Company Profile

Kingsoft is a leading Internet-based software companies in China. It provides online games, Internet security software, office software and cloud services. Group has in-house software development team, and provides application software services through their own Internet platform. In online games they have the famous “JX series” as the flagship product for many years and attracted millions paying players. For Internet security and office software, there are Kingsoft Anti-Virus and WPS Office. Products are mainly sold in the mainland China, but also exported to Hong Kong, Macao, Taiwan and Southeast Asian countries.

Financial Highlights

The revenue rose by 54% yoy to RMB 2.173 billion (as below) for FY13, which revenues from online games increased by 28.7% to $1.096 billion and from application software surged 94% yoy to $1.056 billion. Gross profit increased by 53.3% to $1.876 billion, the gross profit margin was about the same of 86% as before. Operating profit was $682 million, an increase of 65% while profit attributable to shareholders was $671 million, an increase of 55%. Final dividend was HK$ 0.12. Kingsoft's performance for last year was excellent, especially in the Internet services and software, both achieved significant increase in sales.

Changes in product mix, the Internet service will become the main source of revenue

Compared to the previous financial year, the product mix for FY13 has changed significantly. In FY12, revenue from online game was a major source of revenue for the company, accounted for 60%of the total revenue; followed by the software business, 20% of total revenue; Internet services, including Internet security software, online platform and mobile applications, consist of only 18% of the total revenue. However in FY13, revenue from online game was $1.096 billion, accounted for 50% of total revenue; software revenue as $370 million, 17% of the total while revenue from Internet service surged to $686 million, as of 32% of total revenue.

It is expected in the next few years, the revenue from Internet service will continue to rise. The proportion will increase to 45% to total revenue in FY14, which will become the largest source of income. In FY16, there will be a further rise to 53%.

One thing to mention, the revenue from Internet service in FY13 was $686 million, a substantial increase of 168% from $256 million. But this increase may due to the rapid growth in online sales for “Double Eleven Shopping Festival” (Single Festival), and increase revenue from KIS game platform. Therefore it is expected

1) Despite that there will still be impressive sales volume in this year's Shopping Festival, the growth is difficult to compare with last year; 2) The growth will mainly achieved by KIS game platform and its mobile Internet applications.

And the sales of office software, benefited by the PRC government's policy of protecting legitimate software which required to use the legitimate software in the public organizations. This stimulated the sales of WPS Office software and software business is expected to have nearly 30% annual growth in the coming years.

Steady growth in the online game business, good cost controls

For FY13, company's online game business recorded 28.7% growth, mainly due to the ten consecutive quarters growth of its flagship game "JX 3". In the fourth quarter of FY13, "JX 3" had published its additional patch, led to its daily average peak concurrent users (DAU) increased by 3% qoq to 630 thousands, but a slightly decline yoy. As of the end of FY13, the average monthly paid users (MPU) was 1.87 million, an increase of 13% yoy and 4% qoq. However, compared to peak 2,000,000 paying users in summer, it could not fully regain the lost ground. The average monthly revenue of paying users (ARPPU) slightly increased 2% to RMB 49. It was expected the future online gaming revenue will grow slowly, with an average annual growth rate ranging from 7% to 9%.

Despite the rapid growth in total revenue, expense to revenue did not increase significantly. Research and development expenses rose 55% to $596 million, sales and marketing expenses increased by 64% to $383 million and administrative expenses increased by 30% to 192 million. The overall expense to revenue rose only according to its operating income, reflecting the company's good cost control.

Spin-off of Cheetah Mobile Inc, focus on Internet and mobile services

Kingsoft spin-off its former Kingsoft Internet Software (KIS) Holdings Ltd, renamed to Cheetah Mobile Inc. (CMI) and applied for the initial public offering of American Depositary Shares in NYSE, which was priced at US$ 14 and started to trade on board on May 8. According to company reports, CMI shall not engage in games and software research and development, or operation of its self developed games. CMI will mainly engage in information security software, web browser. Its main mission is to develop and operate mobile games and applications, and provides online advertising services and Internet value-added services. After the spin-off of CMI, Kingsoft's voting power on CMI remains unchanged, but the stake will decrease 7.1% to 47%. Therefore, the profit attributable to non-controlling interests will increase, resulting to profit attributable to Kingsoft's to reduce accordingly.

In addition, Kingsoft has also announced its subscription of 31.94 million of Xunlei Series E preferred shares, representing 9.98% of the total shares that had been issued. These preferred shares were convertible at any time to Xunlei Series ordinary shares. The subscription was to strengthen Kingsoft's Internet services penetration rate.

Valuation

We believe that the market valuation of over 40x P/E of Kingsoft at the beginning of this year is indeed too high. Despite of supportive government policy for its software business and the high growth in Internet business, the revenue growth of Internet service in FY13, in partly due to a substantial increase in online sales for the Single Festival last year. Besides, the market estimate on Kingsoft's mobile Internet revenue was just over-optimistic. Given the recent market volatility, the out-performing stock last year dropped significantly recently, and investors begin to pay attention to the high valuation of IT stocks. After re-examine the valuation, we estimate the 6-12 months target price for Kingsoft to be HK $ 21.42, which is 24 times of FY14 forecasted earnings and give rating as "neutral". This is calculated by the valuation HK $ 17.63 for operation and HK $ 3.79 for cash.

However, in the long run, HK $ 21.42 is only equaled 15.4 times and 14 times of the forecasted earnings in FY15 and FY16 respectively. It is expected the long-term valuation will rise back to the around 20 to 25 times.

Potential risks

Revenue from online games decrease

Internet business growth slows down

After the spin-off Cheetah Mobile, revenue affected by reduction in stake

Costs and expenses increase more than expected

Financial Status

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