Focus Media (NASDAQ:FMCN) is quite the stock-market darling. It's trading at frothy levels, with a P/E of 64 and a price-to sales ratio of about 25, even though its stock price has already doubled over the past year. The largest out-of-home network advertiser in China, providing advertisements via LCDs, does currently have a dominant position in its market, though, which is worth something. In addition, sales and earnings are growing at enormous triple-digit rates. However, investors shouldn't expect that to continue forever; at some point, growth will slow, and competition will start to gain traction.
The competition, however, is nowhere to be seen this quarter -- probably because Focus bought Target Media, the No. 2 player in the market, a few months back. Amusingly enough, the company came in with $61.1 million in revenues for the third quarter, up more than 200% year over year and roughly 20% sequentially. Why is this amusing? Well, the stock was slammed 8% last quarter after the company lowered guidance below analysts' estimates, which coincidently were $60 million. Sandbag much? Note as well that margins continued to rocket upward in this quarter; gross margins hit 65.3%, up from 58.9% in the previous quarter alone. Operating margins enjoyed more of the same, with nearly a 1,000-basis-point jump sequentially, from 33% to 42.3%.
Much of the company's growth has come from acquisitions like Target Media and, more recently, Appreciate Capital, which essentially owns the rights to sell advertising previews to more than 120 theaters in China. While this has caused substantial share dilution -- diluted shares outstanding are up about 44% year over year -- it makes sense, since Focus it is essentially cutting off many competitors at the knees before they can become real threats. In a quickly growing market, such an aggressive strategy can build short-term competitive advantages.
Note that I said nothing about the long term. Decisions by Wal-Mart (NYSE:WMT) and Carrefour to adopt different approaches to advertising via LCDs are examples of the lack of Focus Media's value offering to key customers. Focus is already running into issues with real estate rents; with its Target Media deal, it had to reject about a third of its convenience-store base because the rents were too high. It instead focused on putting more screens in current stores and sites, a strategy that could hurt when Focus's non-exclusive contracts are up for renewal.
I'm inclined to think that potential competitors like Viacom (NYSE:VIA), WPP Group (NYSE:WPPGY), Interpublic (NYSE:IPG), and Omnicom Group (NYSE:OMC) will have the marketing experience needed to better solve tough issues like tracking the LCD ad efficiency, if they can weave their way through China's regulatory environment successfully. Focus Media may be shining brightly now, but don't look too closely -- there might be a few dead pixels on that LCD screen.
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Fool contributor Stephen Ellis does not own shares in any companies mentioned. You can view the stocks he owns and check out his 98th-percentile ranking in Motley Fool CAPS, the Fool's new stock-rating community. The Motley Fool has a disclosure policy.
