FMCN’s net revenues in 4Q06 increased by 11.8% QOQ. The commercial location and frame segments were strong in 2006, and the in-store segment was restructured successfully. In 4Q06, net revenues of commercial locations, the largest segment, increased by 7.8% QOQ. Gross margin improved 1.6 percentage point QOQ. The sell-out rate in all tier-I cities and 5 of tier-II cities reached 100%. Slots sold in tier-II cities increased dramatically by 49.3% QOQ following a road show. FMCN increased prices in tier-I cities at the beginning of 2007 and planned to raise prices every 6 months. 4Q06 Revenue from the frame segment, the second largest segment in FMCN, increased by 22.1% QOQ. In 4Q06, frame prices rose by 18.6% QOQ, which reflects FMCN’s bargaining power. Gross margin improved from 70.7% in 3Q06 to 75.4% in 4Q06. In-store network got the lowest gross margin among three main businesses, but FMCN continues to withdraw from supermarkets and convenience stores who charge more, and migrate to hypermarkets who charge less. Management believe gross margin can reach 55% - 60% at the end of 2007, much higher than 34.8% in 4Q06.
Operating expenses, excluding share-based compensation, increased 26.3% reflecting FMCN’s aggressive expansions. We believe EBIT will improve when sell-out rates rise in newly explored cities. On February 28th, FMCN announced acquisition of Allyes, the monopolist of Internet advertising agent and software in China. We believe the acquisition will raise FMCN’s revenue significantly. 1Q07 will be seasonally weak, but we believe FMCN will grow strongly from 2Q07. We project a target price of $96.51, 29.5% higher than the current market price. Taking Allyes into account, FMCN should be worth more. We rate FMCN a BUY recommendation.
FMCN’s total net revenues in 4Q06 increased by 11.8% QOQ. (Exhibit 1) Commercial locations segment contribute $3 mn to a total revenue increment of $7.2, while In-elevator poster frame segment contribute $2.5 mn. Cumulative advisers for commercial locations and In-store network rose from 2500 in 3Q06 to 2700 in 4Q06, and cumulative frame advisers rose from 1000 in 3Q06 to 1500 in 4Q06.
We are optimistic about FMCN’s financial results for full year 2007, although the 4Q06 growth rate is lower than previous quarters without significant acquisitions and 1Q07 will be seasonally weak. We note that both commercial locations and frame segments were strong in 2006, while the in-store segment was restructured successfully.
Commercial Locations Segment
Commercial locations segment is the biggest segment in FMCN, which contribute 61.5% of total net revenues. In 4Q06, net revenue in this segment increased by 7.8% QOQ, compared to 2- digital growth rate in 3Q06 and 2Q06, but we have enough confidence in commercial locations segment due to positive signals below.
1) Gross margin continued to improve from 71.4% in 3Q06 to 73% in 4Q06. (Exhibit 2) The Company’s management declared that they tried to improve gross margin to be over 75% in the long term.
2) The sell-out rate in tier-I cities (Beijing, Shanghai, Guangzhou, and Shenzhen – the four most developed cities in China.) reached 100% in 4Q06, (Exhibit 2) which suggests strong demand in these cities. (Sell-out rate = Slots sold / Network capacity, slots sold means 30-second equivalent time slots sold and network capacity means 30-second equivalent time slots available for sale.)
3) The sell-out rate in 5 tier-II cities (Nanjing, Chengdu, Wuhan, Changsha, and Hangzhou) also reached 100%, while the average sell-out rate in tier-II cities was close to 50% in 4Q06 (Exhibit 3).
4) Slots sold (30-second equivalent time slots sold) in tier-II cities increased dramatically by 49.3% QOQ after a road show. (Exhibit
5) FMCN increased prices in tier-I cities at the beginning of 2007 and planned to raise prices every 6 months. It is FMCN’s right to take full advantage of monopoly.
When there is less room for expansion in tier-I cities, FMCN is successfully extending their businesses to other cities. So we expect high revenue growths at least in year 2007. However, we also believe aggressive expansions in tier-II cities and discounts offered there can press margins in the short term, although management are confident in margin improvements, when the sell-out rate rises.
In-Elevator Poster Frame Segment
Frame segment is the second largest segment in FMCN, which accounts for 20.2% of total revenues. (Exhibit 1) We also believe the segment will grow rapidly in 2007.
1) Frame revenue in 4Q06 increased by 22.1% QOQ, which is rapidest in all four main business lines. (Exhibit 1)
2) In 4Q06, frame slots sold (on a monthly base) rose merely by 4% QOQ (Exhibit 8), but ASP (average advertising revenue per frame slot per month) rose by 18.6% QOQ (Exhibit 9). Price rise contributes dominantly to revenue growth, which implies that FMCN controls pricing power in the market.
3) With pricing power, gross margin improved from 70.7% in 3Q06 to 75.4% in 4Q06. (Exhibit 2) Furthermore, frame prices are negotiated case by case, so that price rise can be reflected on the income statement immediately.
In-store Network Segment
In-store network revenue, which accounts for 11.5% of total net revenues, grew by 8.3% QOQ, more rapidly than commercial locations segment. However we note there is a gross margin concern in the in-store segment.
1) In-store segment got a lowest gross margin among three main businesses. (Exhibit 2)
2) Gross margin declined from 36.4% in 3Q06 to 34.8% in 4Q06. (Exhibit 2)
FMCN explain the margin decline in following way - When a hypermarket owner want to set up a new store, FMCN has to follow up to install new screens in the new store, while the retail industry expands very rapidly. However, FMCN did not take into account those additional screens when signing contracts with advisers
We believe there are two other reasons for the low margin:
1) The retail nature of the stores is the root cause of low margin. Stores are retail locations, so they used to charging for every square centimeter of space, whether on the floor or on the wall, to generate cash inflow. On the contrary, office buildings in which the commercial segment operates have little marginal cost besides electric power supply; they have no opportunity cost at all.
2) Demand for stores causes lower margin. We note that goods becomes more and more crowded and aisles become narrower and narrower in China’s supermarkets. As retail channels are becoming a scarce source, stores will charge more.
However, FMCN has been trying to optimize this segment. FMCN continued to exit supermarkets and convenience stores, but cumulated hypermarkets from 2Q06 to 4Q06. (Exhibit 5) During the transformation, both growth rates of displays installed and slots sold recovered (on a per week per store basis). (Exhibit 6, 7) Management believe that aggressive expansions in hypermarkets help the Company target a gross margin of 55% - 60% at the end of 2007, which is much higher than the current gross margin of 34.8%. Obviously, hypermarkets charge much less than supermarkets and convenience stores.
We note that because retail stores charge much, FMCN faces almost no competition in In-store market. That provides FMCN enough time and market room to finish the transfer - partly and gradually from supermarkets to hypermarkets.
Gross margin improved from 65.3% in 3Q06 to 68.5% in 4Q06, but EBIT margin declined by 1.9 percentage point QOQ. (Exhibit 10) Operating expenses increased rapidly due to the rise of share-based compensation, which doubled QOQ in 4Q06. Excluding share-based compensation, the pro forma EBIT margin improved 0.5 percentage point QOQ.
Operating expenses, excluding share-based compensation, increased 26.3%, reflecting FMCN’s aggressive expansion. We believe EBIT will improve when sell-out rates rise in newly explored cities.
On February 28, FMCN announced that it had entered into a definitive agreement to acquire Allyes Information Technology Company Ltd., the largest Internet advertising service company in China. Allyes owns AdForward, a software suite, which covers all aspects of online ad publishing, - ad production, tracking, and performance analysis. Allyes also owns three Internet ad agents in Beijing, Shanghai, and Shenzhen. David Zhu (Zhu Hailong) will remain as the CEO of Allyes.
The transaction is expected to close by the end of March 2007. Under the agreement, FMCN will acquire a 100% equity stake of Allyes for $70 mn in cash and $155 mn in FMCN’s ordinary shares, while additional payment of up to $75 mn in FMCN’s ordinary shares will be subject to Allyes’s meeting certain earning targets during 12 months from 2Q07 to 1Q08. All FMCN shares used in the transaction will be newly issued.
We believe the acquisition will significantly increase FMCN’s revenue. In 2006, Allyes earned revenue of about RMB480 mn, or USD65 mn equivalent, which equals 30% of FMCN’s revenue in 2006. Furthermore, in 2006 Allyes’s revenue increased 75% YOY. Allyes is a market monopolist like FMCN. From 2001 to 2006, Allyes is the No. 1 holder in Internet ad market share. In 2006, Allyes occupied 85% of the Internet ad software market.
We also believe there will be few integration problems with the acquisition. In 2002, Allyes moved to Zhao Feng Plaza and became a next-door neighbor of FMCN. David Zhu, CEO of Allyes, declared, “We cannot be more familiar with each other”, “We can be in each other’s position as CEO”, “He knows every one in my management team” (“No. 1 Person in China Internet Advertising Market”, Peng Peng, The Bund, page A16-A17, March 15, 2007).
Valuation and Recommendation
We assume 1Q07 revenues for both commercial location and in-elevator frame segments will decline by 23% QOQ due to Chinese New Years holidays. (Exhibit 11) We also assume in 2Q07 commercial location revenue will grow by 30% QOQ, while in-elevator frame revenue will grow by 35% QOQ. Growth rates of these two segments will slow down during 2-4Q07. (Ibid.) 5% is for the assumption of QOQ In-store revenue growth during 2007 and 2008. We believe gross margins in all these three segments will improve as discussed in previous chapters, but EBIT margin will maintain the same level as in 4Q06 due to aggressive expansions in the future. So revenue will increase by 47% and 40% in 2007 and 2008, while EBIT will rise by 62% and 48% in following 2 years. Excluding the Allyes acquisition factor, we project a target price of $96.51, 29.5% higher than the current market price.
Based on our earning projection and the current market price, forward P/E will decline significantly from 45.6x for 2006 to 29.2x for 2007 and 19.7x, (see Databox on page 1) while the average P/E of advertising services (ttm) is 31.9x. Furthermore, if taking Allyes into account, FMCN should be worth more. We rate FMCN a BUY recommendation.
FMCN is the China’s largest out-of-home advertising media company, which founded in May 2003 and went public on July 13, 2005. The company attracts advertisers with an idea of audience-centric, which allows advertisers to promote products or services via different video channels in different locations where target clients are. The premier office-building channel A/B targets white-collars, while are the elite channel for golf clubs and airport VIP lounges. Other examples are the travel channel for airport shuttle-buses, hotels, airports and airlines, the fashion channel for shopping malls, restaurants, Karaokes, bars, and the healthcare channel for drugstores and hospitals.
There are four main business lines in the Company.
1) Commercial Location Network. The segment mainly installs flat-panel LCD television displays in elevators, lobbies, and dining room of office buildings, where advertisers can promote white-collar oriented products. The company also sets up displays in other public places like banks, restaurants, airports, etc.
2) In-store Network. FMCN installs displays in hypermarket corridors, supermarket, and convenience stores, near the escalators, by the shelves, in the aisles and at the checkout bars. So fast moving consumer goods companies can promote to house-holding consumers.
3) Poster Frame Network. Similar to commercial location network, FMCN leases out frameworks in office buildings.
4) Internet ad. Based on recently acquired Allyes, this segment is the Internet ad agent and Internet ad software monopolist.
Other business lines includes a mobile handset advertising network and a outdoor LED network.
After acquiring Target Media Holding Ltd. in January 2006, FMCN almost monopolizes the China market of out-of-home flat-panel display advertising. At the end of 2006, FMCN had more than 80 thousand displays in over 90 cities in China, and time slot sell-out rate reached 100% in three most developed cities of China. The Company was awarded ‘Country Winner of Ernst & Young Entrepreneurs of the Year 2006’, No. 1 in ‘2007 China Potential top 100’ by Forbes, and arm’s length other awards since it came into existence.