Move to 3G: The eventual move to 3G (in several years), could lead to increased competition, as online portals (SINA, SOHU, Tencent, China.com) and online gaming companies (SNDA, NTES, NCTY) try to enter the mobile content and services space. In fact, the Chinese government could restructure the wireless industry in 2006, prior to issuing 3G licenses, which could be a disruption for WVAS providers. Further, the move to 3G could also lead to free WAP portals, which could focus on selling advertising and, if successful, could alter the current business models used by leading WVAS providers (Note: WAP represents about half of 2.5G revenue). As background, 3G is not expected to gain material traction (like 10% of wireless subscribers) until 2008 or 2009.

CATALYSTS

Growth in China wireless market (especially 2.5G): As mentioned, mobile phone users are about 25% of the Chinese population and could grow by 50-70 million subscribers a year. That would imply about 550 million subscribers in 2008 (penetration of 35-40% of the population), up about 50% from the current base of subscribers. Urban markets such as Beijing (~90% penetration) and Shanghai (~80% penetration) are already highly penetrated, so growth will increasingly come from smaller cities.

Increased penetration of pre-paid customers: Most of the wireless subscribers in China are pre-paid, and these pre-paid subscribers historically could not purchase data applications from their carriers. In mid-2005, China Mobile began implementing a new billing platform, which enables WVAS providers to bill about 30% of the pre-paid base. Over time, China Mobile could open up 70% of its pre-paid base by mid-2006, a catalyst for growth in WVAS.

Industry consolidation: Due to regulatory actions (e.g. registered capital requirements, content quality rules, customer service obligations), it’s estimated that roughly one-third of competitors have disappeared or been acquired over the last 12 months. This trend is expected to continue, especially as the industry continues to mature.

High insider ownership: Management owns about 40% of company’s shares. Prior to founding the company in 2002, the management team (Yunfan Zhou and Nick Yang; both Stanford guys) started ChinaRen.com in 1999, which was the largest online alumni portal in China and was sold to SoHu in 2000. Float is about 30% of outstanding shares.

Large cash position (over $3 per share and growing) could be used for accretive and strategic acquisitions or to repurchase shares.

Catalyst

Stock trading at very low multiple of forward earnings, net of cash
Growth in China wireless market (especially 2.5G)
Continued leadership in 2.5G market segment
Increased penetration of pre-paid wireless customers
Industry consolidation
High insider ownership
Large cash position used for accretive and strategic acquisitions or share repurchases