A8 Digital Music (800 HK, HK$1.50) – First take FY12/08 results

FY12/08A results first take. Turnover increased 146.9% YoY to RMB706.1m while net profit was up 45.0% YoY to RMB80.2m, in line with expectations. Gross margin was down 7.3pcp YoY to 37.7%, though adjusted gross margin was steady at 21.4%, down 0.2pcp YoY. In our view, the adjusted gross margin is a better metric to track the company as it takes into consideration all revenue sharing, selling and marketing related expenses for the company. The relatively weaker bottom line growth was due to several one-off items in FY12/07A (amounting to RMB23.2m), which inflated net profit in that year. Stripping out these items, net profit grew 152.1% YoY and in line with revenues. Music related revenues jumped 150.8% YoY to RMB495.3m, led by ringback tones (up 204.9% YoY) and IVR (up 475.7% YoY) and accounted for 29.9% of turnover while non-music related revenues was up 138.2% YoY to RMB210.8m. At end FY12/08A, the company had RMB315.6m (HK$0.80 cash/share), representing 53.3% of stock price.

Our view. The company was able to record such strong growth in FY12/08A due to a combination of: 1) rebound from effects of industry restructuring in 2007 and 2) increased proliferation of mobile music, especially user generated content. With the company expected to embed around 10m units of A8 Box on mobile handsets in 2009 (2008: ~6m), and several players in the mobile space such as Tencent (700 HK) and Sina (SINA US) indicating that operating environment for mobile SPs have improved markedly, we expect A8 should be able to maintain a relatively high rate of top line growth for FY12/09 (though moderating from the triple digit seen in FY12/08A). Our only concern remains whether the company can sustain its margins going forward. We think that increasing competition, slightly higher revenue sharing with handset manufacturers and working more with music labels may pressure margins, though we have previously allowed for some margin compression in our FY12/09F estimates. We are currently reviewing our model and will issue an updated report shortly.

What to do with the stock. The stock is currently trading at 6.3x P/E and 3.0x ex-cash P/E on FY12/09F earnings, prior to earnings revision. We think that operating environment will remain favourable to SPs in the near term as China Mobile (941 HK) seeks to sustain growth through promoting consumption of MVAS offerings. Despite some concerns of competition, valuation in the counter remains attractive and A8 is one of the few quality companies with pure play exposure the wireless sector, a domestic consumption oriented sector which is expected to display solid industry growth in 2009. We think there is momentum behind the stock and upgrade our call to Trading BUY (from Trading SELL).

Update on Friday, March 27, 2009 at 10:33AM by VAYUE.com Team

OK our bad.  So we were probably half a trading session early yesterday in making our Trading BUY call.  The counter ended the day down 17.3% to HK$1.24.  We underestimated the management's slightly unclear delivery of their financials during their analyst meeting on 25 Mar 2009 after the announcement of their FY12/08A annual results, which led to the sell down in the morning session.  In our view, the management was unclear in the way that failed to highlight to the analyst that several one-off items artificially inflated the company's FY12/07A net profit.

We still stand by and re-iterate our trading call (Trading BUY) on A8.  Our key reasons are that:  1) Mobile VAS space is a domestic consumption oriented space and the industry is one of the few in China that is expected to deliver meaningful growth in 2009; 2) A8 has solid positioning in the mobile music area and 3) cash rich company at attractive valuations.

Look out for our research report to be issued shortly.

Update on Monday, April 20, 2009 at 2:27PM by VAYUE.com Team

A8 Digital Music (800 HK, HK$1.79) - Closing our position

Roadshow takeaways.  Company undertook a roadshow recently.  Some key takeaways included:

• Company is earmarking 2009 as an "investment year", mainly due to increased use of funds to: 1) drive embedment and adoption of A8 Box and 2) investment to secure contracts with CT and CU
• Target shipment of handsets with A8 Box is 10m units (2008: 6m).  Management estimates that actual A8 Box users is currently ~2m.  Expect more material contribution in 2010
• Compared with content from music labels, UGC royalty fees are lower but require more marketing expenses.  Management estimates that overall difference is about 5-8pcp in favour of UGC
• Management guided that 1Q earnings are flat compared to 1Q08 (after excluding the one-off promotional event with CM in 1Q08).  This suggests that 1Q FY12/09 revenue would fall on a YoY basis
• Company plans to use its new R&D centre to develop a hub for digital music, with about half of the 20,000m2 to be rented out to other players in the supply chain

Switching to Trading HOLD.  We think that A8's stock price will be capped in the near term after rallying 19.3% from the day of results announcement and 44.5% from the closing price in the first trading day after their results announcement.  On a trading basis, we suggest investors to close their positions and cap profits.  (Long-term investors should stay as fundamentally, the stock's valuation of 7.3x FY12/09F P/E remains attractive, see "Domestic consumption underline growth").