Focus Media (NASDAQ:FMCN) reported earnings last Thursday, and the market liked what it saw, driving the stock up more than 12% in Friday's trading. The Chinese company has a rather unusual business model -- it sells out-of-home advertising in China -- ads that are seen on elevator LCD displays and the sides of buildings, as well as inside hospitals, hypermarkets, subways, convenience stores, and the like. I think it is a highly original idea that targets the emerging and newly affluent Chinese middle class, who often spend more waking hours at work than at home. It kind of takes the old-fashioned billboard one step further, although some of the methods are rather low-tech. For example, the content on each screen has to be updated manually via a memory stick or DVD, because if the updates were done via a network, the company would need a TV license to do so. However, the company has tapped into quite the unique and lucrative business niche, thanks to the lack of effective advertising channels in China.

The 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. Given that this was the seasonally weak quarter -- the two-week Chinese New Year holiday had many office buildings closed for part of the quarter -- the results were strong.

The mature directly operated commercial buildings, which carry higher margins than the relatively new in-store networks (63% versus 25%), were the major business driver, growing at 127% year over year to $21.5 million. Keep in mind, though, that margins for the in-store network rose 2,000 basis points from 5% in the fourth quarter of 2005, and management expects them to reach the 40% range in the near future.

Finally, the company strengthened its competitive positioning by acquiring its largest competitor (and number two in the market), Target Media. The deal, worth $325 million in stock and cash, closed last quarter.

However, none of this has gone unnoticed by investors, who 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.

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Fool contributor Stephen Ellis does not own any companies mentioned in this article.