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There has been a lot of discussion lately in regards to U.S. listed China stocks, and for good reason. Many of these companies are trading at a forward P/E of around 5 and most under 10 with a growth rate near 50%, which is an incredible undervaluation for many of these companies. As many know, the reason for much of this is due to claims of fraud and continued negativity. Many individuals want to claim that the majority, if not all, of these companies are fraudulent or severely exaggerating earnings.

Is it really possible to think that every one of them, or even a majority, are frauds? No, that is not a highly realistic assumption. While there are many companies that an investor should be cautious about and extract further information out of, and take every step necessary to ensure the quality of investment, there is more quality out there than not.

Also, an investor in this sector needs to invest in more than just the fundamentals and a low P/E. What is very important going forward is whether they pass the legitimacy test, but also their view towards shareholders as well.

Just recently one investor stated to me,

I think I've figured out how to spot the high-probability frauds in the space. Not coincidentally, they are the names with unusually high margins that are, not coincidentally, always trying to do dilutive offerings and that can't get any debt financing. They appear to raise money when it doesn't appear to make sense.

I agree with this investor as well on two aspects. First, if they meet this criteria it could definitely represent some form of fraudulence. Second, if not fraudulence, it certainly points to their lack of caring for their investors, and neither one is good. So that is definitely a good place to start.

So much focus is being put on companies in another country when right here in the United States there are probably 100's, if not 1000's, of stocks trading fraudulently. All one has to do is take a look at the Bulletin Board and Pink Sheet stocks and you will almost laugh at how easy it is to find these fraudulent ventures and many using several different shells of prior companies. The wrong space is being picked apart, although it is probably easier due to the cultural differences and China being a far distance from the United States, on top of "the too good to be true" theory. Basically, it is easier to pick on things which one does not understand or sees as different; this is also known as ignorance.

This gets me to my point of this article, China MediaExpress (OTCPK:CCME) shows why they are the cream of the crop by not only having competitive advantages, high margins, undervaluation, strong growth, new ventures, strong management, but the fact that they are probably - more than any other of the China small caps - the easiest to identify as being completely legitimate.

First, to get an understanding of many of their qualities, here is a recent article that I wrote, which includes CCME, as I believe it is one the best possible stocks to own and one of my favorites, alongside AAPL.

The easiest thing to do to evaluate a company's worth is to do the normal research to realize their fundamentals and growth, but in this space, much more must be done to realize the validity of a company. To find a U.S. listed Chinese small cap in this space with the amount of transparency, legitimacy, growth, and value, look no further than China MediaExpress, as it carries it all. I spent time getting various opinions from many investors to see what they consider to be legitimate within these companies and what they look for to determine if a company is more than just an underpriced stock, but a legitimate business that surpasses expectations.

Below, I am going to elaborate a little more on the compilation of ideas and information that I derived from others, including my own beliefs as well. This will also show why CCME meets the criteria of being a top China stock with the likes of Baidu (NASDAQ:BIDU), Focus Media (NASDAQ:FMCN), China Mobile (NYSE:CHL), China Life Insurance (NYSE:LFC), among many others. 

1. What type of groundwork has been done on a company and by whom?

This may be the most important aspect of all. With many of these Chinese companies, other than maybe the auditor, it is usually a couple of individuals that visit the company and management for a few days, or at most weeks. Where CCME surpasses this test is that they have been completely vetted and researched by two firms for several months each.

Starr International - Headed by Hank Greenberg

- 4 months of due diligence

- 3rd party cross checks of operations

- Independent audit

- Verification of commercial contracts

- Appointed member to CCME's board of directors

- Ability to audit China MediaExpress periodically and have access to the Company's books and records - filing SC 13 D, pg 13

Global Hunter Securities - October 15, 2010 report

- 3 months of due diligence

- Interviewed ad agencies and direct advertisers China MediaExpress works with

- Interviews with bus operators

- Took rides on the buses

- Met with regional managers

- Visited Starr International

- Checked bank statements

- Checked sales contracts 

2) Who else covers the company and/or what publications mention the company?

Northland Securities

- Sets $32 price target on CCME -

- Covered by Darren Aftahi - Senior Analyst covering digital media and entertainment including Netflix (NASDAQ:NFLX); Aftahi's top pick is CCME.

There hasn't been a public release of the research done by Northland Securities, but for Darren Aftahi to make it his top pick states a lot.

Mike Koza - One of the World's best stock pickers

- Several articles in Forbes and mentioned in The Warren Buffetts Next Door book - CCME is by far his top holding.

Forbes

- CCME ranked #1 out of 200 companies in the 2011 Forbes China 200 small-to-mid sized companies with the most potential. First stated by Forbeschina.com; mentioned in the U.S. Forbes citing the #1 ranking.

While these are not indications in themselves of a company being legitimate, it helps add to the numerous amount of other information to show their validity and how highly regarded CCME is.

IBD Top 15 World Stocks

- CCME is ranked #4

3) Do the margins match up with competitors?

If a small cap company has significantly higher margins than everyone else and even states some sort of heavy advantage, despite it being much smaller than some of the competition, something may be wrong.

China MediaExpress does not currently have direct competition, but in comparing both China MediaExpress and Focus Media's LCD business, their margins are very close and CCME actually has an average margin from 2007 through 2010 lower than that of FMCN.

FMCN LCD

2007

2008

2009

2010 1Q

2010 2Q

Revenue

183,528

239,505

208,499

80,056

55,428

COGS

51,850

77,866

75,467

14,486

14,945

Gross Profit

131,678

161,639

133,032

65,570

40,483

           

Gross Margin

71.75%

67.49%

63.80%

81.91%

73.04%

Note that these margins are on par with CCME's margins.

CCME

2007

2008

2009

2010 1Q

2010 2Q

Revenue

25,837

62,999

95,934

44,525

53,511

COGS

13,164

25,065

32,937

17,931

11,398

Gross Profit

12,673

37,934

62,997

26,594

42,113

 

 

 

 

 

 

Gross Margin

49.05%

60.21%

65.67%

59.73%

78.70

Source:  

4) What is management doing to show both their belief in the company and their care for shareholders?

Many companies do not seem to be shareholder friendly or don't show confidence in their company by continually diluting, not giving updates, having no insider buying, having no share buybacks, and not having a dividend. They either just act as if it is a way to get money to fund the business, with less focus on investors, or it could be an indication a company is hiding something.

China MediaExpress has gone above and beyond to show not only their confidence, but their care for shareholders:

- Dividend Policy

This not only shows that they are looking out for investors, but it shows that not only do they have cash, but are willing to pay it out instead of continually taking from investors. This is what propelled me to do further research because when a company says that they will pay you to own their stock, it speaks volumes on top of many of the other benefits a dividend offers. Obviously, while doing the research, I discovered many more positives that I have previously discussed along with what is mentioned in this article.

- Share buyback plan

It is approved for CCME to purchase $30 million of their own stock.

This will be one to watch to see if they actually pull through with doing this to continue to support shareholders and their confidence and it obviously would have been better if they did so when the stock was severely depressed, but any buyback is beneficial and hopefully they start doing so soon before the stock price rises more.

- Insider buying

This is straight forward as it shows confidence in the company.

On December 9, 2010 Jacky Lam bought 100,000 shares valued at $1.5 million.  

- Press releases

They continue to provide updates and continue to want everyone to know what is going on. Just last week they made an announcement of new contracts, which will help increase earnings.

What is even better about the announcement is that the timing was perfect as CCME was on a nice run and it was released mid-day while confidence and interest was high, thus helping elevate the price of the stock. That shows that they know what they are doing and are focused on increasing the price of the stock.

5) What auditor does a company use?

This isn't always an indication of innocence as some of the smaller auditors are of high quality, but when a company upgrades to a top 10 or even top 4 firm, it is part of the evidence to help show that the company is not fraudulent. Also, by companies having top firms, it shows their commitment to transparency and shareholders.

Deloitte Touche Tohmatsu - CCME currently has a top 4 auditor in which they also audited the 2009 year end results. They are currently ranked #1 by revenue and employees.

Quick history

While all auditors have their faults, Deloitte has shown they take what they do very seriously with certain controls and actions that must be met. Taking a look at their history through a variety of sources, one will not find many negatives with Deloitte Touche Tohmatsu Hong Kong compared to their size.

6) What is management's past experience and reputation?

Management Profile

The CEO, Zheng Cheng, is a devout Buddhist, which helps add to his already reputable character and he is part of many committees and asssociations. He was also recognized for his charity and assistance of children in need of education. He also helped raise funds from the resulting damage of earthquakes in 2008. In 2005, he was awarded Fuzhou Distinguished Young Entrepreneur of the Year.

The CFO, Jacky Wai Kei Lam, has experience with one of the top four auditors in the world, PricewatershouseCoopers Hong Kong, for over eight years. He is also a member of the Hong Kong Insitute of Certified Public Accountants. 

7) How is the company issuing shares, and when?

If a company has, for example, $100 million supposedly in cash, but are continuing heavy dilution, there may be a problem.

If a company continues to dilute, but never seems to put their plans into place, there may be a problem.

Basically, what type of dilution is occurring? Is it something that is actually going to benefit the company? Is it truly needed? Could the company have used cash? Was the better option getting money lent to them through the bank; if so, why couldn't the company receive a loan?

Many of these companies are continuing to grow and need additional funds to enhance their future growth plans, but many of the companies show a lack of caring or look suspect due to the dilution that occurs because of the reasons above.

China MediaExpress has shown a clear reason for their dilution. First, although the Starr Investment deal was lucrative and diluted the share count, it was very important to get a reputable firm like Starr Internationl on their side, especially after the in-depth research and due dilligence done by Starr International. Second, the earn out shares were a previously signed contract before going public. This is something that China MediaExpress needs to look at again. Since that arrangement, they have grown cash and have highly succeeded. Plus, they mentioned a buyback program, so management should think about accepting much less, if any, of the earnout shares and continue proving to shareholders that they are important and show that they care about the rise in the price of the stock.

8) Is the company putting their growth plan into place?

This also follows up in regards to dilution previously stated. I know, not every little thing can go as planned and adjustments need to be met. If there is a habit of stating growth plans and continually diluting and never coming through with the plans, or management just doesn't come through, it shows a lot and that the management is inept or corrupt.

China MediaExpress continues to put their plans into place. One example, as mentioned above, is the new contracts, as it shows they are dedicated to their growth. Another recent example is their new website SWITOW:

  • boutiques to be opened in certain cities

  • SWITOW magazine

  • Contracted adverisers will provide the "lowest price guarantee"

  • Some items sold through SWITOW will offer a longer warranty period

  • Signed contracts with major companies such as Apple (NASDAQ:AAPL), Nike (NYSE:NKE), Sony (NYSE:SNE), Adidas (OTCQX:ADDYY), Toshiba (OTCPK:TOSBF), and more

Just taking a look at the press releases, it is easy to see that their growth plan is being put into place and that they continue to make investors aware of this as well.

9) Is it reasonable to think that the industry the company is in can have the upside stated?

Some companies are in a very lucrative and growing industry while you wonder how others can succeed by selling that particular product and/or service. For example, if a company is selling tires and are smaller than the competition (and there is a lot of competition), but they claim they are going to grow at a 50% rate for the next 5-10 years, or their growth doesn't seem to meet the demand, it is worth listening to your doubts and considering other aspects.

China MediaExpress is not only in a simple business while expanding, but advertising is a huge industry that is going to continue to grow. Here are a couple of articles referring to the advertising trend in China:

January 11, 2011:

"Total advertising expenditure in China in the first three quarters of 2010 rose 14 percent from the previous year, reaching a record-breaking $64.53 billion, according to figures from CTR."

December 6, 2010:

"With ad spending growth of 51 percent projected for the next two years, China will overtake Germany as the world’s third-largest ad market in 2011, ZenithOptimedia said."

December 5, 2010:

"MagnaGlobal even expects China to become no. 2 behind the U.S. by 2013."

So it is easy to believe, and even expected, that China MediaExpress can continue to grow in an industry in China that is surging upwards. There are so many directions that they can continue to go.

In reality, there is no reason for CCME to be trading at the valuation that it currently is and they will continue to prove themselves by having a strong management team, great growth, continued expansion, transparency, and continuing to be very shareholder friendly. The short interest is piling up as investors are jumping on the backs of others hoping to find something negative, and the short interest is near 50% of the float. So while this short interest builds, China MediaExpress continues to grow stronger.

What the shorts are going to say, or have been saying:

They don't own the buses. Better for them, less to deal with.

Their margins are too high. False. After a complete audit by Deloitte, an audit and 4 months of due diligence by Starr International, 3 months of research by Global Hunter Securities, which in fact verified their $170 million in cash, maybe they somehow all missed some big scam. Highly doubtful.

Forbes just randomly picked them because they looked good. Not.

A few things: contracts are going to expire, so how are they going to get new contracts signed and regain new customers? That should not be too difficult as all successful businesses have to go through trying to grow their business and gain new business. Maybe the shorts will state the buses don't exist, like they stated the stores did not exist for China Biotics (OTCQB:CHBT). Maybe the buses are actually empty and nobody rides in them as was stated for CEU. Maybe they will claim the customers do not exist like Orient Paper (NYSEMKT:ONP), even though they did a full investigation that showed otherwise. The shorts still want to say they are frauds.

The thing of it is, with CCME, everything has been verified, checked, double checked, and then checked by someone else. An investor definitely needs to go through as many checks as possible to see if one of these companies are worth the time, besides just being undervalued, and there is even more to go through.

In future weeks, be on the lookout for a more in-depth analysis of uncovering legitimate companies through Trading China. There is a strong and very intelligent reason to believe in CCME and their future. In a nutshell, they are LEGITIMATE and all of the factors stated above are reasons to own CCME - other than the many positives that go along with it.

Disclosure: I am long OTCPK:CCME, AAPL.

Source: Is China Media Express a Top Tier Company? You Decide