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Wei Zhou, CFO of Charm Communication Inc.

iChinaStock recently conducted an interview with Wei Zhou, CFO of Charm Communication Inc. (NASDAQ: CHRM). Charm offers a range of advertising agency services in China ranging from planning and managing campaigns to creating and placing advertisements.

In the interview, Zhou discusses Charm’s business model as well as its plans to capitalize upon the growth of internet advertising in China.

1) Diversified Base of Advertising Customers

iChinaStock：The core business of Charm Communication (NASDAQ: CHRM) is advertising agency services. But you only added 3 additional customers during Q2 this year base and there are now 143 customers. Is that a slow pace of expansion?

Zhou: It should be noted that the compound growth rate of our advertising agency business revenue is 39.4% from 2006 to 2010. Last year we launched US $474 million worth of advertisements, and that brought us an incoming of US $25 million, combining service charges and bonuses.

Our customers come from a wide range of industries including FMCG, medicine, home appliances, finance, and transportation. Our agency services aim to provide long-term solutions and service, and we attach significant importance to the percentage of contract renewals. We also strive to reach new advertising customers by expanding our business to new media platforms such as Internet.

iChinaStock: How long is the duration of a contract, normally？ What about the duration of cooperative relationships? Do you have a stable group of major customers?

Zhou: The standard duration of advertisement contracts is one year. At Charm Communications we have many long-term customers with whom we have good relationships. Some, like Lolo Drinks and Bosideng Clothing, have been cooperating with us for 8 to 10 years. Others, like Snow Beer, Agricultural Bank of China and Hualong Food, for 5 to 6 years.

All in all, the company has a rather balanced source of customers, with no single customer occupying over 10% of our total advertising volume. Moreover, advertisements from our top 10 customers never exceed 30% of the total volume; the number was 28% last year. That means we have a healthy, diversified structure of customers.

2) Standard Agency Commission is About 5%, Collected from Both Customers and Publishers

iChinaStock: We noticed that revenue from service charges plus bonuses is equal to only 5% of total advertisement contracts. Why?

Zhou: The sum of service charges paid by customers and commissions from the media is called the agency commission rate; this is the revenue Charm Communication manages to collect from the total value of the customers’ ads. The average conversion rate over the last three years was 5%; the number for the first half of this year is 4.8%.

iChinaStock: Why did the rate drop slightly, and how do you plan to raise it again?

Zhou: We commenced a strategy to expand market share into satellite television channels and local TV stations by lowering commission fees, and that depressed our commission rate a bit. I believe the rate will increase in the second half of this year, as our Internet advertising business thrives and market share grows on satellite TV channels.

3) Internet Advertising: Emphasizing Search Engine Marketing and Video Ads

iChinaStock: How many of your Internet advertising customers are from the group-buying and e-commerce industries?

Zhou: Most of our Internet advertisers are from comparatively traditional industries instead of these emerging Internet industries. We focus on providing excellent services to existing customers and helping them expand by improving our solutions.

iChinaStock: What are the differences between ad agency services on the Internet and in television?

Zhou: Advertising services on the Internet must produce a variety of ad products for the customer, including pictures, video streams, search engine links, text and probably e-community ads in the future. Online advertising is far more demanding than TV, which requires only a single video clip.

iChinaStock: Now that Charm is shifting its ad services from TV to the Internet, what do you think will be the proportion of these two business streams in the future?

Zhou: In total, TV ads still constitute more than 60% of our total volume of advertisements, but Internet ads are surging quickly, increasing from 10% of total volume this year to 15% next year.

4) More Acquisitions of Internet Operations in the Future

iChinaStock: Charm just acquired 60% shares of ClickPro Adversiting Inc. How was ClickPro’s performance before your acquisition? And how much did Charm spend on this acquisition?

Zhou: ClickPro was already an excellent advertising firm before our acquisition, serving prominent customers like Sina.com, 51job.com, Chrysler, Air China Inc. and so on. We do not plan to reveal the price of acquisition, but we plan to pay in installments that will conclude in the 3rd quarter of this year.

iChinaStock: How will ClickPro be integrated into Charm’s previous search engine marketing business?

Zhou: We will merge ClickPro’s team with the search engine marketing division of Charm Interactive, which is a branch of the Charm Communication Group. The new branch will be branded as Charm Click, parallel to existing subsidiaries of Charm Advertising, Shangxing Media and Charm Interactive, which focus on advertising and branding services on search engines.

iChinaStock: Why are you establishing such a brand?

Zhou: Models of advertising service and branding on Internet search engines are quite different from that of normal display advertising. Charm Click aims at advertising for customers on search engines like Baidu by highlighting, selecting, managing and ranking keywords. This is a rather technical model of business; it is quite challenging for a company’s technical staff. Moreover, there is a huge market for search engine ads; that business now occupies 40% of total ad volume on the Internet.

iChinaStock: Do you have any future acquisition plans this year?

Zhou: We’ll see. We might make more acquisitions in Internet advertising industries, should there be desirable opportunities.

iChinaStock: This June Charm cooperated with Aegis Group Plc. to establish a digital media purchasing platform. How will that boost the company’s Internet ad agency services?

Zhou: Aegis Group is our second-largest shareholder. The platform, as part of our Internet services, could increase revenue and efficiency.

Charm and Aegis can use this platform to negotiate with Internet media corporations as a single entity, giving us an upper hand in bargaining that leads to higher bonuses. Such an integrated platform can also raise efficiency of operation, downsize operation teams, and cut costs. Charm and Aegis can conduct joint research on advertising services that will produce better solutions for customers.

iChinaStock: There is another joint venture between Charm and Aegis, Vizeum Advertising. What does that firm do?

Zhou: We also hold 60% of shares in Vizeum, so its performance is included in Charm’s financial reports. Vizeum is a 4A-class ad agency firm, serving two major types of customers: foreign corporations, like Nikon Corporations; and the other are major competitors to Charm’s existing customers. For instance, Charm Advertising cooperates with China Telecom, while Vizeum does a large volume of business with China Mobile.

5) On Profits in Media Operations

iChinaStock: Why is ‘media operations’ the highest-grossing of your three major businesses?

Zhou: The meaning of ‘media operations’ in our company is the division that contracts with certain media channels to buy advertising. In calculating revenue from media operations, we count the total volume of ads launched through these channels. In the first quarter of 2011, media operations made up 82% of our total revenues (note: for media operations revenues are counted as equal to ad spend), while revenue from agency services constituted 14% (note: in agency services, revenue is the commission Charm earns from customer adspend).

But we pay more attention to the total volume of advertisements (adspend). In the first quarter we had US $200 million of ads with 73% from agency services, but only 27% from media operations.

iChinaStock: What are your demands for contracting media? Do you plan to increase the number of media partners?

Zhou: First and foremost, the cost of contracts must not be to high so as to squeeze out our gross profits. Second, our contracting parties must have high potential, a big audience, and influence. Typical examples include Tianjin Satellite Channel, which became our contracting party three years ago; Oriental Satellite TV in Shanghai, with whom we signed a contract 4 years ago; and Hubei Economics TV Channel and Beijing Cable TV, with whom we just became partners. We plan to add one to two channels or programs to our media resources each year.

iChinaStock: How do you calculate gross profits from media operations? And how are the numbers changing?

Zhou: We started to run the media operations business in 2008. Gross profits equal the volume of advertisements sold minus the third-party costs, which include business taxes and contracting dividends paid to the media channels. Contracting fees are also called media costs. Quarterly media costs are rather stable, while quarterly revenues keep rising. Gross profits increasing every quarter.

iChinaStock: There is no fluctuation in media costs?

Zhou: The situations vary on different media channels. Our budgets for media costs are related to the ratings of different channels. Two factors drive up the price of advertising time. One is their own cost per mille; the other is the increase of programs’ ratings, which also adds to the CPM.

Media costs will definitely increase on a year-on-year base. Each year we negotiate with media owners to determine annual media costs, so the costs vary each year.

iChinaStock: What factors will influence gross profits?

Zhou: Gross profit rates are influenced by the available advertising space and prices for advertising time. Capacity of ads reflects how many ads a channel can do. Say, if a channel spends 20% of its time on advertisements, it has a capacity rate of 20%. Generally the ratio is not very high for the first year, but it will increase and drive up the gross profits in the second year, as we become more familiar with our customer’s operations and become more efficient in selling ad time. Gross profits could also increase if we sell ad times at higher prices.

iChinaStock: How do capacity ratios vary? How much are the capacity ratios of Charm’s media partners? Is there still space for growth?

Zhou: The ratios are improving each quarter. The ratios, the prices of ad time and the performance of our customers all vary quarter by quarter.

Case in point, our cooperation with Hubei Economics TV is not that smooth because this is only our first year. Regarding those established media partners, we will sign a annual deals one year in advance, so that we can sell some of their next year’s advertising slots earlier, and at cheaper prices, to specific long-term advertising customers. Then we reserve 20% to 40% of time to sell at higher prices to on-spot customers. Overall, capacity rates were at high levels last year, but they could increase further.

iChinaStock: The general trend of the media advertising business is stable growth. But the number of advertisers using Charm’s media partners plunged to 290 in Q2, a period-on-period base. What are the reasons for this decline?

Zhou: It’s an anticipated decline. During Q2 we suppressed our discount rates on ad prices to increase the ratio of high-value customers, who are willing to pay higher prices. The company aimed at expanding the capacity rate during earlier periods of media operations, so we lowered the prices to attract more low-value customers and to fill the ad slots with a higher number of advertisers.

But as operations become smoother and marketing systems mature, we plan to select and introduce more prominent advertisers. Not only will media partners benefit but the capacity rates can also be maintained.

iChinaStock: Why did the company’s average revenue per user (ARPU) reach its peak during the second quarter?

Zhou: That means our marketing and sales capabilities grew so that we are able to squeeze out more profits from each customer.

But we believe total gross profits are more critical than ARPU. There could be extreme variances among customers and within individual advertisers. Some customers signed deals with us once and will never do repeat business, while others might spend tens of million, sometimes hundreds of million yuans on one channel.

6) Cross-marketing Between Agency Services and Media Operations

iChinaStock: Is it true that some of the advertisers on Charm’s media partners were originally customers of your ad agency services?

Zhou: Yes, the two groups overlap in part. If customers of our agency services find our media resources valuable, we can connect them with our media partners and offer them lower prices. But we realize that if the advertisers and media channels don’t match, we will instead look for other channels that can maximize the effects of advertisements. Our media partners serve not only our agency service buyers but also local brands and companies.

iChinaStock: So Charm is combining its customer resources in agency services with media resources in media operations?

Zhou: Right, you could call it ‘cross-marketing’. Our media platforms can launch ads for both national brands using our agency services and local brands that have been doing ads on these channels before. Through this we add new media channels to our original advertisers and add new customers for ourselves.

iChinaStock: How’s the balance between the two businesses?

Zhou: The total volume of advertising revenues is increasing as the numbers of both customers and media partners rise. But the ratio of the two sections could vary.

In 2009, the ratio of adspend by agency services versus media operations was 77% to 23%. Last year we added quite a few media partners so the ratio changed to 74% to 26%, meaning media operations were expanding while agency services shrank in relative terms. In the long run, we hope to maintain the ratio at 70% to 30%.

iChinaStock: Why so?

Zhou: The 70% volume of agency services has a lower risk, while the 30% volume from media operations is high in both profits and risks. We believe maintaining such a balance will support the fundamentals of our business.

iChinaStock: So you are hedging against media operations with agency services?

Zhou: Exactly. Media operations have higher risks because we could suffer losses simply by not being able to sell our contracted time slots for advertisements. On the other hand, agency services bring safe payments from agency commissions and bonuses, which incur literally no risk.

iChinaStock: Branding services have a pretty small proportion of revenue. Who are the major customers?

Zhou: Branding services are creative designs that we provide primarily to customers using our agency services.

7) Coordinating Between Charm’s Agency Brands: Charm Advertising is Still the Core

iChinaStock: We know that Charm now has three major realms of business—agency services, media operations and branding services, and four brands—Charm Advertising, Charm Interactive, Charm Click and Shangxing Media. How do you coordinate relations among the branches and operations of different realms?

Zhou: Agency services operate three brands: Charm Advertising, Charm Interactive and the newly established Charm Click. We also co-run Vizeum. Agency services bring the majority of advertising volume. Shangxing Media is in charge of media operations.

Charm Advertising is the flagship of our fleet, the platform where we attract advertisers. Other brands provide two additional resources for it. One is media resources from satellite television channels and local TV stations, managed by Shangxing Media. The other is service resources, including Internet campaigns and search engine marketing services, from Charm Interactive and Charm Click, respectively.

So Charm Advertising is the core and the other three brands focus on bettering its services; but each of the three brand can attract new customers for Charm Advertising.

8 ) The Future is Internet Advertising

iChinaStock: Where will future growth come from?

Zhou: Our growth depends on increasing the number of advertisers and volume of advertisements.

Most specifically, we must maintain our leading position in launching advertisements on CCTV channels, while also expand our business on various satellite TV channels. In Internet advertising we must raise our revenue conversion rate by professionalizing our services. We must also add media partners. The focus of our future agency business will be Internet advertising.

iChinaStock: Does Charm have a stable cash flow because it has conservative financial policies?

Zhou: Yes. We are very prudent in cash management. We never do short-term speculation and only invest in areas related to our core business.

iChinaStock: Why did Charm decide to launch its IPO in the USA when its major customers and operations are all located within China?

Zhou: First, agency services have a long tradition dating back a century in the USA and we believe US investors can easily comprehend our business models.

Second, an IPO in USA boosts our brand awareness, which is critical for an advertisement service firm.

Finally, we can connect with many international investors in US, and there would be more chances for re-financing.

(Source: Jane Li, iChinaStock)

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