Value Question Towers Over KongZhong

If a Chinese Internet stock looks cheap next to its racy peers, what are the odds that it's still overpriced?

That's the question facing investors after last week's initial public offering of KongZhong ( KONG). The Cayman Islands-incorporated, Beijing-headquartered company offers advanced interactive services to cell-phone customers in China.

If that description sounds familiar, that's because it is. KongZhong runs in the same circles as three recent favorites of trigger-happy Nasdaq traders, Sina ( SINA), Sohu.com ( SOHU) and NetEase.com ( NTES). And judging by the action in those stocks -- all three rallied sharply in 2003 before plunging this year -- there's little agreement in the market as to the true value of the closely watched Chinese Internet business.

So it is with KongZhong. One investor in the company says that while it isn't quite a value stock, it offers the sector's requisite promising growth -- at a relatively low price tag, compared with those better-known competitors. Yet another buy-sider -- an analyst following Chinese stocks -- says the risks are too great with any of the cell-phone information providers to merit making an investment in them.

And with the tech sector under heavy earnings pressure this month, the going in the Chinese Net sector could be even rougher than usual. Shares in KongZhong, which have slipped 7% in the week since the company's $100 million IPO, dipped 40 cents Thursday to $9.30.

Big Questions

At issue is the usual risk-vs.-reward analysis facing American investors who want to recapture some of that turn-of-the-century dot-com mojo by investing in the Chinese Internet market. On the one hand, the Chinese market is young, vast and fast-growing. On the other hand, the wild cards don't necessarily lessen the risk the second time around.

Some of the risks are specific to China, such as the role that government can play in the company's future, smaller per capita disposable income, and the policies of the mobile-phone carriers through whom KongZhong and others sell their services.

Other risks are universal. As countless U.S. Internet companies have proven, one can't forecast future revenue simply by charting past results and continuing the line up and to the right. And, as many of those same companies have shown, relative cheapness within a sector is meaningless when the whole kit and caboodle heads to zero.

And yet, the KongZhong numbers do grab one's attention. The company delivers services such as games, news, karaoke and instant messaging to cell-phone users, and it has focused on what's known as "advanced second generation," or 2.5G services. These are positioned as a step up from the second-generation services that make up the bulk of wireless revenue for Sina, Sohu.com and NetEase.com.

KongZhong, which delivers these services primarily through the wireless carrier China Mobile ( CHL), has shown impressive growth over the last few quarters, though on a small base.

The company's revenue went from $2 million in the quarter ended Sept. 30 to $3.8 million in the quarter ended Dec. 31 to $7.1 million in the March 31 quarter. That works out to sequential revenue growth of 89% in the fourth quarter of 2003 and 86% in the first quarter of 2004.

Those numbers have led one portfolio manager to forecast that KongZhong will have $61 million in revenue in 2004, on the basis of sequential revenue increases of 65%, 50% and 40% for the second, third and fourth quarters, respectively, of 2004. And on the basis of tweaks to gross margins and other elements of the profit-and-loss statement, the portfolio manager comes up with a 2004 earnings-per-share forecast of 80 cents. The portfolio manager's firm holds KongZhong shares; the manager, citing firm policy, spoke on condition of anonymity.

Given KongZhong's current American depositary share price of $9.30 -- down from last week's offering price of $10 -- the EPS estimate translates into a price/earnings ratio of 11.6. That's not bad for a company that, under this forecast, would have revenue nearly eight times above year-earlier figures.

That's also not bad compared to Sina, Sohu.com and NetEase.com, which according to analysts polled by Thomson First Call, are expected to show revenue ranging from $100 million to $200 million in 2004, revenue growth rates of 38% to 76%, and P/E's in the range of 15.7 to 20.9.

Greed and Fear

KongZhong, argues the portfolio manager, thus represents a relatively inexpensive way to play the Chinese Internet market, in which much interactive content is delivered wirelessly and the 2.5G market is growing.

The buy-sider is not alone. KongZhong, along with competition such as Sina and, to some extent, Sohu.com, "are all well-positioned to benefit from continuous growth" in China's wireless value-added services market, writes Lehman Brothers analyst Lu Sun in a recent report. The analyst has an overweight rating on Sina, an equal weight rating on Sohu.com and no rating on KongZhong.

Certainly, acknowledges the portfolio manager, the risks are plentiful, starting with the company's dependence on China Mobile. "If you've got all your revenue coming from one channel -- that's a risk," says the buy-sider. KongZhong's offering document, points out the investor, has a remarkably long section devoted to the possible pitfalls of investing in the company.

Another buy-sider -- a China analyst who also spoke on condition of anonymity, citing firm policies -- said it was advisable to avoid the Internet sector completely. (The analyst's firm has no holdings in KongZhong.)

The analyst pointed out NetEase.com's recent revenue preannouncement, citing stricter wireless carrier billing procedures. "KongZhong will face the same issue," said the analyst. Other caveats, according to the analyst: Competition is fierce; thanks in part to loose credit policies, barriers to entry for further competition are minimal; tax rates for interactive service providers will increase; and purchasing power for Chinese consumers is relatively low.

It's a bad sign, says the analyst, that so many companies are entering the wireless services market, including the recently public TOM Online ( TOMO), Linktone ( LTON) and Shanda Interactive ( SNDA). The analyst wouldn't be comfortable investing until companies start quitting the market. "This cycle looks like it's peaking," says the analyst.

Meanwhile, the portfolio manager with KongZhong holdings calls the stock relatively cheap, though not exactly a value play. "I don't think you could ever call it conservative," says the portfolio manager.

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