China MediaExpress: Q1 Results Confirm Strong Fundamentals

Includes: CCME, FMCN
by: Chimin Sang

Recently I presented a long thesis on China MediaExpress (OTCPK:CCME), a China outdoor media company that broadcasts commercials on long distance express buses.

On May 14, 2010, the company issued 2010 Quarter one earning report and held a conference call.

The Conference Call

Revenue increased by 137% to $44.5 million as compared to $18.8 million last year; Gross margin for the first quarter was 60%; Net income increased by 143% to $18.1 million as compared to $7.5 million.

As a reminder, For 2009 Q4, CME made $32 million revenue, with gross margin 69%. Net income $14 million. At that time, the company guided a slightly weaker Q1 compare to Q4. They over-achieved in Q1, which was due to several reasons. Compare to 2009 Q4, the CEO quoted that there is an increase in advertising time sold, higher average advertising rates, the expansion in geographic coverage and client base, higher proportion of direct versus agency sales, more embedded soft commercials and, more importantly, they generated $7m by separately packaging airport express buses.

Excluding the airport bus business, CME's revenue keeps growing. It is interesting to note that the typical Chinese spring festival slowdown did not affect CME. Chinese New Year is like Christmas in the States, people travel a lot to reunion with family. Hundreds of millions people get moved in a short period of time. It is not a good time for outdoor media companies like Focus Media (NASDAQ:FMCN) which has a strong presence in office buildings, but it is a prime time for an inter-city express bus media company like CME. Instead of giving up two weeks' revenue as seen in Focus Media, CME collects the full revenue, then some. CME must have felt a weak season in 2009 due to the global recession and guided accordingly, but this year it actually increased advertising time sold this quarter versus last quarter, a seasonally strong quarter.

The airport express bus business is a good move. The CFO commented that its margin in this quarter is low, which I estimate to be about 30%, but will be "much" higher than their usual business in the future, which would put it into 70%+. The currently low margin is due to higher setup costs. My understanding is that the cost will probably stay since it is mainly the concession cost but the rates on these routes will increase much faster in the future.

The gross margin of Q1, 60%, is much lower than the gross margin in Q4, 68%, and that raised some concern. The cost jumped from $10 million in Q4 to $18 million in Q1. My understanding out of the conference call agrees with my earlier guesses. The existing express bus market has already been occupied by various players, with CME controlling 50% of it. To get new buses, CME can no longer go through the old ways by signing up bus operators directly with little signup fee. Many smaller media firms already have agreements with bus operators. CME has two options to acquire them, either through assets acquisition or through equity acquisition. CME chose the former because it did not want to buy the management of those smaller firms. So they bought off the assets from the media firms and paid high concession fees up front to break the lease between the previous media firms and the bus operators. The upfront concession fee is now typically between 50,000 RMB, or $7,400, and 100,000 RMB, or $15,000. It is amortized for the whole lease period, typically 5 years to 8 years. Moving forward, this should be the business norm.

Note that the concession fee is on the scale of one year revenue, which is amortized evenly on the entire contract duration. This means a difference of about 20% gross margins between new buses and old buses. This cost structure is much easier to understand than if they do acquisition by equity.

Now let us look at some numbers on the bus count. At the end of November 2009, CME's bus count was 20,000, and it acquired 1,000 new buses in December. It acquired an additional 500 buses in the first quarter. Its compressed margin is out of concession adjustment year of year, which I assume to be probably 15%, the addition of higher cost assets, and the addition of new assets which have lower margins to start with. In the future, if we assume that the economy does not have a major correction, and the company's revenues continue to pick up, we should see two forces working on the gross margin: Organic growth will expand the margin; The addition of new bus routes will compress it. For 2010, I expect the gross margin to expand from quarter to quarter.

In Q4, CME was expecting to convert 35% of revenues to direct sales by end of 2010, but they've already achieved this goal in the first quarter. Now they are expecting 50%. The CFO acknowledged that there is potentially a conflict of interest between its ad agency and its direct sales efforts since this will hurt the ad agencies. He shrugged it off, explaining that so far, no big deal. My take is that it is a tricky situation. It depends on CME's market position. It is possible that if CME had enough market power it could afford hurting ad agencies.

The expected one-time charge on Starr International preferred shares was $9.2m , which can be totally ignored. It is a non-cash item and only affects the book value calculation. For a company like CME which has very high ROIC and P/B at 4, book value does not mean much. A more pertinent impact is the share dilution, which is accounted for in the EPS calculation.

The CFO also mentioned that he is meeting with more institutional investors and sell-side analysts to promote the stock.

Other points to take away from the question and answer sessions:

  1. There seem to be rumors that CME may choose to be listed on Nasdaq instead of AMEX. When asked, the CFO said something pretty much to the effect that it was one of their options, but they had no commitment and the whole thing is confidential. I personally don't see much benefit out of the move, but I assume that AMEX traditionally has been linked to low quality firms, so that there is some motivation to link the name with Nasdaq or the NYSE main board. If the stock does move, it may help the stock to gain full recognition.
  2. The management confirmed that they are doing acquisitions but they are just getting the assets. A follow-on question asked about their acquisition P/E since CME only acquires the assets and shares the SG&A, this question seems a little out of the context.
  3. New expansion ideas. CME is onto something. The CFO repeated some ideas that they are pursuing, the old ones being commercials in the bus station and etc. A newer idea he presented is to garner revenue from the travelers, as well as from the advertisers. Materials similar to "SKy Mall" on planes could be offered to passengers to promote products and services. The CFO also hinted that they have a relatively large project in the making, which is related to 'transportation media' and which requires signing contracts. No other hints were given. The only thing that rings a bell to me is to have media on trains. I know some companies are already in the market. But there could be many other possibilities, which I have no knowledge of.
  4. The CFO commented that their original plan to reach 84 million net income in 2010 included expansion of the bus network to 30,000 buses, which will cost $20 to $30 million cash. It is unclear if this is still management's plan. I also doubt if that is management's best choice. CME already has the best routes in their market. Acquiring the rest will be of less and less efficient use of capital. The 500 bus acquisition for the whole first quarter certainly does not make it look like they are going to acquire 8,500 buses in the next three quarters. If I had to guess, I'd say the CEO has a new plan.
  5. An analyst went to great lengths to have the CFO confess that they are low-balling the full year estimation, which currently stands at $73 million, but a linear extrapolation of the current quarter earnings puts the whole year's earnings at $72 million. I believe that transparency is universally liked on Wall Street. The management should learn to make conservative, but not overly conservative, estimations.
  6. I called in to ask some questions. My questions were very lame. I asked two house-keeping questions. One was to make sure that they don't have legacy assets from their previous Focus Media joint venture. The other was to get to the calculation of deemed dividend. The answers came back within my expectation. The third question was on the option offering. The CFO clarified that it won't be significant since the founder is already incentivized with earn-outs. Those options are going to be for the lower employees.

As a conclusion of the conference call, CME proves itself to be a very well run company. I expect it to over-achieve the bonus share benchmark, $83.5 million in net income, this year since it already made $18 in the first quarter and it has other cards under its sleeves.

Post Conference Call Events

Soon after the conference call, two significant events were announced by the company.

On Monday, the company signed up 816 buses in Inner Mongolia with the same acquisition method I mentioned above. It showed the commitment of management to continue its expansion plan by acquiring assets. The concession fee was not stated in the press release. However, I expect that the rate comes below 50,000 RMB per bus it paid in Guangdong.

On Wednesday, the company announced that it will move its stock listing to the Nasdaq Global Select market starting June 3rd, confirming the rumor. This move is very significant. AMEX has historically been linked with low quality companies, but Nasdaq Global Select Market has been developed for the highest quality companies in the Nasdaq, above Global Market and Capital Market. Market Cap is not what makes the Global Select Market, but the financial standards and corporate governance is.

NASDAQ developed the initial listing standards for the NASDAQ Global Select Market to be the highest financial standards in the world. In addition, NASDAQ Global Select Market companies have to satisfy all of NASDAQ’s corporate governance requirements, which we believe are already superior for investors and for companies. NASDAQ is continuously looking for ways to enhance our market and bring more transparency to investors." -- from Nasdaq FAQ.

I received quite a bit of feedback since I wrote my long thesis, many comments related to concerns about the stellar numbers. I hope the Nasdaq approval is another endorsement on their book besides many other endorsements I mentioned in my previous writeup.

Looking forward, the stock will have more liquidity due to future inclusion in many indexes, such as the Russell 2000. Its market cap is already more than $500 million, which I expect to move north of $1 billion soon. Sell-side coverage seems to be coming sometime soon.

Based on all these facts and some of my reasonable guesstimates, I advocate going long on this name.

Disclosure: Long CCME