Takeover talk lights up Chinese Net stocks
Shares of several firms have soared thanks to rapid growth and merger speculation. What's the smart money doing now?
By Paul R. La Monica, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) - Chinese Internet stocks are all the rage on Wall Street.

Thanks to the growth of Internet access in China and strong demand for online advertising, sales and earnings are expected to grow at a healthy clip for Chinese Net firms. According to several estimates, more than 100 million Chinese are online, making China second to only the U.S. in terms of Web users.

Investors have fallen in love with Chinese Net stocks because of their strong fundamentals and takeover potential.
Investors have fallen in love with Chinese Net stocks because of their strong fundamentals and takeover potential.
No broken China: Sohu.com, The9 Limited and 51job are just three of a handful of Chinese Net stocks that have surged this year.
No broken China: Sohu.com, The9 Limited and 51job are just three of a handful of Chinese Net stocks that have surged this year.
INVESTOR RESEARCH CENTER INVESTOR RESEARCH CENTER upgrades & downgrades earnings & warnings public offerings INVESTOR RESEARCH CENTER INVESTOR RESEARCH CENTER
Bargains in Beijing
Sharees of top Chinese online firms trade at a discount to Google and Yahoo! despite similar growth rates.
CompanyP/ELT Est. EPS Gr.
The9 Limited21.225%
Netease.com21.525%
Sohu.com35.623%
Tom Online26.726%
Google41.731%
Yahoo!61.925%
* data as of 5/4/06
Source:Thomson/Baseline
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And investors have taken notice.

Shares of wireless Internet services firm Tom Online (Research) have surged 40 percent this year. Portal Sohu.com (Research) and online gaming firm Netease.com (Research) are each up more than 50 percent.

Recruitment site 51job has soared about 65 percent and The9 Limited (Research), another online gaming company, has skyrocketed almost 90 percent.

Beware the takeover hype...

But analysts say there is another reason many Chinese Net stocks have taken off: takeover chatter.

Google (Research), in particular, has been mentioned as a company that may want to expand its foothold in China. The company has a presence with its own site and a small stake in Baidu, the leading Chinese search engine.

But some analysts say it would make sense for Google to make an acquisition, with firms like Sina (Research) and Tom Online, or a deal for the rest of Baidu (Research), most often cited.

Takeover speculation, though, is just speculation. So some analysts caution against jumping into Chinese tech stocks since Google, or other U.S. firms, may not actually make any significant purchases.

Tian Hou, an analyst with C.E. Unterberg, Towbin, said there would probably be too many political hurdles for a U.S.-based company to buy a Chinese Net firm outright.

Instead, she thinks Google, for example, would be more likely to take a stake in one of the firms. Along those lines, Yahoo purchased a 40 percent stake in Chinese online retailer Alibaba.com last year while Expedia owns 52 percent of Chinese online travel firm eLong.

Michael Tieu, an analyst with Brean Murray, Carret, agrees that it's unlikely a Chinese firm would relinquish total control to a company like Google or Yahoo.

In addition, he said, most of the big Chinese online firms are expected to report strong results in the next few weeks. Sohu has already reported better-than-expected earnings for the first quarter and sales growth of 32 percent.

Looking ahead, Tom Online is on tap to report its first-quarter numbers on May 10 and analysts expect sales and earnings to jump more than 35 percent from a year ago. 51job will release its first-quarter sales on May 11 and forecasts call for sales growth of about 20 percent and a more than two-fold gain in profits.

For the long-term, analysts are projecting annual earnings growth of 20 to 30 percent, on average, for the next few years for most of the top Chinese firms.

So it's clear why these companies would be desirable to a Google or Yahoo. But it also means there's no urgent need for any of the Chinese firms to hitch up with their U.S. counterparts.

"Keep in mind these companies are earning strong profit margins. They're not in a position where they have to sell. When you take a company that's growing fast and is highly profitable, they're sitting in a good position," said Tieu.

With that in mind, analysts said investors should be wary of Sina since the 21 percent jump in its stock this year is due more to takeover scuttlebutt than strong results.

...but there are some values

But even if none of the major Chinese firms get taken over by a U.S. firm, that doesn't mean that U.S. investors should shun the group. There's still a good chance of mergers but it might be that Chinese firms will be buying, rather than Net firms from overseas.

"The Chinese Internet industry is highly fragmented. Here you have a few big giants. Going forward, we may see consolidation and there's no political risk if deals are among Chinese Internet companies," said C. Ming Zhao, an analyst with Susquehanna Financial.

C.E. Unterberg, Towbin's Hou said the performance for several stocks is justified given Sohu's strong numbers. "Online advertising is growing very rapidly. That's a big reason why Sohu and other stocks are up," she said.

Tieu at Brean Murray, Carret adds that several Chinese Net stocks still look attractive, trading at a discount to Google and Yahoo even though their projected growth rates are comparable to the U.S. firms.

Google, for example, trades at about 42 times 2006 earnings estimates while Yahoo has a P/E of more than 60. But two of Tieu's favorites among the Chinese online firms, The9 Limited and Tom Online, have multiples of just 21 times and 27 times 2006 earnings estimates.

Hou's top picks Netease and Sohu also look attractive when compared to Google and Yahoo. Netease trades at 22 times 2006 estimates while Sohu is at 36.

Michael Zhang, an analyst with ThinkEquity Partners, also likes Sohu, partly because the company will be the exclusive online video provider for World Cup soccer games in China this summer. The company's sponsorship of the 2008 Summer Olympics in Beijing is also a plus, he said.

But what about Baidu? The company, which went public last year and surged more than 350 percent on its first day of trading, has attracted arguably the most buzz of the Chinese Net firms since it is heavily dependent on search-advertising.

Baidu, often been referred to as China's Google, has the highest growth rate of all the Chinese Net players, with analysts projecting annual earnings growth of 50 percent a year for the next few years. But the stock trades at a whopping 116 times 2006 earnings estimates.

Tieu thinks Baidu clearly has a great future but that the stock is just too richly valued.

"Baidu is one of those strange phenomena. It is the leader in the search market in China and continues to win traffic. But the stock's a little ahead of its fundamentals," he said.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.