BlueFocus Communication Group:Digital marketing business to drive revenue and earnings growth,upgrading to Neutral

Fast revenue growth + low NPM in digital marketing are priced in.

    1) Following the Q116/H116/Q316 reports, the market has priced in slowing revenuegrowth and low-single-digit net profit margins (NPM) in the company's traditionalmarketing segment. 2) Considering the stronger-than-expected boost to earnings fromfast revenue growth in its digital marketing business, we are raising our 2016-18Edigital marketing revenue growth assumptions and upgrading our earnings forecastsfor the company. 3) Our residual income model estimates that the level of implied longtermgrowth priced into the stock is in line with historical levels, and we believevaluation has returned to a reasonable range. We are raising our rating to Neutral.

    Digital marketing: Main driver of the company's revenue & earnings growth.

    Acquisition of internet marketing companies has been an important part of thecompany's long-term development strategy. Helped by ongoing M&A since 2014, thecompany's digital marketing revenue has continued growing at 80%+ YoY since 2014,rising to 73% of overall revenue in H116 (2013: 45%) and reaching 64% of overallgross profit. This segment has become a major source of revenue and earnings for thecompany. We are forecasting digital marketing revenue to grow at 35%+ YoY in 2016-18E, causing the segment to reach over 80% of total gross profit in 2018E.

    Traditional marketing: Steady rev growth, profit contribution to keep falling.

    In response to the ongoing deceleration in the traditional advertising market, thecompany is following a strategy of maintaining its existing well-performing businesseswhile shrinking its low-margin segments. Although we expect revenue from itstraditional marketing business to return to steady growth, earnings contribution fromthis segment is set to continuously decline, reaching 17% of gross profit in 2018 from53% in 2014.

    Valuation: Upgrading to Neutral, lifting PT to Rmb11.6.

    We are raising our 2016-18E EPS to Rmb0.33/0.41/0.49 from Rmb0.33/0.38/0.45based on the H116 and Q316 results (considers potential dilution due to convertiblebonds). Our DCF-derived PT of Rmb11.6 (from Rmb10.5) assumes an 8.3% WACC.

    Upgrade to Neutral.