WR Hambrecht analysts James Lee and Xiaofan Zhang recently sent a note to clients in which they initiated coverage of Chinese advertising display company Focus Media Holding (FMCN). [The full version of this report is available at: http://www.wrhambrecht.com/sector/chinatech/notes/fmcn20061128.pdf. Excerpts follow:
We are initiating coverage of Focus Media Holding Ltd. with a Buy rating and a 12-month price target of $85 per share. The company is the largest LCD display operator in China, targeting out-of-home advertising in offices, stores and residential buildings. We believe Focus Media is well positioned for China’s advertising trends, with budgets shifting from mass-market to segmented, customer-centric media outlets. In addition, the company has created significant barriers to entry with its recent acquisition of Target Media. Finally, we believe the company is a play in the up-and-coming tier II cities in China, potentially driving revenue growth and margin expansion with a highly leveraged business model. Our $85 price target is based on 30x our 2007 pro forma EPS estimate plus net cash, which is reason able compared with the company's long-term expected growth rate, in our view. Our key points are as follows:
- LCD display plays well into advertising trends. Unlike developed countries such as the US, advertising in China is still a growing industry at a double-digits rate. With major events such as the 2008 Olympics and China’s WTO entry, we believe they serve as catalysts for the advertising industry going forward. We believe Focus Media unlocks the goldmine of display advertising in China, providing a targeted platform for advertisers to reach desirable demographics in a captive environment.
- Dominating market share. After acquiring Target Media, the company has a virtual monopoly in the LCD display business in tier I cities, creating barriers to entry and pricing leverage. Going forward, we believe the company will continue driving pricing upward in major markets while delivering revenue growth in secondary markets and in-store networks, which are growing at a much faster pace.
- Strong operating leverage. The LCD display business is largely fixe d costs, with building rent and investments in flat panel screens accounting for most of the expense line. The company has been successful in driving the utilization rate in major markets, selling almost all of its slots available and achieving nearly 70% in GM. The next wave of margin lift should come from tier II markets, where capacity utilization is still significantly lower, since they are in the early phase of deployment.
- Planning to expand into other growth avenues. Beyond in-door LCD advertising, Management plans to expand into outdoor, in-movie and mobile advertising to capitalize on other growth segments in China. We view these activities as developing stories, which could provide upside over the longer-term.
- Strong financial outlook. We expect EPS growth rates of 48% and 35% for 2007 and 2008, respectively, reflecting a strong demand for advertising space in commercial, in-store and residential locations. With that in mind, we expect the company to drive pricing leverage in major cities and higher utilization rates in smaller markets.
- Valuation attractive vs. growth. Our price target of $85 is based on 30x our 2007 pro forma EPS estimate of $2.75 plus $2 in net cash, consistent with our expected long-tem growth rate for the company. On a relative basis, FMCN trades at a discount to peers for 2007E and 2008E PE ratios (24x vs. 36x for 2007 and 18x vs. 26x for 2008), despite having a similar expected growth rate (41% vs. 37%).
OVERALL STRATEGY – TARGET, PENETRATE, AND SEGMENT
We believe that Focus Media’s overall strategy is straightforward, yet very effective. The company first identifies its targeted consumers, establishes LCD display locations close to them, drives penetration, gets pricing leverage, and then pursues segmented consumer groups.
• Follows most desirable demographic. The company follows the lifecycle of its target demographic, which is high-income, white-collar professionals. Management chose office buildings as an ideal starting point since these locations aggregate their audience in a captive environment (outside and inside the elevators). According to AC Nielsen, professionals working at commercial buildings average five elevator trips per day with 2-2.5 minutes of wait per trip.
• Expansion and penetration. Once established, the company will drive penetration in the market through expansion and acquisitions, targeting different spaces and locations to maximize the company’s advertising exposure. The company currently has a presence in 95% of the top-100 office buildings in China.
• Segmentation. As a particular group of the market reaches critical mass (i.e. high capacity utilization for advertising slots), Focus Media looks to target a segment of the consumer group or business vertical to take advantage of their spending patterns. This is particularly helpful to luxury goods advertisers that find mass-marketing to be ineffective.
• Scale and scope drives leverage. The LCD display business is mainly fixed costs (mostly building rent and investments in LCD panels) and therefore provides high operating leverage. Focus Media has a presence in over 90 markets in China. The company operates in 50 markets directly and 41 markets indirectly through regional distributors.
BUSINESS MODEL – CAPITALIZE ON CAPTIVE AUDIENCE
Focus Media’s LCD advertising model plays into the strength of China’s growing consumer spending. This advertising medium enables the company to zoom in on the demographic advertisers highly sought after – the middle income and up consumers. Advertisers love the model as it complements well with the rest of the advertising budget, which is mostly in-home based marketing (i.e., TV, radio and the web).
Strong advertising trends in China. According to industry stats, total advertising spending on urban consumers in China is ~$12-13B. Unlike developed countries such as the US, advertising is still a growing industry at 16% in 2005. With major events such as the 2008 Olympics and China’s WTO entry, we believe they serve as catalysts for the advertising industry going forward. As a reminder, China will be opening to foreign competition in key industries such as telecommunications and financial services as part of the WTO agreement. With that in mind, we expect MNCs to be aggressively marketing to build brand recognition. On the other hand, we believe domestic firms need to cement their market positions, as consumers get more choices.
Multiple ways to reach growing middle-class. Management has a knack for identifying consumer behavior and buying patterns of its targeted audience and has translated its know-how into its success in the LCD advertising space. As stated before, the company is leveraging its LCD locations in office buildings to monetize via advertising. As we will outline later in the report, we expect tier II and III cities to be the next phase of China’s economic growth, creating significant growth opportunities for Focus Media. At the same time, the company is expanding into other strategic locations revolving around the lifestyle of its targeted consumers to enable advertisers to capture their spending power.
• Recent quarter results. Focus Media had a very strong quarter, beating consensus on the top line ($61M actual vs. $60M consensus) and EPS ($0.55 actual vs. $0.47 consensus). Revenues grew 214% YoY due to a strong increase in slots for Commercial, In-store and Residential businesses. Gross margin expanded from 59% to 65%, driven by increased utilization rates in tier II markets and higher ASP in tier I cities.
• Q4:06 expectations. We believe that guidance for Q4:06 is achievable as we expect increased penetration rates and ASP (except for tier II markets) for all three major business segments. At the same time, we expect the gross margin to expand 200 bps to 67%. In all, we estimate overall revenue growth of 181% YoY and 13% QoQ (slightly above the company’s guidance of $67M - $69M). As for pro forma EPS (excluding option expenses and intangibles), we are looking for $0.64 per share (at the high-end of guidance).
• Revenue trends. We expect consolidated revenues to grow ~40% annually to $600M in 2009. Our revenue forecast assumes that the Commercial business will grow at a 39% CAGR, reaching $364M in revenues (or 61% of revenues vs. 64% in 2006). At the same time, we expect In-store to grow 49% annually to $91M in 2009 from an estimated $27M in 2006, and Framedia to grow 40% annually to $108M in 2009 from an estimated $40M in 2006. By 2009, we estimate that core businesses will contribute roughly 94% of revenues.
• EPS trends. Excluding options expenses and amortization of intangibles, we expect EPS to grow at ~35% annually from an estimated $1.86 in 2006 to $4.62 in 2009. We note that the tax rate is expected to increase from an estimated 1% in 2006 to a fully taxed rate of about 15% in a few years.
BALANCE SHEET AND LIQUIDITY
As of Q3:06, Focus Media had $130M in cash and short-term investments, and $3.1M in debt. Accounts receivable was $62.2M with a DSO of 87 days compared to 85 days in Q2:06 and 83 days in Q3:05.
Our $85 price target is based on 30x our 2007 pro forma EPS estimate of $2.75 plus $2 in net cash, consistent with our expected long-tem growth rate for the company. On a relative basis, FMCN trades at a discount to peers for 2007E and 2008E PE( 24x vs. 36x for 2007 and 18x vs. 26x for 2008), despite having a similar expected growth rate (41% vs. 37%). As indicated in Exhibit 20, media companies in HK and the US trade at 1.2x and 1.5x PEG vs. just 0.6x for FMCN.
Risks to our rating include, but are not limited to the following:
• Chinese economy. A slowdown in the Chinese economy may cause the slowing of domestic consumer demand, and hence advertising expenditures. As a result, Focus Media's growth and profitability may be negatively impacted.
• CEO’s recent pledge to raise capital. In September 2006, Jason Jiang, the company's chairman and CEO, entered into a variable pre-paid forward contract with Credit Suisse Capital LLC. Under the terms of the agreement, Mr. Jiang pledged 2M ADSs to Credit Suisse, which will receive the ADSs one year from the date of the contract subject to certain adjustments depending on the market price of the ADSs. The pledged shares represent 22.5% of Mr. Jiang's current shareholdings in the company and 3.75% of the issued and outstanding shares of the company. Focus Media's share price may be negatively impacted when these shares enter the market.
• Pricing and bidding wars. Well-funded competitors, such as BAMC in Beijing, and Oriental Pearl in Shanghai, have been expanding their TV display advertising networks. Focus Media's profitability may be negatively impacted if any of the competitors, including the company itself, tries to gain market share with aggressive pricing and bidding strategies.
• M&A risk. Recently, there has been speculation that Focus Media may buy the shares of Sina Corp. (SINA: Hold) that are held by Shanda. We think this is very unlikely to happen, given management’s assurance that they will only make acquisitions relevant to its core business.
• Lock-up expiration. In February 2006, Focus Media completed the acquisition of Target Media for $325M, including $94M in cash and $231M in stock (7.7M shares at $30 per share). The first lock-up of 3.9M shares expired in September 2006, of which the company issued 2.5M shares in a private placement. The remaining 3.9M shares will expire at the end of February 2007.
• Building leases. Currently, ~40% of Focus Media’s rental contracts will expire after December 2007. This may result in higher rental costs due to landlords demanding higher prices. We believe the building ownership in China is fragmented, and as the dominant provider of advertising media in commercial buildings, Focus Media has the bargaining power in the negotiation process and will be able to handle the pricing pressure well, in our view.
• Wal-Mart’s (WMT) acquisition of Trust-Mart. In October, Wal-Mart emerged as the top bidder for Trust-Mart, a large customer of Focus Media with ~100 stores. The acquisition is pending government approval. If the deal goes through and Wal-Mart decides not to continue Trust-Mart’s relationship with Focus Media, revenues of Focus Media may be negatively impacted as a result.
FMCN 1-yr chart: