A Further Discussion of KongZhong (KONG)

Jelly Roll Capital Equity Research

Market Analysis, Education, and Wall Street-Quality Stock Reports

More On Our Latest Stock Brief: KONG

Today we released coverage on a stock that, in many ways, is unusual for us to cover. KongZhong is a Chinese company that provides wireless value-added services (WVAS) for cell phone users - essentially, small add-ons like ringtones, games, chat, and news. Normally, the stock selection process we use leads to traditional, old-economy value stocks in hard asset businesses. Examples of this include Alliance Resource, a coal MLP, Builders FirstSource, a residential construction materials company, or consumer products staple Johnson & Johnson.
Why, then, did we select KONG as the latest stock to feature? The answer is slightly complicated, and hits at the heart of the growth vs. value dichotomy. References to that always strike a chord, because without growth, it is very difficult for a company to be considered undervalued. Every time we value a company, one valuation is done assuming that the company does not grow profits at all, and seeing the contrast between the valuation target given for that scenario and for others shows just how important growth is to value.

Speaking inversely, looking at the value side of growth shows that investors routinely overpay for a growing bottom-line. This is being done with well-known stocks like Apple, Google, and Coach today, and it will be done with other stocks in the future. At some point, investors are overpaying for growth - and ignoring the value side of growth is greatly detrimental when speculative excesses are unwound in the markets.

The value and growth puzzle looks to come together with KONG given the current share price ($7.04) that is more than half comprised of cash on the balance sheet ($3.75/share). Although I largely regard P/E as a useless metric, here it illustrates a point: backing out the cash shows that KONG is trading for less than 5x earnings. I realize the uncertainties surrounding investing in China in general and KONG in particular, but 5x earnings for a company whose potential market will approximately triple in size (less than 1/3 of Chinese people have a cell phone) and is experiencing near-10% real growth seems to be an the signs of a market overreaction in shares of KONG. The stock brief on KONG have a target price with about 50% upside, but I think that shares of KONG bought at current levels could easily yield a multi-bagger and rise to $20 or more. Granted, it is much more difficult to justify that valuation than $10 or so, I still feel it is completely possible given the tendency for the Chinese market to be more prone to rapid moves on speculation. Getting back to the zero-growth comment earlier, KONG’s end multiple using a 15% discount and no growth is 7x earnings, or less than 3.5x earnings after netting out cash - a 28.5% yield in a market that, in 2012, might finally be hitting full stride with mobile penetration and 3G adoption? I think the valuation on KONG looks very interesting in light of that “no growth” assumption.

I can’t pretend that KONG is a sure thing; there are numerous risks and uncertainties. The stock at current levels seems to offer a compelling valuation along with enormous potential for future growth. While not a widows-and-orphans stock, or even a stock for those sensitive to volatility, I believe that KONG is an excellent play for those looking to capitalize on one of the hottest growth markets (wireless) in one of the world’s largest and growing economies (China). Unlike many foreign stocks, this one has earnings power and a solid balance sheet behind it - as well as the support of one of the greatest hedge funds of all time (Jim Simon’s Renaissance Technologies fund is the largest shareholder). I think the stars are aligned for a great run from KONG, and that this stock could power a portfolio for years to come.