DiDi is the ride-hailing app many had never heard of. After listing on the New York Stock Exchange and being given a glowing endorsement by the likes of US business news channel CNBC host Jim Cramer, the initial public offering (IPO) popped and the share price jumped more than 15% in the first couple of days. Things went badly wrong thereafter.
As news broke that the Chinese regulators were clamping down on DiDi due to data privacy concerns, the share price tanked. Within days, it was more than 30% off the peak and nearly 20% off the IPO offering price of $14 a share.
The Wall Street Journal reported that DiDi knew the regulators were unhappy. The company went ahead with the listing anyway. Perhaps in coming weeks it will become clear what the ramifications of this will be under securities law in the US. Being on the board of DiDi isn’t an enviable position right now.
Of course, DiDi could’ve looked to the horror show of Ant Group’s last-minute-dot-com cancellation of its IPO for guidance. After Ant founder Jack Ma publicly criticised the Chinese government one time too many, the all-out assault on the tech sector by the regulators began. Ant was squashed.
Before we look at the likes of Tencent and Alibaba, we need to understand why China appeals to investors and what the regulatory issues are.
Recent census data shows that since 2010 China’s population grew by 72-million people. The UK has nearly 68-million people and New Zealand has nearly 5-million. To put China’s growth in context, a population almost the size of the UK and New Zealand combined has sprouted out of the country in the past decade.
After having a one-child policy for more than 35 years, China has struggled to reverse the trend of an ageing population. The government is now actively encouraging people to have more children, which should result in a higher population growth rate.
For investors, population growth is an opportunity. There are more mouths to feed. There are more smartphones to sell. There are more conversations among families and friends that can take place on apps.
Unfortunately, there’s the small matter of the Chinese Communist Party (CCP). With great opportunity comes great risk, to adapt the famous line in Spider-Man comics.
Founded in 1921, the CCP established the People’s Republic of China in 1949 after the Chinese Civil War forced the leadership of the Republic of China to retreat to Taiwan. Both parties still claim Taiwan and China as part of their respective territories, which is why the relationship between those two countries is tense.
China’s relationship with Hong Kong is also problematic. You may notice a trend here.
When a government is barely willing to recognise the sovereignty of other regions and countries, it feels a bit silly to expect them to behave reasonably when corporates are becoming problematic. In the same way China has tolerated the existence of Hong Kong and Taiwan, the authoritarian leaders tolerated the growth of a company like Tencent.
The CCP of today is, objectively seen, not an oppressive regime towards its citizens. The party reportedly enjoys support and recognition among the people of China, though there is an overall concern about debt levels in the country and what the impact of inflation could be on living standards that are already under pressure.
Also, when a government is committed to surveillance of its people and listening to what they are saying to an extent Mark Zuckerberg can only dream of at Facebook, there is always a nagging question of how genuine this "support of the people" might be.
The "benevolent despot" dream is fading among corporate leaders in China and the broader investment community. At this point, it’s unclear what the future could hold for Chinese companies trying to list in the US and achieve substantial valuation multiples while tapping into a deep pool of growth capital.
The juxtaposition of East and West was something to behold in recent weeks. As Facebook celebrated a critical win in the courts against antitrust suits brought by regulators, Tencent took a knock from being blocked in China from merging two of its gaming investments into one business.
The timing of Independence Day celebrations in the US was the icing on the cake. Zuckerberg’s post-victory Instagram video of him hydrofoiling (using a powered surfboard) while holding the American flag went viral as patriotism swept across the US.
Across the water, Chinese tech executives were being cut off at the knees by the CCP.
Clearly, there is significant risk in Chinese internet stocks at present. The CCP is celebrating its centenary this year and appears more driven than ever to retain control over the country, even if it decimates new capital flows in the process.
A further risk relates to the Variable Interest Entity (VIE) structure that is a feature of almost every listed Chinese company that can be invested in by non-Chinese residents. Technically, there is no ownership of the underlying business, because the CCP prohibits foreign ownership in most Chinese industries. The VIE is a complicated set of legal arrangements that creates a claim on the profits and assets.
The VIE structure works because the Chinese regulators have historically turned a blind eye to it. If they decided to enforce these laws, the VIE structures could genuinely become worthless. The impact on the Chinese economy and its relationship with the West would be enormous, so a practical case is put forward that the VIE structures are as good as legal ownership.
However, if the chow mein hits the fan, this just isn’t true.
As any seasoned value investor will tell you, everything comes down to risk and price. Contrarian investors live for these opportunities, hoping to identify the baby that was thrown out with the Chinese tech stock bathwater.
To change the metaphor, a failure of the VIE structure is a black swan risk, with a binary outcome on the value of these investments. While this structure will always drive a discount in the valuations of these companies, a better portfolio management tool would be to limit overall exposure to such structures. It doesn’t help to put everything into "cheap" Chinese stocks that have a remote chance of going to zero simultaneously!
When considering the Chinese tech environment, it’s important to understand how "super-apps" work. WeChat is the best example. It is the cornerstone of Tencent and thus the valuation of the Naspers-Prosus group.
On WeChat people can send instant messages, make calls and video calls and create groups for people with common interests. A feature called WeChat Moments is a bit like Instagram, allowing photos to be shared that friends and followers can see. WeChat Channels enables short videos to be uploaded, like TikTok. In addition, the app allows you to subscribe to content of your favourite creators and will make recommendations for content that you might enjoy.
You may be thinking that it sounds like any other social platform. There’s a lot of truth in that. However, WeChat Pay is a key feature of the WeChat infrastructure that helps drive user engagement and revenues. WeChat Pay is an electronic wallet that allows for payments at vendors who have a QR code, much like SnapScan or Zapper. Because the app provides a payments solution, WeChat can offer multiple other services, like access to shopping apps.
To understand WeChat’s power, you would have to imagine Facebook and Square together and fully integrated, with widespread vendor and user acceptance — a network effect that is near impossible to build from scratch.
Square trades on a price: revenue ratio of more than eight. Facebook trades at more than 10.5. Tencent trades at just 1.3. This relative valuation gap is why many investors are willing to look past the risk of Chinese regulation (for a direct entry into Tencent) or the additional governance issues around Naspers-Prosus.
Is the discount justified? Until recently, many would have said no. After the events of the past few weeks, a number of those people seem to have changed their minds.
At time of writing Tencent’s share price is flat in the year to date and nearly 30% off its February peak.
Part of the structural discount in Tencent is because of the VIE structure. This isn’t unique to Tencent at all. In fact, this brings us neatly back to the highest-profile target of the CCP in recent times: Ma and Alibaba, which he co-founded.
If ever there was a value stock on the Chinese menu, Alibaba would be it.
Alibaba holds about 33% in Ant Group, which runs Alipay — second only in size to WeChat among the super-apps in China. WeChat has more than 1-billion users and Alipay isn’t far behind, with more than 900-million.
Alibaba’s famous Singles Day event yielded nearly $75bn in sales in November 2020. In the year ended March 2021, Alibaba achieved organic revenue growth of 32%. Adjusted earnings before interest, tax, depreciation and amortisation grew 25%. Non-GAAP (generally accepted accounting principles) free cash flow of $26.35bn is a free cash flow margin of 24%.
Much like Amazon, Alibaba is also making strides in cloud computing. In the 2021 financial year, cloud revenue grew 50% for the year to reach $9.2bn, less than 9% of the group total. Cloud is still loss-making in Alibaba but the growth rate suggests that this won’t be the case for long.
For those who love a left-field idea, SoftBank holds about 25% in Alibaba. The rest of SoftBank has been messy and the firm trades at a significant discount to NAV. You wouldn’t be wrong for thinking that this sounds a lot like the Naspers-Prosus-Tencent situation.
Other ideas for investors to look at in the Chinese e-commerce space include JD.com and Pinduoduo.
JD.com focuses on quality products and on having its own logistics team. The warehouse network is a formidable moat, with more than 21-million square metres of storage. This covers almost all counties and districts in China and is supported by about 20,000 delivery personnel. It allows the company to fulfil most orders within 24 hours across China. The logistics business itself was spun out as an IPO in May, with JD.com still holding about two-thirds in the company.
The opportunity for the supply chain alone is immense, with an integrated solution offered to small and medium enterprises.
Unfortunately, the share price of JD Logistics has also been a victim of general Chinese sentiment in the past few weeks, down more than 3% from the IPO price and off the highs of early June after investors climbed into the IPO.
Pinduoduo is a totally different model, based on social sharing and bulk purchases. It focuses on lower-tier cities.
Investor Cathie Wood has been buying more JD.com shares recently. You can decide for yourself whether that’s a good or a bad thing.
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