Are Chinese Tech Stocks Undervalued?
The China Tech Crackdown
China's tech stocks once rewarded investors with lucrative returns and were characterized by their explosive growth in the second-largest economy in the world.
However, sweeping state-led crackdowns spanning multiple industries have significantly increased risks and depressed valuations, causing these firms to lose trillions of dollars in market value.
The decision to suspend the $37 billion IPO of Alibaba affiliate Ant Group on November 3, 2020, marked the start of China’s year-long crackdown. Ant Group has a valuation of over $600 billion and owns major assets in online investing, insurance, and consumer lending, such as the popular payments app Alipay.
Four days later, the State Administration for Market Regulation (SAMR) released its draft of antitrust guidelines to control internet-based monopolies.
In the following month, SAMR began slapping fines on the Chinese tech giants. Alibaba, JD.com, and Tencent-backed China Literature were all fined for pricing irregularities and the failure to report acquisitions properly. It would be the first of many fines for the tech companies—for reasons ranging from mishandling user information to price dumping and fraud.
In 2021, Beijing investigated dozens of major companies, including Tencent, Alibaba, JD.com, and Pinduoduo, for monopolistic behaviour or breaching customer rights. Alibaba was fined a record $2.8 billion in April, while Ant Group was ordered to overhaul its operations. Ant Group was to become a financial holding company, supervised by the central bank, along with the fintech branches of 13 other firms, which included Tencent and Meituan.
SAMR imposed additional fines totalling 206 million yuan ($32.5 million) in the first half of the year, according to a statement published on the agency website.
July saw China ban ride-hailing giant Didi from its app stores just days after the company went public in the United States, which sent its stock price plummeting. The government launched a cybersecurity review into the company, accusing them of major violations regarding the collection and usage of user information.
Later that month, China unveiled new rules on education and private tutoring in an effort to help reduce the financial pressure on parents. Education in China is fiercely competitive, and families often spend large portions of their incomes on hours of supplemental courses for their children.
Tutoring companies teaching school subjects were required to go nonprofit and banned from raising capital, essentially upending a $120 billion industry. These measures subsequently led to a sell-off in Chinese stocks, as investors pondered which industry would be a target next.
Chinese regulators have long been concerned about gaming addiction among young people and the potential impact on their physical and mental health. In August, China banned those under 18 from playing online games for more than three hours a week—an hour a day on Fridays, Saturdays, Sundays, and holidays. Companies like Tencent, China’s largest social media and video game firm, have implemented anti-addiction systems that limit user game time.
However, authorities have talked about getting companies to adapt game designs to make them more child-friendly, stoking fears about losses in video game revenue.
To learn more about Tencent, we have a full breakdown of their financials, businesses, and competitive advantages for investors in the following:
Tencent (TCEHY): Building China's Most Important Technology Ecosystem
Tencent, Alibaba, JD.com, and Pinduoduo continue to see double-digit revenue growth year over year, but the new macroeconomic and regulatory challenges may already show signs of taking hold.
In the September quarter of 2021, JD.com was the only one of the four tech giants to beat earnings expectations—218.7 billion yuan ($33.9 billion), an increase of 25.5% from the third quarter of 2020. However, the company warned that slowing consumption amid higher input costs could hurt business in the second half of its fiscal year.
Tencent’s revenue grew 13% to $22 billion in the third quarter, which was the slowest growth since it went public in 2004. Minors accounted for a mere 1.1% of Tencent's total domestic gaming income in September, compared to 4.8% recorded in September 2020.
Alibaba’s Q2 fiscal quarter saw it slash its revenue guidance for its current fiscal year. It was expected to bring in 930 billion yuan ($147 billion), a 29.5% y-o-y growth. Now, it expects growth between 20% and 23%. Alibaba is also facing intense competition from its rivals like JD.com and Pinduoduo.
Pinduoduo reported total revenue of 21.51 billion yuan ($3.37 billion) for the third quarter. The company mentioned focusing more on investing in research and development, marking a significant shift in strategy as the growth rate slowed and its user base stabilized.
Tencent, JD.com, and Alibaba saw declines in EBITDA in 2021. Ma Huateng, Chairman and CEO of Tencent, said, “We invested actively in key strategic areas, as well as in frontier technologies, along with making new commitments in common prosperity initiatives.” Meanwhile, Alibaba’s EBITDA fell 27% year-over-year to $34.84 billion in the September quarter alone, citing increased investments into new and existing businesses. JD.com blamed the increasing cost of revenues for its lower earnings, particularly fulfillment, marketing, and share-based compensation expenses.
Both Tencent and Alibaba had similar EV/EBITDA between 20 and 30 in recent years, comparable to more familiar tech giants like Amazon and Microsoft.
The declines in share prices have potentially put these companies at more attractive valuations. They currently trade at P/S ratios of 6.6 and 2.8, respectively.
The Bottom Line
The Chinese State Council and Central Committee have vowed to strengthen legislation and law enforcement in a wide range of sectors. They also promised to create new laws in areas such as artificial intelligence, cloud computing, and internet finance. China is determined to fully regulate the tech sector, claiming it will ensure data security and promote equal development.
Alibaba and Tencent could soon face new limits in tailored advertising and location-based services, derailing a once fast-growing area. The government's heavy-handed approach could backfire by stifling the innovation and entrepreneurial spirit within these companies that have proven vital to China's rapid economic rise.
Many western investors have understandably exited positions in the uncertainty. Several aspects of these positions and the dynamics between large tech and government can be difficult to understand. The reality is that it is a story still being written.
For investors willing to invest in the arena of geopolitical uncertainty, there are some wonderful Chinese technology businesses trading at historically attractive valuations.
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