Warming Up For China's Earnings Season

Earnings announcements are one of the most important moments for public companies. This is a bonanza for fundamental analysts who can x-ray the companies by examining these financial statements. My firm and I are no different; we have been following U.S. listed Chinese companies for many years to understand how to best interpret the results.

Some skeptics say the Chinese cook their books, and to rely on those financial disclosures is suicidal. We do not share those negative opinions. Actually, we think of those skeptics as investors who are just trying to find an excuse not to venture into China. Considering the stellar performance of the Chinese markets, we know what these nay sayers are missing out.We have always liked giving our subscribers a look at the Chinese stock universe from a different angle. This is why we created the revenue and earnings chart below in contrast to current P/E.

Given that there are no official 2006 figures yet, we used our own estimates, based on 2006 first three quarters numbers and latest growth trends. It is important to note that the chart features NASDAQ names only. This is because most of them will report in February, while NYSE listings typically report a month later. The first visible observation of the chart is that there is a noticeable correlation between earnings growth and P/E. The longer the blue bar, Earnings Growth, the higher the red dot, Current P/E.

This correlation may sound common sense; however remember that there are skeptics that argue that the Chinese stock universe is highly manipulated. This chart clearly dismisses their argument. As this chart reveals, stock prices consistently reflect financial results. Stocks with high top and bottom line growth are trading at a higher price. Let’s take a closer look at a few stocks on the chart. Focus Media (FMCN) is not only the revenue growth champion over the last five years, but revenue growth has actually transferred into earnings growth. No wonder the company is trading at close to 80 times current earnings and is looking attractive even at current price levels. Looking at Baidu.com (BIDU), the company proved to be an excellent investment in 2006. However, its sky-high valuation may pose potential problems in the future.

Online game operators earnings and stock prices are extremely volatile due to the short life cycle of online games. Once the most popular game, MIR of Shanda (SNDA), is practically history. Similarly, NetEase's (NTES) Westward Journey peaked in the summer of 2006 and the Company seriously needs to find a replacement to keep revenue and earnings growth constant. Efforts to diversify revenue stream away from online games alone has been modestly successful. Both Shanda and NetEase still derive 93% and 82% of total revenues from online games, respectively.

The difference between two online travel agencies is also striking. While revenue growth for Ctrip.com (CTRP) and eLong Inc. (LONG) is somewhat similar, earnings growth could not be more different. While Ctrip.com has been delivering over 100% earnings growth on average over the last five years, its rival has been in the red three times during the same period and has a negative P/E at present. Remember, we have been strong advocates of Ctrip.com over eLong Inc. over the last three years highlighting the importance of delivered earnings vs. potential.

Earnings

Having the earnings calendar ready, let's see what to expect from the upcoming earnings season.

One of our favorite stocks for February is Yanzhou Coal Mining Co. (YZC). The company is expected to report between April 16-26 but preliminary numbers and news suggest a positive surprise. We have seen very substantial institutional accumulation of YZC shares in Hong Kong. Also, rising spot prices for coal are a good catalyst for positive results. The average spot price of coal is likely to rise 5 percent in 2007, and since YZC sells about 48% of its output at spot prices, the rising price benefits the company. Also, earlier this month, coal producers and power plants agreed to lift coal prices this year by an average of 30 yuan per ton, or around 10 percent. Shares in listed coal firms have soared in January on improved prospects for coal prices, but we think YZC has even more room to grow.

Preliminary numbers and statements of China Life Insurance (LFC) suggest that the company will report a minimum rise of 50% in its 2006 net profit on a 14% rise in insurance premiums and strong investment returns. Given the fact that shares of the company rallied over 280% in 2006, the current high valuation may put a cap on further stock price appreciation in February.

Another company we have liked and named it “Stock of the Month” several times in 2006 is China Mobile Ltd. (CHL). This wireless operator behemoth with over 300 million mobile subscribers is not only the dominant player in China at present but will remain that for some time. The company added 4.8 million subscribers in December 2006, keeping its subscriber growth steady. This number is almost four times that of smaller rival, China Unicom’s December 1.26 million new subscriber figure.

Given the robust financial reports of CHL in the past, we expect the company to deliver another outstanding quarter in 2006 Q4. On the same note, Merrill Lynch raised its price target of the firm by 40 percent on January 24.

Another important development of January was when seven alumina refineries jointly raised prices of spot alumina. Should prices stabilize at the new 2800 yuan per ton, Chalco (ACH) would make about 20 percent more in the coming quarters.Looking at Chinese airliners China Southern Airlines (ZNH) and China Eastern Airlines (CEA), it’s hard to miss their 2006 run-up. Both companies are up by over 50 percent since January 2006; but the rally seems to have ended in the middle of January. Possible government injection and lower oil prices are probably the reasons for the run-up. However, should oil prices hover around $50 a barrel, these airliners maybe a good bet for February.

Venturing into the internet sector, it’s important to note that Chinese internet users spent about 170 yuan ($25) a month on services in 2006, almost 8 percent higher than the amount in 2005. Beijing-based Sina Corp. (SINA) defended its title as China’s No. 1 internet portal, but its peer NetEase.com (NTES) surpassed Sohu.com (SOHU) to become the second most popular portal in China. Still Sohu issued Q4 2006 guidance above analysts’ estimates propelling the stock price 40% since then. However, we think this rally may have come to an end. To the contrary of Sohu’s run-up, NetEase has been struggling. The company has to replace its aging WWJ online game. Since NetEase derives over 80 percent of its revenues from the online gaming sector, we don’t expect the company to gain much momentum until this critical issue is solved. Regarding Baidu.com (BIDU), the dominant Chinese search engine, we are still bullish.

While all oil majors pumped more oil in 2006 than in 2005, the most important factor determining future earnings growth is the price of the crude. As the following chart displays it clearly, the lower the crude price (USO), the higher the margin on refined oil for Sinopec (SNP). CNOOC Ltd. (CEO) is hurt by lowered output target for 2007 while diversified PetroChina (PTR) may be the best bet for the coming month.

Disclosure: Author has no position in the above-mentioned securities.