2006 in Review: KongZhong

It's been a challenging year for wireless value added service (WVAS) providers in the People's Republic, and that's thanks mostly to Chinese mobile communications behemoth China Mobile (NYSE:CHL). Though KongZhong (NASDAQ:KONG) got soundly smacked by by China Mobile's new regulations, competitors like TOM Online (NASDAQ:TOMO), Hurray! (NASDAQ:HRAY), and Linktone (NASDAQ:LTON) also tasted the pain. Despite a precipitous 60% drop that had investors tasting g-forces, 2006 was still a remarkable year for KongZhong.

A look back
The first quarter started the year with a bang -- overall revenue was up 64% year over year and 26% sequentially. Though higher salary and marketing expenses held profits back from growing as fast as revenue, net income was up 46% year over year and 37% sequentially. While growth in the company's 2.5G revenue was a strong 31% over the first quarter of 2005, 2G service revenue jumped 208% over the previous year. Part of this 2G growth was due to the acquisition of Sharp Edge Group, which the company closed in January, but demand for SMS services during the Chinese New Year also helped push SMS revenue to four times the level of 2005's first quarter.

The second quarter saw more nice top-line results, as KongZhong hit their projections for the quarter and grew revenue 64% year over year and 8% sequentially. Revenue from 2G services continued to grow in leaps and bounds, making up for lackluster performance from 2.5G services. Because of marketing expenses from the company's push for the Kong.net portal, expenses hampered profit growth and year-over-year net income growth was just 15%, but a sequential decline in general and administrative spending was a promising sign. In addition, 23% of revenue came from China Unicom (NYSE:CHU), China Telecom (NYSE:CHA), and China Netcom (NYSE:CN), as compared with 9% in the first quarter of the year. While China Mobile still made up the vast majority of KongZhong's revenue, this showed the company's commitment to remedying their historically high customer concentration with China Mobile.

Alas, in the third quarter the pinch came down on KongZhong and the rest of the wireless clique. On July 7, KongZhong issued a press release regarding new regulations from China Mobile that would require two notices to be sent to all new subscribers to WVAS offerings; lengthen the free trial period for services from 3 to 11 days to 11 to 41 days; cancel all subscriptions inactive for more than four months; and send notices to all current WVAS subscribers to remind them of the services they were signed up for and the fees being charged. As a result, KongZhong cut the midpoint of its 2006 full-year revenue projection about 15% to $95 million. In another press release at the end of July, the company announced that it would be cutting 15% of its work force. When the third-quarter numbers finally did come out, they confirmed tough times; the sequential decline in revenue was the first in 16 quarters. Despite this, there were some bright spots in the quarter, including continued year-over-year revenue and profit growth and further progression toward building the Kong.net portal.

For investors that were able to hang in there over a tough summer, it's been worth it -- the stock has rebounded nearly 70% off the lows it hit in August. Though the third quarter was challenging, it did come in above expectations, and that could mean that the impact from the new regulations won't be the worst-case scenario. Looking into 2007, KongZhong management seems to be diving headlong into diversifying the company's customer base and revenue streams. At the end of the third quarter, revenue from carriers other than China Mobile has climbed to 25% of the total. Meanwhile, in response to the new regulations, KongZhong is concentrating even more on transaction-based (as opposed to subscription-based) services and its Kong.net portal.

As for the China Mobile regulations, the biggest downside is likely to be seen over the next couple quarters as the "fat" is trimmed off of some of KongZhong's subscriber base. In the long term, though, it's very likely that these new rules could benefit KongZhong and the other major WVAS providers. As the industry continues to grow there are going to be a lot of upstarts using guerilla warfare to try to siphon off a share of the dollars going to WVAS. For over-eager new service providers, there hasn't been -- let's say "a strict adherence to" -- transparency about the subscription nature of their services or the fees associated. The China Mobile regulations will be felt in a big way by these small-fries -- the result being that not only will some competitors be taken out of the ring, but customers' perceptions of the industry could also change for the better.

A look ahead
So is it smooth sailing ahead? Though the company seems to have a course charted, there are still challenges ahead, including the big fat elephant in the room -- the possibility of China Mobile taking WVAS in-house. Fortunately, that's still just a threat. And the more time KongZhong has to build a strong line-up of content and services, the less impact that threat could have.

But where do investors really stand? Well, our Motley Fool CAPS community members have something to say on the subject. Just take a look at how the overall sentiment stacks up:

CAPS members have been very positive on KongZhong, and that sentiment has become even more pronounced with the company's big win in The Motley Fool's Best Small Cap for 2007 contest. While it's tough to find a bear ready to speak up against KongZhong in CAPS, there are plenty of bulls eager to share their thoughts. Player cooljoe3000 shares this easy-to-follow equation for KongZhong success: "1 billion people + cell phone + wireless + china + China Mobile partner = can't miss."

Meanwhile, other Fools like the fact that the company has done very well and still sports a relatively low valuation, All-Star GREGGAJ said that KongZhong is an "absurdly undervalued Chinese Wireless services provider. Rule changes in China knocked its revenues down 10%, so Mr. Market took it down 50%." Fellow All-Star darkflame added that it's an "extremely profitable, cheap company with fast growth and a lot of cash ... this company looks like a Bonanza stock."

Can't miss?
There's no doubt that it's been a challenging year for KongZhong, but there are no really great companies out there that have never faced tough times. I would posit that it's the way that a company responds to major challenges that can peel back the shiny veneer and reveal whether the company has a real engine underneath. The coming year could be such a test for KongZhong and, who knows, it could just turn out to be China's first year of the ape.

Check out the other companies featured in "The Motley Fool's 2006 in Review and 2007 Preview" special.

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Tom Online is a Motley Fool Stock Advisor recommendation.

Fool contributor Matt Koppenheffer did not have to climb any buildings to gather information for this piece -- though he gladly would have. He does not own shares of any of the companies mentioned. The Fool's disclosure policy could take on King Kong in hand-to-hand combat.