These Internet Service Providers Have Upside Potential in China

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With a constantly and rapidly-growing internet and mobile user base, China presents internet services companies with plenty of growth opportunities going forward. Alongside increasing traffic, corporate advertising budgets are also rising quickly, and SINA (NASDAQ: SINA), Baidu (NASDAQ: BIDU), and NetEase (NASDAQ: NTES) are three companies that seem positioned to benefit from the expansion. For those looking for long-term investments, these companies most certainly deserve a close look.

SINA: Plenty of opportunities

SINA is one of China’s first and largest internet services providers. It the leading online advertising platform in terms of revenue. Although this might seem as a problem at first sight, the fact is that corporate budgets for publicity have been and will continue to expand as the Chinese economy develops, thus providing plenty of upside opportunities. Moreover, the company’s strong brand name and “attractive user demographic (mostly well-educated, middle-class urban residents) should continue to draw advertisers” in the years to come (Morningstar).

One of the company’s most interesting business prospects is its Twitter-like microblog Weibo service. Although the web-page counts more than 500 million registered users, the active ones are the ones that matter, and bulk up to roughly 50 million people that spend an hour on the website every day. Only last year did SINA start taking advantage of this opportunity and, after several quarters of bulky investments, monetized the portal through the use of display advertising and applications.

This will boost revenue in the upcoming quarters and will most likely be complemented by other revenue sources including e-commerce, online gaming, and online payments, among others. Consequently, analyst consensus estimates project an annual EPS growth rate of over 200% going forward.

SINA’s most recently reported quarterly results beat consensus estimates comfortably and management raised its revenue guidance. As a result, shares surged and currently trade at 119 times its earnings, more than double the industry mean valuation. However, its price-to-book ratio of 3.4 versus the 4.1 industry average makes its valuation a little bit better looking.

Although a little expensive, I would still recommend buying and holding on to this stock; SINA looks well positioned to benefit from growing advertising budgets, the advance of mobile technology, Weibo’s growth, and partnerships with firms like Baidu and AutoNavi.

Baidu: The "Chinese Google"

Baidu is roughly 10 times bigger than SINA, holding a market capitalization of more than $33 billion. As China’s largest internet search platform -- considered by many as the Chinese Google -- this firm looks good for a long-term portfolio, especially as consensus estimates project an above average EPS growth rate of 20.16% per annum over the next five years. Trading at only 19.5 its earnings, compared to the 50.8x industry average, while presenting wide margins, returns and, growth rates, I'd say that this stock is undervalued and would strongly recommend buying and holding on to this firm's shares.

Since the company controls over 70% of the total paid search sales in China, most of its revenue comes from them. Paid searches provide small and medium businesses with the opportunity to advertise their brands, while strongly contributing to Baidu’s growth. Some other less profitable services, like music streaming and online forums, continue to drive traffic to the site, thus increasing value for advertisers and creating incentives for new customers to use Baidu´s publicity services. Furthermore, a fast developing economy will result in higher corporate promotion budgets in the years to come and the company seems well positioned to make the most of this rising source of revenue.

Moreover, Baidu has been diversifying its business, making an incursion in the mobile, real estate, travel, and cloud computing segments, among various others. Although paid searches are expected to continue to account for most of the firm’s income, these arising verticals -- especially the mobile industry -- should also contribute to revenue in the upcoming quarters. Even if Alibaba, Tencent, and Sohu present strong competitive threats, I believe that Baidu’s strong brand name and stable market dominance should assure profitability for a few more years, at least.

NetEase: Dominance in gaming services

NetEase derives roughly 90% of its income from online gaming services. Operating in a market of over 350 million gamers that generated $10 billion in revenue in 2012, this firm stands as an interesting investment opportunity, especially as it trades at 13.6 times its earnings, a 73% discount to the industry average valuation, while offering great margins and returns.

After a solid first quarter that presented a decent balance between in-house developed and licensed games and consistent increases in online advertising revenue, Citigroup upgraded its recommendation from a neutral to a buy and the stock price continued to rise, now trading close to an all-time high. Nevertheless, valuation-wise, the shares are still cheap and long-term prospects are promising.

Analysts expect an annual EPS growth rate around 13% for the next five years, a conservative calculation given the company’s size and market presence and the fast-growing internet demand in the China. The firm’s high in-house research capabilities should drive growth even further in the years to come. By creating games that adapt to ever-changing gamer preferences, increasing loyalty among users, the company should retain and even widen its market share.

Moreover, profits should keep increasing while costs should drop and margins increase on the back of constant development of expansion packs and innovative marketing initiatives that help games keep running, played, and monetized. Furthermore, the licensing agreement established (and recently renewed) with Activision Blizzard for the exclusive operation of the popular game “World of Warcraft” in China should prove substantially beneficial, increasing the firm´s traffic and revenue.

Bottom line

If you are looking to ride the momentum of Chinese internet expansion, SINA, Baidu, and NetEase are three titans you shouldn’t ignore. With promising but sustainable outlooks for the future, these companies stand as compelling long-term investments. Baidu and NetEase trade cheap, thus providing an interesting entry point; SINA, on the other hand, is valued expensively in relation to its earnings, reflecting plenty of confidence from investors in the firm’s future. I’d say, buy the three of them now and wait for returns to come over the years. However, if I had to pick, I’d go with NetEase, for value, or SINA, for its moat and stability.

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Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Baidu, NetEase.com, and SINA . The Motley Fool owns shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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