Two Ways to Play China’s Consumer Boom

01/09/2008 12:00 am EST

Focus: STOCKS

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, says China's growing wealth will spur a big rise in consumer spending and he says two companies in particular should profit from it.

Chinese real estate prices more than doubled over the past five years and the stock market more than tripled during the same period. As a result, millions of Chinese have seen their personal net worth increase sharply over the past couple of years. This increase in wealth will translate into more purchases.

Overall, Chinese households spend heavily on three things in particular: education, health care, and housing. To take advantage of these spending trends, we own private education leader New Oriental Education (NYSE: EDU) and real estate marketing firm E-House (NYSE: EJ).

Both have strong brand names in their respective industries, are private-sector firms founded by Chinese entrepreneurs with significant expertise and stakes in their business, and are asset-light, service-oriented growth leaders in China's consumer cyclical sector.

Currently, E-House is the largest real estate brokerage in China, with more than 2,000 real estate sales agents in 30 cities throughout the nation. E-House provides primary real estate agency services, secondary real estate brokerage services and real estate consulting and information services. New home sales are the company's biggest revenue source, generating more than 80% of its revenue.

A recent Merrill Lynch research report pointed out that the Chinese real estate market will likely maintain its fast growth over the next several years thanks to strong demand. As the leader in the industry, E-House should be able to continue its strong 80% annual earnings growth.

I'm confident that the company will continue to deliver superior performance and profit growth. Buy EJ under its newly adjusted buy limit of $28. (It closed at around $23.50 Tuesday-Editor.)

(There's one important thing you must know about E-House, though: this recent initial public offering is prone to wild price swings, but ultimately I believe it will reward those with the patience to let this holding reach new highs.)

Scholastic test preparation is still [New Oriental's] largest profit point, generating 38% of the company's revenue. The company commands a price premium over competitors.

Because education is a high priority for most Chinese households, Chinese parents are willing to pay large sums to increase the odds that their children will pass important tests. High scores on these standardized tests can help determine whether their kids make $400 a month or $4,000 a month after they graduate from college.

Education made up 15% of China's total consumer spending, second only to food and ahead of housing and transportation. New Oriental's main competition includes regional niche companies that lack capital and nationwide brand presence.

EDU is expanding rapidly into second-tier Chinese cities and still maintaining high margins. Although the company's valuation is high at a P/E of 86x, [I have] confidence in the growth momentum of the company. Continue to buy EDU under $80 a share. (It closed Tuesday below $83-Editor.)

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