Chinese Phones Get Smart

Chinese Phones Get Smart
By: Benjamin Shepherd

For the better part of three decades, China’s economic growth strategy has largely revolved around leveraging its large force of cheap labor to become the manufacturing and export powerhouse of the world. That has proven hugely successful, as the country grew its gross domestic product (GDP) in excess of 10 percent for several consecutive years.

However, the cracks in that strategy have begun to show, as GDP growth fell to 9.3 percent in 2011 and an estimated 7.5 percent last year.

Labor costs in China have crept up over the past few years, thanks to the country’s red hot economy. Consequently, many foreign manufacturers initially attracted to the country’s low-cost workers have begun to shift capacity to other, cheaper Southeast Asian countries such as Thailand, Malaysia and even Myanmar. A sharp drop in global demand for Chinese exports has also revealed a fault in China’s export-oriented economy, exposing the country to the economic troubles of the rest of the world.

To combat those challenges, Beijing is looking inward to the huge demand potential of its own domestic consumers.

As wealth in the country has exploded over the past decade, consumer spending has been growing by about 18 percent annually, according to China’s National Bureau of Statistics. That compares to consumer spending growth of only about 2 percent in the US.

It’s interesting to consider what the Chinese have been spending their money on over the past few years. Much of this spending represents the eager pursuit of “the good life” as showcased in the West.

Wine consumption has skyrocketed, reaching nearly 200 million cases per year. Imported wines now account for about a quarter of that consumption, up from nearly nil just a decade ago. Consumption of wine and other luxury goods is expected to grow by about 18 percent annually over the next two years, reaching $27 billion by 2015.

Thanks to that growth, China has become the fastest-growing market for luxury goods made by companies such as Tiffany & Co (NYSE: TIF), Prada (France: PRP) and LVMH (OTC: LVMU). Those luxury manufacturers have seen their sales more than quadruple in China over the past three years alone.

But the taste of Chinese consumers also runs to the more practical.

The country has become the world’s largest smartphone market, with millions of devices from manufacturers such as Apple (NSDQ: AAPL) and Samsung (Korea: 5930) sold every year. Foreign companies aren’t the only ones tapping into that demand; Lenovo Group (Hong Kong: 0992, OTC: LNVGY) has developed its own propriety smartphone technology for exclusive release in China later this year.

A number of companies have also been investing heavily in rolling out advanced data networks across the country, expanding the reach of 3G technology into rural areas and introducing the beginnings of 4G networks in urban markets. That improving data infrastructure has produced surging smartphone sales, which shot up by nearly 140 percent last year alone.

With smartphone penetration expected to reach about 35 percent this year, its forecast that nearly 300 million new phones will be shipped to China in 2013.

While smartphone manufacturers and service providers such as China Mobile (NYSE: CHL) are the obvious play on exploding smartphone sales, a technology that was once in the exclusive purview of the US military and has now become ubiquitous throughout the world offers the greatest upside potential, because it comes preloaded on almost every unit shipped.

AutoNavi Holdings (NSDQ: AMAP) is the leading developer and purveyor of the advanced maps used in GPS applications in China.

The first Chinese company to be granted the licenses required to developed advanced maps, AutoNavi spent eight years conducting surveys, collecting geographical data and accumulating traditional photographic and satellite imagery to develop a map database covering most of China.

Thanks to its “first mover” advantage, none of the other 10 Chinese firms licensed to develop similar maps are ever likely to catch up with it in terms of the breadth and depth of AutoNavi’s data.

As a result, AutoNavi is the provider of choice for in-dash GPS units preinstalled in many automobiles sold in China. GM (NYSE: GM), Mercedes-Benz, BMW and Volkswagen are just a few of the major foreign automobile manufacturers who rely on AutoNavi, along with most domestic Chinese car manufacturers.

The company also licenses its map data to application developers and device manufacturers such as Samsung (Korea: 5930) and Apple (NSDQ: AAPL), which provide GPS capability integrated into smartphones for both navigation and location-finding purposes.

Despite its name, AutoNavi also supplies its mapping data to a number of government entities and corporate users for urban planning and development purposes, land use studies and planning for pipelines and other large-scale infrastructure projects.

AutoNavi has grown its revenues by more than 40 percent per year since going public in 2009, but the company’s shares have lost nearly a quarter of their value over that period.

The company’s subpar stock performance is even more surprising, in light of earnings that have more than tripled over that same period because of a relatively low cost of goods. While the company had to make a heavy upfront investment to develop its map database, there’s relatively little expense involved in maintaining it. As a result, the revenues realized from any data sales are licensing agreements that flow straight to the company’s bottom line, minus administrative costs.

That also means that it’s an extremely high-margin business, with a gross margin of 72 percent as of its last fiscal year and an operating margin of 29 percent.

The company also carries no debt, having paid off startup costs from its initial cash flows. The bulk of the company’s expenses now fall into selling and marketing, and research and development (R&D).

The company has been expanding its sales force over the past two years to reach out primarily to application developers and domestic Chinese automobile manufacturers. It also typically invests about 15 percent of revenues into R&D, developing capabilities such as Siri Chinese language search to better integrate its data with Apple’s software and mapping applications.

Currently trading at just 11 times forward earnings, the shares are undervalued considering the company’s phenomenal growth rate. While earnings growth is likely to slow to about 25 percent annually over the next few years, AutoNavi could easily command a much higher valuation.

I expect the valuation gap to close over the coming months for two reasons. The first is that there’s been a great deal of concern that Chinese automobile sales would slow along with the broader Chinese economy. However, as I’ve written several times over the past couple of months, the economic data coming out of China strongly suggests that the economy has bottomed out.

But even when there were strong signs of economic trouble in China, auto sales there have held pretty steady, maintaining a 12 percent growth rate per government data. While there have been a few months in which sales dipped recently, most of the decline can be accounted for by sharp sales reductions in Japanese-made vehicles, which is more reflective of nationalistic tensions than any economic malaise. As long as Japan and China remain locked in territorial disputes, Chinese consumers will likely continue to shun Japanese products.

Another major check mark in the company’s favor is that with the close of 2012 it will soon have three complete years of financial data available as a publicly traded company.

That’s a significant milestone, because most major American mutual funds, with the exception of those that specialize in young companies, require three years of financials to perform sufficient due diligence.

Now that the hurdle can be met, I suspect AutoNavi’s shares will begin appearing in the portfolios of many emerging market and China-focused mutual funds. See my free report for more top international stock picks.

This article was written by Benjamin Shepherd of Investing Daily.