Profit as Millions of Chinese Start to Play the Stock Market

It’s little secret that China is one of the fastest-growing countries in the world. It already boasts the world’s largest population of nearly 1.4 billion citizens, and through the first half of this year, its economy grew by +11.1%, which comes despite a global slowdown brought on by the credit crisis. In other words, China stands out for the vastness of its consumer base and track record for rapid growth. The country is a star compared to more developed markets that are struggling with housing bubbles and high unemployment coupled with crimped consumer spending.

China recently overtook Japan as the second largest economy in the world, and it shows few signs of slowing down. Exports are driving much of the current growth and there is incredible potential for Chinese citizens to become consumers and drive another exciting round of economic expansion.

Along with increasing wealth and consumerism, a Chinese market of individual investors has vast growth potential. The interest in investing has, so far, mirrored the ups-and-downs of China’s stock market. Growth in the past two years has been more subdued, but it opens the door for savvy investors to find ways to profit from this growing market.

Current statistics put the number of investors in China at around 50 million. Most of this is made up of individual investors, as the institutional market is even less developed. By these estimations China Finance Online (Nasdaq: JRJC), the leading finance portal in China, can already count 40% of the market as registered users, though a small fraction are currently paying subscribers. The ability to further gain market share coupled with an overall market that can at least double in size means serious upside for years to come.

China Finance Online bills itself as the leading provider of financial information in China. Given its growth in China and the large and growing number of registered users, the company can also lay claim as one of the largest financial portals in the world. The features are what you would expect for a financial information portal: the ability to find stock quotes and financial information for companies relating to their common stock, bonds, as well as derivatives and more exotic securities.

Sales growth at China Finance has been blistering, though it started from a pretty small initial level. The official commercial launch was in 2001, but things didn’t really take off until late 2004 when it acquired the rights to its main website, Sales in 2005 were only $7.5 million, but they have since jumped more than seven-fold to $53.6 million in 2009, its last full year. This year, sales should reach more than $61 million and grow more than +14%.

Profit trends have been more murky, which isn’t all that surprising given the firm has essentially been a start-up and has had to invest in its infrastructure and marketing to build brand awareness. In the past five years, profitability has been reached only one time in terms of earnings — back in 2008, when diluted earnings came in at $0.17 per diluted share.

Negative earnings actually mask the fact that China Finance has been cash flow positive for some time now. (Last year, operating cash flow came in at $16.2 million.) Subtracting out $4.5 million resulted in free cash flow of $11.7 million, or nearly 13 cents per diluted share, current year expectations call for only a few cents in bottom-line earnings, but cash flow trends should be much stronger.

Total growth trends also remain impressive. Management expects to end this year with +43% more registered users that should push the total to 20 million. It pointed out that this is +82% higher than 2008’s 11 million total. Paid subscribers are only a fraction of the registered user base, but grew +27.2% during the most recent quarter to reach just under 140,000 individuals. A strategic alliance with China Telecom, one of the largest broadband Internet access providers in China, has brought its web portals to China Telecom’s 40 million broadband customers and could propel further growth.

Compelling organic growth prospects and a healthy acquisition program suggest the company will continue picking up users and lucrative subscribers at a rapid pace. China Finance has acquired several rivals in the past few years, including CFO Genius, which serves institutional Chinese firms. It also bought Stockstar Information and Daily Growth Securities to beef up its website and brokerage capabilities. Activity has slowed along with the stock market in the past couple of years, but should pick up again going forward.

Action to Take —> Given the growth of China’s economy and that new investors are born every day in the country, China Finance Online’s potential remains huge. Despite the rapid adoption of Internet usage and investing in China, it still considers the market for online financial data underdeveloped and highly fragmented. As a result, its first-mover advantage in the space gives it a big leg up on the competition. It is also shielded from foreign competition, as China limits foreign ownership of Internet companies to 50%.

The stock, which traded as high as $47 a share before the global financial meltdown, is in the bargain bin at around $7 a share. Current earnings metrics don’t properly reflect China Finance Online’s profit potential, but other metrics, including a price-to-book ratio (P/B) of less than 2.0 and a price-to-sales (P/S) multiple just over 2.0, imply that the market is not giving the stock much credit for the compelling growth potential the company has.