Description

Sky-Mobi (Mobi) is China's first mobile internet pure-play listed in the US. It operates the leading application store platform on feature phones in China with +50% market share. It has 3bn user visits and 800m app downloads in Q3'10. This write-up does not repeat the obvious in the IPO prospectus.

1. Highlights

1.1 Technology Strength
Mobi owns proprietary MRP format (superior code efficiency) for 2G feature phones. It requires 20-30% memory space compared to Java and enables much enhanced user experience on low-spec feature phones, with graphic acceleration, virtual-memory and virtual-machine over-the-air (OTA) download technologies etc. It enabled and expanded application download/upgrade on MediaTek's turnkey chipset solution. This "middleware" role was critical in developing China's 2G/2.5G mobile internet market today.

The company values R&D (50% staff in it). It has strengthened its technology lead by expanding its expertise from the handset software to the "mobile cloud" - shifing more tasks to the server/cloud and minimizing the burden on handsets. For example, it features itself by optimizeing network connection and data service across China, based on its detailed knowledge of network servers and gateways in each province (operated by provincial operator). Today Mobi has one of the biggest mobile software R&D teams. 

Mobi also develops certain most popular apps/tools by itself. Latest example includes the popular video chat app, where its solution enables +15fps video on 2.G feature phones through the GPRS data channel, seen as an attractive option by China Mobile, who had difficulty promoting 3G video call since it jams the voice channel. Note that this video chat app has been downloaded >100m times from mobi's server mostly OTA, i.e. peer recommended by consumers after purchasing the handset, rather than pre-installed.

1.2 Pioneer in Business Model and Ecosystem
In early days Mobi spent much time to establish cooperation with hundreds of handset makers throughout China. Handset makers run on relatively thin margin and found Mobi's profit-sharing model attractive. Mobi also serves as content aggregator to engage with various content providers (CPs). Its app store offers unified API and ensures compatibility across different handset brands and models, therefore allowing one-time development effort by CPs. This was highly welcomed and cultivated the development of the ecosystem. Access to top-quality local content and top local CP is key to Mobi's business, and serves as important entry barrier.

1.3 SNS Apps and Community
To enhance user stickiness and loyalty, in 2009 Mobi developed the Maopao community for mobile SNS applications, particularly online games on handsets. It saw rapid increase of user base since launch in Mid 2009, to estimated +50m registered users by Dec 2010. This is gathering attention and Tencent starts to notice this, as it sees from it a Tencent itself 5 years ago!

Its first SNS game, "Fantasy of Three Kingdoms", received great success upon first launch, generating 3m RMB revenue in first month. It has become +10% of the total business within a year. A video link below demonstrates this game on Mobi's platform. It showcase a good game with reasonable quality on feature phones.

http://v.youku.com/v_show/id_XMTQ0MzQ1NDg4.html

1.4 Third-party Payments
Mobi partnered with third-party payment providers (ChinaPay, online banking, etc etc) that allow users to top up (through WAP or offline channel) its SNS community account in the form of "K currency". Note that ALL of Mobi's SNS apps/games accept only third-party payment, no mobile operator billing through SMS is allowed. This removes profit sharing with China Mobile and allow Mobi to directly verify the billing data. Many major parties have began to agree that third-party payments are becoming mature and widely accessible after years of development.

As gamers purchase "virtual-item" or "upgrade" in game with much higher payment amount, this significantly simplied the process and reduced Mobi's reliance on mobile operator billing. It also improves the ARPU and gross margin. Going forward, mobile online games will be a major monetization driver for Mobi.

1.5 Consumer Franchise Value
Today Mobi runs the app store with hundreds of millions of downloads per quarter. This requires dedicated technical support to partners and customer services to users. Given the direct customer-facing role, Mobi's early lead has allowed it to gain valuable knowledge of the mobile app customers and their preference/behavior. Mobi has set up award-winning dedicated 24/7 customer call centers, and can track user requests/activities on real time basis. The majority of Mobi's app purchasing is via
returned customers.

The value proposition of an independent app store operator is validated by Mobi, as consumer behavior and technical requirement are very different from internet or software business. It requires deep understanding of the mobile network communications as well as of the mobile ecosystem. Mobi has gained 2-year lead in this space and continues to innovate.

1.6 Further Monetization Potential
Apart from app downloading and mobile gaming, further monetization is possible through advertising. 2.5G OTA downloading of each app typically takes 10-30 seconds and ads can be displayed during download. Ads can also be shown before app is launched or on a side space concurrently. Early talks with ad agencies show encouraging feedback, as Mobi serves as potential medium to reach 3rd tier cities and low-income mobile population (migrant workers etc), where advertising yield is attractive.

Given Mobi's user base and download volume, its topline has further monetization potential, particularly if benchmarked with Apple. Currently it charges 2 RMB per app for most of its standard apps, whereas a movie ticket in China can cost between 20 to 100 RMB. Mobile remains an attractive alternative entertainment channel.

1.7 Overseas Market to Provide Future Upside
Handset export is becoming an important business and trend in China, powered by MediaTek's turnkey solution, China's efficient supply chain as well as solid demand from emerging markets. Mobi's relationship with local Chinese handset design house/manufacturers well positions itself to capture the overseas growth in due course. Being default pre-install option on the phone, it is actively promoting its business model in populous overseas markets (southeast asia etc) and teaming up with local developers to build platforms.

1.8 Visionary and Energetic Management Team
Mobi founding management team is all from the handset business and understands the industry very well. The team is visionary and aims to nurture the whole ecosystem and to grow with it. It seeks to minimize and share upfront cost/risk with CPs. Founders are humble, passionate and down-to-earth.

The management team is still fairly young for a listed company, so expect some possible detour down the road. But one should note that mobile internet business involves fast-changing pace and constant innovation. So far the team has executed its strategy well, which gives comfort on its future strategy and execution.

2. Risks

2.1 Payment / Billing
For the majority of Mobi's apps (i.e. single-user apps), typically it offers free apps upfront to users and charge a fee when users demand a premium version. The handset sends billing instruction through SMS to Service Providers (SP, such as Kongzhong, LinkTone etc), which then access China Mobile's billing system to coordinate. To prevent fraud or unauthorized charging by malicious apps, China Mobile recently introduced double and triple confirmations to let users confirm twice by SMS before a purchasing decision is accepted. Such extra trouble worsened consumer experience and have caused Mobi's ARPU to drop in recent quarters. On the positive side, such regulation change also squeezed out smaller competitors. China mobile has also come to realize that such harsh measures hurt its own mobile data traffic income. It aims to remove illegal practice but is keen to encourage the usage. Hence it is seeking direct collaboration with major vendors like Mobi, who has had excellent track record and little customer complaints on illegal charging.

Nevertheless, such billing process mismatch is one potential weakness in Mobi's business model today, as it lacks transparency of billing data. It is still subject to the operator policy change and sometimes unable to reconcile/retrieve some of the payment. After China Mobile's recent policy update (known as "triple confirmation"), Mobi can only monitor user's initial download requests but is unable to verify whether a user eventually purchased the app after 2 or 3 confirmations. It is working to embed instructions in its app to solve this issue. In addition, China Mobile does have direct billing partnership program that Mobi can apply to, given its volume of transactions.

2.2 Pre-install Model
Sky-Mobi heavily relies on handset makers to pre-install its apps on the phones. This is a relatively loose cooperation model, with no legal agreement to enforce quantity. It is up to the handset makers which models would pre-install Sky-Mobi apps and whether on an exclusive exclusive basis or not. From a handset maker/IDH point of view, the criteria of pre-installing are simple: dedicated customer service, able to generate profit (i.e. platform with scale, complete app offering). Mobi fits these criteria perfectly and most players see Sky as a strategic partner going forward.

Channel check indicates that even on future Android phones, pre-installed apps can be customized and fixed by the handset maker on home screen (unremovable). Users behavior will be influenced by pre-installed apps. In short, the pre-install model will remain critical gateway for China's Mobile Internet, and third-party "app store" is expected to still have a role to play on smart phones. For example, it is suggested that LG android smartphone in Korea would have 4 app stores, 1 from SK Telecom, 1 from LG itself, 1 by Google and 1 by local app operator.

2.3 User life cycle and dominant share
Feature phones are normally low-cost phones and user life cycles are much shorter, typically 9-12 months. Therefore Mobi's user base is constantly "recycled" and lacks loyalty, Given that Mobi's market share is already 50-60% in China, it has limited room to increase its share and is exposed to more downside risk.

Aware of this, Mobi intends to use the IPO proceeds for brand marketing and step up the Maopao community development. With the sticky Maopao community, user record/scores are stored online and can be brought over to new handsets (so users will look for handsets powered by Mobi upon next purchase).

2.4 Operator App Store
App store requires constant innovation and change management, a fast-changing culture that operators are not used to. Though operators try to compete in the space, it is unlikely that they will dominate the space, but rather more likely to be just part of it.

One important distinction is that handset is +80% through retail channel in emerging markets such as China, India etc, whereas in developed markets the structure is geared more towards operator-bundle and subsidy. This is because developer market users have higher ARPU and operators can afford to subsidize the handsets. It is expected that in the foreseeable future China Mobile and other emerging market operator will have limited impact on the overall handset market, despite the trend towards 3G and smartphone.

2.5 Smartphone
Smartphone is the future trend. Mobi has proven its technical capability and business model flexibility by quickly transplanting its SNS apps onto the Symbian S60 OS, with minimum R&D efforts. Friends with MTK phones and Nokia phones can use the same online games or apps together. MTK + Nokia platforms represent likely ~70% of China's mobile users base today.

It is reported that leading handset makers such as Lenovo are trying to develop their own Android app tore on smart hones. Market check suggests that Android will grow fast but remain a smaller part of the market in the next 12-18 months, due to cost and performance issues. Meanwhile, note that different Android OS involves changes and hence Android apps are not necessarily compatible across Android OS. Furthermore, handset makers are interested in differentiation over the Android platform and try to modify Android OS (HTC, Lenovo LePhone, Motorola etc), with different screen size, memory and CPU options, this then causes compatibility issues too. There is still potential need for appstore to address such issues and provide unified platform for app developers.

More importantly, one hurdle for Android handset to face in emerging markets is still the payment issue (lack of credit card options for consumers). Mobi's aggregator role of multiple local payment options in China still has value by itself.

Overall, it is recognized that competition to Mobi will increase upon arrival of Android. Mobi's historical "middleware" advantage and entry barrier will be weakened. However, note that all of Mobi's remaining competitive strengths still apply in the Android era (mobile cloud expertise, consumer knowledge and operational experience, access to and aggregation of top local content and payment providers, relationship with handset makers etc).

2.6 China Handset Market Landscape
Mobi's success to date replied on the fragmented white lable handset industry in China (it is difficult for CPs to work with the several hundred handset players). It is expected that moderate consolidation will occur going forward, yet many players will still survive and co-exist, as handset requires differentiation. Big players cannot cover all types of demands or cannot response to market dynamics in time, whereas smaller players will always have niches to target and remain very efficient in serving certain segments of the market.

Several major handset makers intended to run their own app store but had come to realize that it is not their core strength to interact with the consumers in such a capacity. They may well be better off outsourcing to Mobi, who can also provide user UI differentiation, exclusive apps for their phones and professional app store operations and services.

2.7 Threat from Internet/Portal (mostly Tencent)

Today Tencent is Mobi's partner as Mobi distributes Tencent's QQ and browser products and feature them on its store.

Will Tencent likely do it by itself in future? Possible, survey shows that Tencent does not share profit with handset partners, is weaker in customer technical support in mobile area, and the majority of its apps today are based on browser, not apps (hence limited user experience). Latest MTK chipset allows enough hardware memory space for both Tencent and Mobi platforms to be installed. Though Tencent QQ is a must-have on the phone, handset makers see Mobi as an important source of revenue sharing, as well as a partner to balance Tencent. They do not want to see Tencent to dominant this mobile space.

Furthermore, for the same QQ app, handset makers much prefer Mobi's versions to Tecent's own version. Feedback shows that Mobi version is half size (100kb) of the Tecent version, and runs much more stable. As a result, Mobi has become important channel for Tencent, where ~40% of its QQ access are via mobile, and +60% of its mobile QQ access is through Mobi installment. Latest channel check suggests that Tecent wanted to manage Mobi's dominance of QQ, but may still consider renewing the contract, to authorize Mobi to distribute QQ and other apps, with favorable terms.

Admittedly, Tencent remains a credible threat in the long run given its brand, R&D strength, and sheer QQ user base. Mobi has the next 1-2 years to prepare itself while Tencent catches up. It is most likely going to co-exsit with Tencent as a third-party independent app store provider. It is likley that Tencent is the most formidable competitor in this space and other internet portals may not be as strong (sina, baidu etc). today they are all partners of Mobi.

Catalyst

1. Over-reaction to CYQ4 update

It is publicly disclosed in roadshow and prospectus that Q4CY10 will be impacted by operator competition in China and congestion of user download traffic. In reaction Mobi has moved its IDC servers to China Mobile. The market may be over-reacting to this negative update, as this is more likely one-off disruption and management took prompt action to address it (although it does highlight the business model risk). Direct billing option does exist and being a listed company can help Sky-Mobi work with China Mobile going forward (Note that Tencent has historically enjoyed the exclusive direct billing for quite a long time with China Mobile). Fundamentals remain solid, as user download requests still continue to increase despite the server problem.

Given the current IPO window and uncertain market conditions going forward, as well as shareholder interest, Mobi proceeded with the IPO plan but cut down offering size to minimize dilution. Due to concurrent Chinese IPOs at the same time (Dangdang etc) and conflicting analyst schedule, there has been change in the underwriters which cause negative perception and market confusion. Such an IPO timing choice may present upside potential later.

Management remained confident that its operations are in good shape and it has sufficient cash balance to sustain operations by itself.

2. Distressed valuation
Given the above IPO dynamics, small offering size, low-end pricing and Bona's dramatic IPO fall on previous day, Sky-Mobi suffered 25% fall upon IPO with poor momentum, it continued to fall another 10% on day 2. Hedge funds rushed in to place order at last min lured by Dangdang/Yoku "China concept" pop. Then they do not see the sign of pop upon opening, they sell right away.

Current share price is $5.26 (despite $8-$10 IPO pricing range). It implies $170m market cap and 9~9.5x P/E (based on Citi pre-deal marketing non-GAAP CY11E PAT), which compares to 13x P/E'CY11 by China MVAS peer Kongzhong (source: Bloomberg).

Sky-Mobi has more diversified ecosystem and product offering compared to KongZhong's one counter-party (China Mobile) and limited product lines (ringtone, picture etc). It is recommended that Sky-Mobi should trade at a clear premium to KongZhong, rather than a discount.

Even if Mobi should trade on par with Kong, if one look at Kong's historical fwd NTM P/E, Kong traded mostly between 13x and 35x in the past 5 years (source: CapitalIQ). Its P/E only ever once briefly touched 10x for one month during Jul/Aug 2006.

Therefore, IPO dynamics aside, in terms of fundamental value, limited downside is expected at $5 per share (8x-9x P/E) price level. Once market momentum settles and focus returns to fundamentals, expect the market to recognize +50% multiple expansion, if Mobi can prove itself with two strong quarters.

Underwritter pre-deal marketing research (without quoting exact numnbers) projected historical strong growth trajectory to continue and profit margin will improve/recover due to expenses incurred pre-IPO and ASP improvement / SNS contribution in coming years.

3. Mobile SNS Gaming may provide upside
Sky-Mobi reportedly has several SNS games in the pipeline / on internal-testing phase. Following the first notable success of its Three-Kingdom game, it rapidly gained top position in China mobile gaming space and attracted much attention with its platform potential. Top developers (previous on Java-based games) are more willing to dedicate resources to work with Sky-Mobi. Though visibility is not there yet, another hit game can significant boost its topline growth and offer upside surprise.

Channel check with 3rd-party research company and game developers show strong signal that a inflection point of China mobile gaming is coming, bullish view suggests +50% CAGR in coming years. It is not impossible for Mobi to post similar growth as a pioneer in the field.

Overall it is hard to use ~9x P/E to justify a top player in China's rising mobile internet tide, despite all the clear risks recognized.