The Best Small Cap for 2007: KongZhong

Looking into my crystal ball, I can identify three megatrends for the 21st century:

  1. Emerging markets
  2. Health care
  3. Value-added wireless communications

Emerging markets and health care were already addressed in our search for the best ETF for 2007, so for this small-cap contest, I'm going with a company that enhances the experience of on-the-go communications. My pick is KongZhong (Nasdaq: KONG  ) , a pure play in both wireless communications and the biggest emerging market of them all: China.

Growing like a giant gorilla
KongZhong is the second-largest wireless value-added service (WVAS) provider in China, a country with 1.3 billion people. WVAS is a catch-all term for the vast number of cool add-on services that supplement cellular subscribers' basic voice service. That includes wireless Internet, music and video downloads, multimedia messaging, mobile video games, and customized ringtones. The market for WVAS in China is huge; the country's total number of cell phone subscribers has increased from 85 million in 2000 to more than 425 million today. That's more than twice the number of cell phone users in the entire United States.

WVAS demand has increased commensurately with basic demand for cellular service, with China's number of wireless text messages rising from 19 billion in 2001 to 305 billion in 2005. Looking forward, analysts predict that WVAS revenues in China will grow at a double-digit rate for years to come.

China's wireless subscriber base is not only larger than that of the U.S., but also has more room for future growth. While more than 70% of the U.S. population already uses a cell phone -- that figure's a whopping 90%-plus in Western Europe -- the penetration rate is only 33% in China. Based on these numbers, it's pretty clear that the sky's the limit for KongZhong's market opportunity.

Although KongZhong's No. 2 position in Chinese WVAS is reason enough to invest in the company, CEO and co-founder Yunfan Zhou has set his sights on an even higher goal: becoming one of the top two wireless Internet destination sites in China. In the first quarter of 2006, the company launched Kong.net, and the subsequent national marketing campaign has already made the site one of China's top five wireless Internet portals. Zhou has stated that he believes Kong.net will eventually become the company's core asset, and that each $1 invested in the portal today will be worth $5 a few years down the road. The big payoff will be wireless Internet advertising, which will take off once the portal is fully developed.

From pygmy marmoset to great ape
KongZhong was founded in 2002 by Zhou and Nick Yang (now ages 31 and 30, respectively), who had master's degrees in electrical engineering from Stanford University and significant prior work experience at the Chinese Internet portal, Sohu.com (Nasdaq: SOHU  ) . Zhou and Yang, along with CFO J.P. Gan (who holds an MBA from the University of Chicago), have brought Western-style best corporate practices to KongZhong. Financial disclosure is excellent, as demonstrated by the company's decision to provide a cash flow statement with their quarterly earnings reports, something that many U.S. companies don't even provide.

Right from inception, the company has been a growth machine. Look at these numbers:

KongZhong

FY 2003 (ending Dec. 31)

Sep. 2006 (ttm)

Total Growth

Compound Annual Growth Rate

Revenues

7.8

105.2

1248.7%

157.5%

Operating Income

2.4

23.6

883.3%

129.6%

Net Income

2.4

27.3

1037.5%

142%

Free Cash Flow

1.1

20.1

1727.3%

187.6%

Numbers in millions, except percentage figures.

On an operational level, the company's operating income margin of 22.8% and net income margin of 25.9% beat those of all three of its major competitors, TOM Online (Nasdaq: TOMO  ) , Hurray! Holdings (Nasdaq: HRAY  ) , and Linktone (Nasdaq: LTON  ) . Combine this growth and margin superiority with a rock-solid balance sheet of zero debt and $3.40 in net cash per share -- 42% of the current $8.10 stock price -- and you'd think KongZhong's stock would trade at a premium multiple to its competitors.

You'd be wrong. KongZhong trades at a discount, making it one heck of an investment opportunity:

Valuation

Enterprise Value to EBITDA (ttm)

Price to Earnings (TTM)

Tom Online

14.4

18.4

Hurray! Holdings

14.1

23.8

Linktone

7.0

19.2

KongZhong

6.7

10.6

A possible two-bagger?
Last July, China's mobile phone carriers introduced new consumer protection rules for WVAS, mandating extended free trial periods, double confirmation notifications, and automatic cancellation of inactive accounts. In the short term, this shrank WVAS revenues by 20%-30% for most providers. The stocks of WVAS providers, including KongZhong, declined as a result, and the companies' shares have yet to fully recover. I consider this temporary stock setback a buying opportunity, because the new rules will drive a lot of small and unscrupulous WVAS from the marketplace, leading to industry consolidation and less competition in the future.

KongZhong was trading at $15 prior to the new consumer protection rules, and it's now trading around $8. While I can't promise you a 25-bagger, there is no reason that the stock cannot get back to its prior highs within the next year, as industry consolidation continues and revenue growth resumes after this one-time regulatory hiccup. The two co-founders own a combined 35% of the company and thus have every financial incentive to get the stock back on track.

Another big owner (in fact, the single largest institutional holder) is Renaissance Technologies, widely considered the most successful hedge fund in the world. If fund head James Simons sees the moneymaking potential of investing in one of the premier emerging-market stocks among the megatrend of wireless communications, don't you think it makes sense to invest alongside him?

Seen our other contenders for best small cap? If not,click here.

So is KongZhong the best small-cap stock for 2007? I sure think so. Don't monkey around -- go right now to our brand-new community-intelligence database,Motley Fool CAPS, and vote! All you need to do is rate KONG an "outperform." To make your voice heard, clickhere.

Jim Finkdoes not own any shares in the companies mentioned. TOM Online is a Stock Advisor pick. The Motley Fool isinvestors writing for investors.


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