Friday, May 26, 2006

Motley Fool questions digital signage giant Focus Media's stock valuation

Focus Media is one of the poster-children of the digital signage world, along with PRN (and the Wall-Mart TV network) and I suppose the UK's Tesco digital signage installation. Publicly traded on the NASDAQ, for a while many thought that they could do no wrong -- and for a while it looked like they were right. With tens of thousands of screens deployed to retailers and upscale office buildings mostly concentrated in Shanghai, Focus easily controlls three quarters or more of the existing Chinese market for digital signage, which isn't network connected, but instead powered by a "sneaker net" of inexpensive Chinese laborers who go to each site every month to swap out compact flash cards (or in some cases, DVDs).

If you think that's too low-tech to make them any money, think again: As the Motley Fool tells us: "[their] first-quarter reports were quite impressive -- revenues were up more than 246% year over year. Net income was up similarly, to $9.4 million, which equates to roughly 29% net margin." Growth prospects are still high given the number of cities left to expand to, but there may be some trouble on the horizon...

[Investors] have awarded the company a rather jaw-dropping $2.9 billion market cap. This places the company at a forward 2006 P/E of 56, and a price to sales ratio of 15. Needless to say, this prices in considerable growth for some time to come, and there may be some cracks in the armor already. The company already controls 70% of the market in Shanghai, but as of December 2005, wholly foreign-owned advertising companies has been allowed to enter China, exposing the market to companies like Viacom (NYSE: VIA), Interpublic (NYSE: IPG), and WPP Group (Nasdaq: WPPGY).

With the very low barriers to entry (namely the cost of the LCD screens), and the lack of exclusive contracts in the space, Focus Media could end up in the dumpster in a hurry. For example, Inside Value pick Wal-Mart (NYSE: WMT) and Carrefour both have substantial operations in China, and both are taking different approaches. Wal-Mart is relying on the experience they have on operating their own in the U.S, and Carrefour is using CGEN, another Chinese competitor. Investors would do well to keep this in mind, since the growth expectations embedded in the stock price, well, might just be too optimistic.

While others see the possibility of Focus trying to expand into the US market, their existing tactics don't give them any competitive advantage here, and their foreign heritage might actually create additional barriers to entry here (in any meaningful way). Instead, I'd expect to see them continue their push in China, and maybe elsewhere in Asia, either going it along (and using their existing cash reserves to build out their network), or partnering with some other big marketing or media firm.

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