Advertising Is Big Business In A Still-Growing Chinese Economy

by: Justin Kuepper

Chinese advertising stocks have been strong performers over the past month relative to the overall market. According to Tickerspy's index, the sector has risen 8.8% over the past month, which is 8.4% higher than the S&P 500. Moreover, the industry's average price-earnings ratio of just 5.9x is significantly lower than the S&P 500's 22.8x multiple.

Some companies in this space include:

  1. Inc. (NASDAQ:BIDU)
  2. Focus Media Holding Limited (NASDAQ:FMCN)
  3. Charm Communications Inc. (NASDAQ:CHRM)
  4. AirMedia Group Inc. (NASDAQ:AMCN)
  5. VisionChina Media Inc. (NASDAQ:VISN)

Capitalizing on China's Growing Economy

China's advertising industry reported revenues of around $7.9 billion in 2010, representing a CAGR of 9.8% between 2006 and 2010, according to Research and Markets. Meanwhile, the industry is expected to accelerate over the coming years with a projected CAGR of 13.3% between 2010 and 2015, reaching $14.7 billion by the end of 2015.

China's online advertising industry grew nearly 60% to $5 billion in 2010, according to iResearch Consulting Group. While this is only a small piece of the U.S. market, the country's rapidly growing and increasingly wealthy population has many investors betting that the figure will only increase and eventually surpass that of the United States.

Some Risks to Consider Before Investing

There are some signs of trouble that could impact China's advertising industry. First, consumer spending may be at risk, particularly after the country reduced its growth forecast from 8% to 7.5%. Since manufacturing generates most consumer incomes, this reduction in growth could lead to a reduction in spending, despite the government's plans.

Meanwhile, Chinese companies don't have the best reputation on Wall Street. The country's government can be difficult to operate in, while there have been many instances of fraud, and there have even been allegations made against Focus Media. And finally, the Chinese economy remains on unstable ground in the wake of the recent reduction in growth forecasts.

Focus Media: A Play on Traditional Advertising

Focus Media is one of the largest companies in China's traditional advertising sector with a market capitalization of about $3.4 billion. Despite its 228% increase in revenues and 107% increase in net income, the stock currently trades at roughly the same valuation as it did in 2006, shortly after it IPO'd, and a price earnings ratio of around 20x its trailing 12-month EPS.

The company operates the largest LCD display network, in-store advertising network and poster frame, as well as movie theatre and traditional outdoor billboards advertising network in China. In 2010, the majority of the company's revenues were from this growth network of LCD displays, which should continue to drive growth down the road as it expands.

During the third quarter, the company reported revenues that increased 53% year-over-year to $196 million and non-GAAP net income (excluding some transactions) was up 69% at $0.59 per share. These record results ushered the company into the "interactive age" and the market remains "healthy and robust," according to its most recent conference call.

With these growth rates, the company's 20x P/E multiple yields a PEG ratio that is below 1.0, which could indicate that the stock is undervalued given its growth prospects. And on a relative basis, the stock also trades lower than its U.S. equivalent that has seen far less growth - Clear Channel Outdoor Holdings Inc. (NYSE:COO), which trades at over 100x its earnings.

Baidu: A Play on Online Advertising in China continues to be the preferred play for online advertising in China with a market capitalization of nearly $46 billion. While the company has soared more than 1,190% over the past five years, it has stalled somewhat during the global economic downturn, and risen just 8% over the past 52 weeks, trading with a price-earnings ratio of 44x its TTM EPS.

During the fourth quarter, the company reported revenues that grew 82.55% and earnings per share that jumped 76.79%. While its cost of revenues jumped marginally, the company reported lower SG&A margins and suffered from an increased tax rate, which means that these issues may not be fully the result of a deteriorating business model.

Despite this growth, the stock trades with a P/E ratio of 43x, which yields a PEG ratio of just 0.63, according to Yahoo Finance. This may indicate that the stock is undervalued relative to its long-term projected growth rates. However, recent turmoil in the sector may justify waiting for a retracement before taking a position, or at least averaging in over time.

Building Exposure to Chinese Advertising

Investors looking for exposure to the Chinese advertising industry may want to consider a conservative bullish options strategy on these two large industry players. For instance, writing covered call options against long positions can help reduce long-term risk by reducing the amount of invested capital over time.

Alternatively, investors may also want to consider using options entirely in the form of long-term equity anticipation securities (or LEAPS). These are longer-term options that can enable investors to gain exposure at a fraction of the price. But of course, a downturn can more easily result in the loss of all your capital, versus just a small haircut.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.