China Digital TV Holding: Valuation Still Reasonable Based on Growth Rate

| About: China Digital (STV)

Shares of China Digital TV (NYSE:STV) came public on just six trading days ago, but the stock is already up 300% from the IPO price. The incredible surge in the price of the stock has paralyzed many investors, and the lack of an operating history makes it somewhat difficult to determine the fair value of the stock. Having read through the prospectus, I am going to attempt to fill that information gap with some basic valuation analysis in order to determine an approximate fair value for the company. Please understand that attempting to value IPO’s is tenuous at best due to limited operating history, but I hope that the exercise of crunching some numbers at least gives investors a better idea of where this stock can trade in the future.

China Digital TV derives more than 80 percent of its revenue from the sale of digital access cards for digital TV. The market is still in its beginning stages, but the Chinese government has plans to shift all TV to digital TV by 2015. According to the prospectus, China Digital TV is the leader in the production of these access cards, having captured 44% of the overall market in 2006. In addition, the company also derives a small amount of revenue from the sale of software for digital set top boxes.

Although the company has only been publicly traded for about a week, the prospectus reveals a solid operating history. I have included some of the basic data below to give a better understanding of the company’s performance. All numbers below are in millions.

Thus far in the company’s history, China Digital TV has shown very impressive top and bottom line growth. According to the prospectus, the overall market for digital access cards is expected to grow from 8.7 million in 2006 to 45.9 million in 2010, a compound annual growth rate of 51.5 percent for the industry. Growth over the near term should substantially exceed this long term growth rate, so we could easily be seeing 2007 revenue growth of 70+ percent. In addition, net margins have consistently expanded over the last three years, reaching 56 percent in the first half of 2007.

Given these numbers, we can try to derive some basic earnings estimates for the rest of 2007 and 2008. I have no special insight as to how the market for digital TV is going to perform over the next 18 months, so I have simply resorted to basic trend analysis in order to come up with some plausible expectations. Given the fact that the company’s growth is obviously going to slow as compared with the hypergrowth of the past two years, I have assumed a more conservative stance for my estimates. Quite simply, I have assumed that the company will be able to expand revenues by 15% sequentially (ie, 65% next year, or slightly above the long term growth rate of the industry), and that margins will continue to increase at a much slower rate of 50 basis points per quarter (starting with net margins of 56.5 percent for Q3 of 2007 and increasing to 59% by Q4 2008). Given these assumptions and a share count of 57.3 million shares, the numbers work out as shown below:

Given the assumptions above, STV’s earnings per share would be expected to grow from 44 cents in 2007 to 75 cents in 2008, which implies earnings growth of 70.5 percent on revenue growth of 65 percent. I view this as a sort of midpoint estimate, because I believe that the revenue growth implied is reasonable, but the small margin expansion may in fact prove to be too conservative. The company could very easily exceed these rough estimates over the next 18 months, but we will have to wait for Q3 results in order to get a better handle on the growth rate going forward.

In the meantime, we can use the estimates above to come up with a reasonable price target for the stock based on the growth rate. For comparison, I am going to use Google because it is the quintessential growth company in the market at present.

Google’s stock currently trades at about 1.2 times its growth rate for 2008 EPS. If we ascribe the same multiple to STV shares, then based on the estimates above, we can easily see STV trading over $63 per share (70.5% x 1.2 x $0.75). This is sort of a mid-range price target, but I would argue that China Digital TV deserves to trade at a premium valuation to Google shares because it has a much faster growth rate and the general industry is also growing much faster. If we stretch the valuation for STV to 1.5 times the growth rate, the stock could trade up to $79 per share. The stock could perhaps even go as high as two times its growth rate before it starts to look overvalued, and that would price the shares at $105.

Overall, trying to put a price target on STV shares is certainly not easy given the difficulty of making estimates for a company experiencing such rapid growth. However, the exercise above helps to put a bit of numerical perspective behind the company’s current stock price, and gives a plausible idea of what can be expected over the next 18 months. While there is certainly a possibility that the company hits a bump in the road, I believe that STV is very well positioned to capture the incredible growth in digital TV that China is currently experiencing. Given the long term growth rate of the industry, STV shares certainly do not appear to be overvalued relative to the potential growth rate for the company, and there may well be very significant upside over the near term as investors gain more information and insight into the company’s growth rate going forward. I continue to hold a sizable position in the stock at a basis of $45, and I continue to believe the stock has more upside over the near term.

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