Ever since the days of Marco Polo, the siren song of China has called out to Western companies and investors, enticing them with visions of the possible riches to be mined from the country's vast population. All too often, these visions turned out to be mirages as successive Imperial governments severely limited contact (and trade) with the outside world.
I know, I know.that's all ancient history. It's now the 21st century, and China has opened up to the world in a major way. The Chinese economy, already the fourth largest in the world, continues to expand rapidly -- GDP growth came in at a stunning 11.3% annualized rate in the second quarter -- as the country cements its position as the manufacturing capital of the world. Exports reached a record $429 billion in the first six months of 2006, up 54% from last year's period, and are on pace to drive China's annual trade surplus to more than $125 billion and its foreign exchange reserves to more than $1 trillion by year-end.
Little wonder that utilized foreign direct investment (FDI) reached more than $60 billion in 2005, according to the Chinese Commerce Ministry. As new factories are built and new workers hired, China's middle class is growing as well -- a middle class that McKinsey & Company expects to reach 520 million by 2025 with a purchasing power in excess of $2.5 trillion.
Hmm.rapid industrial growth coupled with a burgeoning middle class -- what more could an eager investor ask for?
The question facing investors is quite simple: How can we profit from this growth?
Tapping into China's growth
While there's a school of thought that advocates indirect investment -- buying shares of U.S. companies that should benefit from China's growth like restaurant chain Yum! Brands (NYSE:YUM) on the consumer side or General Electric (NYSE:GE) in the industrial space -- I believe that risk-tolerant investors can get more bang for their buck by investing in Chinese companies serving the domestic market. One of my favorite plays here is China Mobile (NYSE:CHL), the world's largest cellular operator in terms of subscriber base.
In a previous article, I mentioned that investors in emerging markets needed to focus on corporations that held a dominant share of their home markets, had strong growth prospects, and were attractively valued: essentially, blue-chip companies by any other name. This is especially true in China where -- I realize it may seem counterintuitive -- I believe that the best plays for the individual investor are the successful "red-chip" companies in which the Chinese state retains a large stake since the government is not likely to kill the proverbial goose that lays the golden egg.
Let's take a quick look and see how China Mobile measures up to these criteria, shall we?
Market dominance
Well, I think it's safe to say that China Mobile fits this bill nicely, as the company had some 274 million wireless subscribers as of the end of June, which is a 64% share of the roughly 426 million cellular customers in China. In comparison, its closest competitor, China Unicom (NYSE:CHU), had 135 million -- a still-respectable number if it weren't in competition with China Mobile.
Growth prospects
I realize that there's been some recent chatter among analysts that the easy days of China Mobile's domestic expansion are over. After all, in previous years, the company was able to expand its domestic network simply by buying provincial subsidiaries -- 10 in fiscal 2004, for example -- from its state-owned parent China Mobile Communications Corporation (CMCC). Since China Mobile has now bought all 31 provincial operating units previously owned by its parent, such easy pickings are no longer available. Furthermore, average revenue per user/month (ARPU) also declined some 2% in 2005 as China Mobile discounted some of its offerings because of competition from China Unicom.
Should investors keep an eye on these issues? Yes. Should they be worried? No.
Foolishly put, while China Mobile's subscriber base is huge by world standards -- 46% larger than runner-up Vodafone's (NYSE:VOD) 188 million cellular customers -- the overall penetration rate in China is a measly 33%, well below the 70%-plus rate in the U.S., and the 90%-plus rate in Western Europe.
Think there's a tad bit of room for growth?
In addition, I believe growth in the subscriber base and the company's move to add incremental revenue streams from new businesses will more than offset the slight decline in ARPU. As always, economies of scale will prevail.
In terms of subscribers, China Mobile has added some 28 million customers (up 11%) since the beginning of the year, well ahead of the 6% subscriber growth managed by China Unicom over the same period.
I don't know about you, but an annualized subscriber growth rate of 22%+ doesn't seem too shabby to me.
As to new business revenue: According to Riedel Research, an emerging market research firm, new businesses -- i.e.,China Mobile's slice of online gaming revenue, ring tones, etc. -- accounted for some 21% of operating revenue in 2005, up from 15.5% in 2004. This trend is likely to continue, given recent announcements like the company's purchase of a 19.9% stake in Hong Kong-listed Phoenix Satellite Television (more content for its cellular customers) and its discussions with Google (NASDAQ:GOOG) about launching a mobile Internet search engine in China.
While expanding its reach in the domestic market is likely to command the majority of the company's energy over the next few years, China Mobile is starting to take baby steps toward expanding in the international arena, as evidenced by its recently aborted $5.3 billion bid for emerging market operator Millicom International Cellular (NASDAQ:MICC). Though the last-minute decision to drop its bid renewed some investors' concerns about China Mobile's ability to build an international presence, management indicated that inspections of Millicom's various operations caused them to drop the bid -- signaling a disciplined approach that should actually reassure investors.
In any case, China Mobile is well-positioned to pursue future acquisitions since the company is sitting on over $13 billion in cash, generates solid free cash flow in excess of $6 billion, and can probably tap its state-owned parent China Mobile Communications for additional funds if necessary.
Valuation
After a nice little run since the beginning of the year, shares of China Mobile currently trade at around 15 times fiscal 2007 estimates, a slight premium to the company's projected long-term growth rate of 13%. While not exactly cheap compared to Vodafone, I believe that shares of China Mobile have further to run given the company's dominant position in the still nascent Chinese cellular phone market and above-average growth prospects. Investors might want to call up China Mobile's financials and take a look for themselves.
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Fool contributor Will Frankenhoff is enjoying his time writing for The Fool more than reading The Financial Times, rooting for the New York Giants, or pondering the vagaries of life (pretty unsuccessfully up to this point). He welcomes your feedback. He does not own shares in any of the companies mentioned above. The Fool has a disclosure policy.
