King Kong?

2.5G service provider prices at bottom of the range after torrid week for Chinese wireless VAS (value added services) stocks.

KongZhong secured a $100 million Nasdaq listing after New York's close on Thursday, pricing a 10 million ADR deal at $10 per unit.

A week ago, lead manager UBS was confident of pricing the deal at the very top of the $10 to $12 indicative price range. Books went on to close two times covered, but a high degree of price sensitivity emerged after the stock's nearest comparables suddenly plummeted two days before pricing.

Ironically, the IPO was in many ways a victim of the underlying company's success at migrating mobile users to 2.5G services. The 2G operators, which it is seeking to displace and provide the only listed comparables, started reporting preliminary second quarter earnings below expectations last week.

On Wednesday, NetEase released disappointing revenue growth figures, which it attributed to falling SMS usage. Given that SMS is forecast to account for 25% of 2004 revenues, the stock dropped. It fell 16% over the course of two days trading and is now down roughly 33% since the beginning of June.

Likewise Sina Corp, which derives nearly half of its revenue from SMS services, fell 15% over the course of last week and 37% since the beginning of June.

The downward trajectory started in mid-June and was initially triggered by a series of analysts' reports suggesting that valuations were becoming full. Many houses, which still have a long-term positive view on the sector, believe the third and fourth quarters may be volatile, with less likelihood of earnings upgrades to cushion high valuations.

They have also started to point out that leaders in 2G may not necessarily be leaders in 2.5G and that IPOs for KongZhong and its counterpart, Hurray Solutions, will divert investors' attention and cannibalize the former's investor bases.

One of the first houses to highlight the risks was Credit Suisse First Boston, which wrote that, "We do not believe the bulk of the market is aware that the 2.5G landscape is decidedly different from a market share, growth opportunities and competitive advantage perspective compared to the SME market (ie the leaders in SMS are not currently and may not necessarily be the leaders in 2.5G and other new services)."

Hence while KongZhong priced at the bottom of the range, it has still come at a premium to a number of comparables. At $10 per ADR, the deal was priced at 16.5 times 2004 forecast earnings of $22 million.

By contrast, Linktone was trading at 15 times, down from roughly 20 times when KongZhong launched roadshows, while Tom Online was at 14 times down from 16 times at the same point. NetEase, which has consistently traded in the mid to low 20's this year, is now at about 18.5 times.

Observers report an order book of about 80 accounts in KongZhong's IPO, of which 10 placed orders for more than 10% of the deal. By geography about 60% of the deal went to the US and the rest predominately to Asia. US retail accounted for about 10%.

There was said to be a fairly equal mix of hedge, long only and US tech funds. Virtually all of the investors are thought to own other stocks in the sector, although a couple of the US tech funds were thought to be completely new.

"I think this deal shows that me too stocks, especially in the 2G space, are going to have a hard time," says one specialist. "Investors are still interested, but stocks need to have something new to say and strong profit track records."

So far, KongZhong has had a limited, but spectacular profit record. It was only founded in 2002 when it recorded revenues of $200,000. By the end of 2003, revenues had jumped to $7.8 million and net income to $2.4 million.

Then in the first quarter of 2004, the company beat its full 2003 figure, recording revenues of $7.1 million and net profit of $3.1 million. This year it is forecasting a seven-fold increase and in 2005 a two-fold increase over 2004.

Net profit margins are expected to climb to 44% in 2004 from 30.7% in 2003.

So far, KongZhong has been China Mobile's 2.5G service provider and offers clients the ability to browse the internet over the phone, play interactive games with other users and even enjoy mobile karaoke. At the end of first quarter 2.5G services accounted for 73% of revenue compared to 7% at Sina.

Pre-IPO, founders Zhou Yunfan and Nick held 45% of the company. This will now drop to 39.6% and 27% will be in freefloat. The 10 million ADR deal, comprised eight million primary units and two million secondary units.