Foolish Forecast: TOM on the Line

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Ring, ring! Will somebody get that, please? It's long distance. TOM Online (Nasdaq: TOMO), one of China's leading Internet portals and wireless service providers, reports its Q1 2006 earnings numbers tomorrow.

What analysts say:

• Buy, sell, or waffle? Ten analysts follow TOM, which garners five buy ratings, four holds, and one sell.
• Revenues. Analysts expect to see 37% revenue growth tomorrow. The target is $48.3 million.
• Earnings. Profits are expected to come close to keeping pace, with the prediction being for $0.23 per share, a 35% increase over last year.

What management says:
TOM issued its fiscal 2005 earnings report in March. Chief among the listed accomplishments has to be the company's impressive 40% sales growth, led by wireless Internet services, sales of which grew 43%. Advertising revenues remain a small portion of the firm's overall revenue stream and grew much more slowly -- "only" 22%.

Management stated flat-out that not only is the company already the "leading wireless Internet firm in mainland China," but it also succeeded in "gaining market share against most of our key competitors" in 2005. However, that increased market share came with a cost. As you will see in the chart below, TOM's gross, operating, and net margins all eroded over the past 18 months. According to management: "This decline in margins was mainly due to the company's strategy of building alliances with distribution . [and] content partners and sharing a percentage of revenues. This has had an adverse impact on margins but . enabled significant market share gains in 2005."

What management does:
Sagging margins aren't the kind of results we ordinarily look for in a company. But if the firm has truly stolen market share from its rivals, strengthened its position going forward by securing profitable partnerships, and is able to continue posting sales gains of the magnitude expected to be reported tomorrow, it might be worth a bit of margin erosion to secure these successes.

Margins %	9/04	12/04	3/05	6/05	9/05	12/05
Gross	48.6	47.2	44.2	42.1	42.4	42.6
Op.	28.1	25.6	23.5	21.6	22.9	23.8
Net	29.8	27.6	26.3	24.2	25.5	26.1

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ending in the named months.

One Fool says:
Also noteworthy is that although TOM's gross margin slipped 600 basis points over the course of the period reflected above, its operating margins slipped by only 430. Part of the reason for this is that operating costs are rising less rapidly than sales gains. Over the past six months, for example, operating costs rose only 18% -- less than half as quickly as sales. Lower down the income statement, we see why the company is posting net margins in excess of its operating margins. TOM earns interest on its cash hoard; recorded a few one-time items that, while small, yielded net positive income; and paid no income tax whatsoever -- actually receiving minimal tax credits -- over the period described above.

I have to imagine that, at some point, this abundance of good fortune will end. Eventually, someone's going to want to squeeze some tax revenue out of this highly profitable company. But for now, it explains why the company is netting so much more than you'd expect from a company that is sacrificing gross margins on the altar of market-share gains.

Competitors:

• Baidu.com (Nasdaq: BIDU)
• Netease.com (Nasdaq: NTES)
• Sina (Nasdaq: SINA)
• Sohu.com (Nasdaq: SOHU)
• The9 Ltd. (Nasdaq: NCTY)
• Yahoo! (Nasdaq: YHOO)

NetEase is aMotley Fool Rule Breakersrecommendation, and Sina is aMotley Fool Stock Advisorpick. Try out any of our investing services free for 30 days.

Fool contributorRich Smithdoes not own shares of any company named above.