Neutral. Disappointed 1Q14 results, maintains Neutral HONG KONG SOFTWARE COMPANY RESULTS. 23 June 2014 KINGSOFT (3888.HK) Rating: Maintains at Neutral

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1 KINGSOFT (3888.HK) Disappointed 1Q14 results, maintains Neutral HONG KONG SOFTWARE COMPANY RESULTS Rating: Neutral Maintains at Neutral Kingsoft s 1Q14 revenue increased 48% yoy and 1% qoq, which was lower than our estimate and showed a slow down on the revenue growth. Both gross profit margin and EBIT margin dropped indicated increase in cost and expenses. Profit attributable to parent surged 26% yoy and 48% qoq since a oneoff gain on disposal of investment was included. We maintain the rating of Kingsoft as Neutral with slightly upgraded target price HK$ for 2014 to reflect more cash in hand. Financial Highlights Kingsoft announced its 1Q14 result with revenue of RMB 675.6millions, an increase of 48% yoy and 1% qoq. While revenue from online games and Cheetah mobile recorded quarterly growth of 2% and 17% to RMB 294.9millions and RMB292.8millions respectively, revenue from office software declined sharply of 33% qoq to RMB 87.9millions. Gross profit was RMB 569millions, with gross profit margin of 84.2%, slightly dropped from 86.3% in 2013 as the increase of cost of sales. Operating profit amounted RMB 130millions, decreased 19.7% yoy and 29% qoq respectively due to the increase in R&D and selling expenses, with EBIT margin sharply dropped to 19.25%. Profit attributable to parent was RMB 246.2millions, surged 26% yoy and 48% qoq since a one-off gain on disposal of investment was included. How we view this Kingsoft was a bit underperformed than our expectation, which revenue was lower than our estimate and showed a slow down on the revenue growth. The growth on online games is in line with our forecast and we are confident that Cheetah mobile can achieve double revenue compared to last year. The performance on WPS was quite disappointed but we expect it will resume growth in the second quarter due to the PRC government s concern on internet security and recent policy on Windows 8 which will probably shift existing Windows Office users to WPS. Investment Action We have slightly lowered the forecasted revenue from office software (WPS) with no change in online games and Cheetah. Besides, we have also adjusted the expenses upward as well as included the gain on disposal for After all, we maintain our rating of Kingsoft as Neutral with slightly upgraded target price to HK$ in 2014 to reflect more cash in hand, equivalent to 25x/21.5x of 2014 and 2015 forecasted EPS. Key Financial Summary FYE 12/12 12/13 12/14F 12/15F Operating Profit (RMB mn) ,095 Net Profit, adj. (RMB mn) EPS (HKD) P/E (X) BVPS (HKD) P/B (X) Target Price (HKD) Forecast Dividend (HKD) Closing Price (HKD) Potential Upside Company Description Kingsoft is a leading Internet-based software companies in China. It provides online games, Internet security software, office software and cloud services. Products are mainly sold in the mainland China, but also exported to Hong Kong, Macao, Taiwan and Southeast Asian countries. Company Data Raw Beta (Past 2yrs weekly data) Market Cap. (HKD bn) 27,694 Enterprise Value (HKD mn) 23, week range (HKD) Closing Price in 52 week range Jun-13 Major Shareholders 1. Lei Jun 2. Tencent Holdings 3. Kau Pak Kwan Valuation Method PE Analyst Kay Ng kayng@phillip.com.hk Aug-13 Oct-13 Volume, mn (RHS) HS I (LHS) Dec % 0% 50% 100% Feb HK Equity (LHS) Apr-14 N/A Jun % 12.60% 9.13% DPS (HKD) Div. Yield 0.50% 0.50% 0.60% 0.60% Source: Bloomberg, PSR est. *All multiples & yields based on current market price Page 1

2 A disappointed 1Q14 result implied a slow of revenue growth Kingsoft s revenue from online games recorded growth of 11% yoy and 2% qoq which in line with our estimate. The growth on online games is expected to be low single digits in the coming years. Cheetah mobile recorded 132% yoy and 17% qoq which is in line with our forecast and we are confident that Cheetah mobile can double its revenue in Office software business, WPS declined sharply of 33% qoq, while an increase of 37% yoy. We expect the growth will resume in the second quarter due to the PRC government s concern on internet security and recent policy on Windows 8 which will probably shift existing Windows Office users to WPS. Fig 1 Revenue estimate Source: PSR, Company report Table 1 Revenue estimate Source: PSR, Company report Gross profit margin slightly dropped from 86.3% in 2013 to 84.2% in 1Q14, showed an increase of cost of sales. Operating profit decreased 19.7% yoy and 29% qoq with EBIT margin sharply dropped to 19.25%, due to the increase in R&D and selling expenses. Although the selling and distribution expenses slightly decreased 4.6% qoq, it surged greatly of 132.7% yoy. R&D expenses also surged 70.5% yoy and 11.9% qoq. However, it is expected the cost and expenses to revenue ratio will decrease in the second quarter and afterward due to expected increase in revenue in later Profit attributable to parent surged 26% yoy and 48% qoq as a one-off gain on disposal of investment was included. Page 2

3 Fig 2 Costs as percentage of revenue estimates Source: PSR, Company report Valuation We have slightly lowered the forecasted revenue from office software (WPS) with no change in online games and Cheetah. Besides, we have also adjusted the expenses upward as well as included the gain on disposal for After all, we maintain our rating of Kingsoft as Neutral with slightly upgraded target price to HK$ in 2014, equivalent to 25x/21.5x of 2014 and 2015 forecasted EPS. The target price is calculated by the valuation of HK$ for business operation and HK$ 4.86 for more cash in hand. Table 2 Valuation Source: PSR Potential Risks Growth on mobile business slows down Cost and expenses continue to increase Page 3

4 FY12 FY13 FY14E FY15E FY16E Valuation Ratios P/E (X) P/B (X) EV/EBITDA (X) Dividend Yield (%) 0.5% 0.5% 0.6% 0.6% 0.6% Per share data (HKD) EPS DPS BVPS Outstanding Shares (basic, mn) 1, , , , , Growth & Margins (%) Grow th Revenue 38.3% 54.0% 32.7% 34.9% 15.1% EBIT 24.8% 64.7% 15.2% 39.5% 12.3% Margins Gross profit margin 86.8% 86.3% 85.3% 85.3% 85.3% EBITDA margin 29.3% 31.4% 27.2% 28.1% 27.5% EBT margin 37.4% 38.0% 36.2% 32.4% 31.5% Net Profit Margin 30.6% 30.9% 29.5% 25.5% 24.8% Income Statement (RMB mn) FY12 FY13 FY14E FY15E FY16E Revenue 1,411 2,173 2,884 3,891 4,477 Cost of revenue (187) (297) (424) (572) (658) Gross profit 1,224 1,876 2,460 3,319 3,819 Selling & Marketing expenses (234) (383) (567) (741) (878) Administrative expenses (148) (192) (266) (346) (428) R & D expenses (385) (596) (793) (1,074) (1,210) Other income Other expense (71) (69) (81) (98) (113) Operating profit ,095 1,230 Non operating income (expense) Net finance income (expense) Profit Before Tax ,045 1,261 1,412 Taxation (61) (71) (94) (120) (139) Profit After Tax ,141 1,273 Minority interest (34) (83) (99) (149) (163) Net Profit ,110 EPS Source: Company, PSR Page 4

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