China's regulatory moves:

cause for concern?

The internet sector has done spectacularly well since the global pandemic began in March last year, showing how interdependent human society has become via the internet. The rapid growth in profits and proliferation of services has therefore led to certain practices being deemed to be against societal interests by politicians and the public alike.

While regulatory discussions in the US and EU are progressing slowly, in China, new regulations are often implemented at very short notice. Traditionally, Chinese tech regulators have allowed innovation to progress, and only once a particular new vertical has reached significant scale have they stepped in aggressively to eliminate the perceived harmful practices.

This was evident three years ago when the regulator reformed the online gaming industry overnight – all players had to log in to online video games using their ID numbers to prevent underage children from playing certain titles, school students were banned from playing games after 9pm, and all new games had to be approved by the regulator before being allowed to monetise.

Tencent was particularly impacted by this set of regulations, due to its dominant position in the Chinese online gaming industry. The company quickly implemented the new rules and adjusted its business model: it began releasing less violent games, monitoring game session durations, and restricting access to school-age users at certain times of day. Tencent’s share price fell 47% during 2018, but recovered well thereafter.

REGULATORY OVERHAUL

The past year has seen significant regulatory overhaul in new internet verticals that have affected major Chinese consumer internet companies. Examples include:

• Ant Financial (the largest fintech company in the world) had its initial public offering (IPO) suspended last year after founder Jack Ma criticised Chinese regulators in public and suggested that the banking industry had a ‘pawnshop mentality’ due to its demand for collateral when issuing loans. Ant Financial uses artificial intelligence in its credit assessments and had built the largest unsecured credit book in China. The regulator was concerned that a systemic risk to the financial system may develop since Ant had limited collateral and balance sheet capital as a buffer if lenders defaulted. The company has since been restructured as a bank.
• Meituan Dianping, the largest Chinese online-to-offline company, was criticised by consumers after a media report showed that drivers were being paid less than minimum wage and tasked with delivering a high number of daily parcels. This is similar to Uber in the US and the EU, where drivers are hired as freelancers, which limits their employment rights. The Chinese regulator created new rules allowing drivers to be recognised as full-time workers, improving their pay and limiting their hours. This means Meituan’s expenses will increase, which is negative for shareholders.
• Didi Chuxing, a ride-hailing company, had its app removed from Chinese app stores and was ordered not to accept any new users – a day after its IPO in New York. This led to a large sell-off and a lawsuit against the company by US investors. The regulator had been investigating Didi and had advised the company to delay the IPO, but Didi listed anyway. The regulator was concerned that Didi had access to all of China’s location data. Moreover, Didi had appointed a former US military officer (now an executive at Apple) onto its board of directors. Since directors can access company data, it was possible, in theory, for the director to access sensitive location data in China.
• The online education technology sector in China recently suffered catastrophic losses due to a proposed regulation to turn all online school tutor companies into non-profits. Shares of TAL Education and New Oriental Ed have fallen by 90% year to date. This is the most devastating move so far and has led to shareholder fear across the entire Chinese technology landscape.

LARGE SELL-OFF

All these factors have led to a large sell-off in Chinese internet companies, including the big three: Baidu (-39% year to date), Alibaba (-17% year to date) and Tencent (-30% year to date, in US$). The regulatory impact on Tencent this time round has been more benign – the company lost its monopoly music distribution rights recently, but this doesn’t feature significantly in its revenue mix. The company has an 80% market share in online music streaming via its Tencent Music Entertainment Group (TME) holding, and this was used by TME to force global music labels to grant it exclusive distribution rights in China. Going forward, Tencent will face more competition in this vertical, but will likely remain the dominant player.

The latest event to impact Tencent’s share price was an article in an online publication owned by Xinhua, a state media company. The piece compared online gaming addiction to ‘spiritual opium’ – a highly emotive phrase given the role of the Opium Wars in China’s history. The article was adjusted later to remove the phrase, and a government official stated that the official view wasn’t as critical as the article suggested.

The Chinese government doesn’t appear to be aiming to destroy the online gaming industry, but it does want to ensure that video game addiction among the youth is reduced. While the regulator itself has not made any comments on the matter, Tencent responded proactively on the day the article appeared, introducing age-related user restrictions. It’s important to note that gaming revenue from minors accounts for only around 6% of Tencent’s revenue from games, so the impact on total gaming revenue is not expected to be material at this stage.

US CONGRESS HEARINGS

Outside China, the US Congress has held hearings with CEOs of large internet companies, as public opinion has shifted towards increasing oversight of the sector. Prominent American senators like Elizabeth Warren have even proposed breaking up Facebook via a forced disposal of Instagram and WhatsApp. This would impact Facebook’s growth outlook, since Instagram provides a significant amount of user and ad revenue growth relative to the core Facebook platform.

Similarly, Warren’s antitrust plan suggests that Amazon should divest Whole Foods and refrain from entering the grocery delivery business, a very promising future growth vertical. Amazon has invested significant capital into supply chain technology for this purpose. As for Google, it would be forced to divest DoubleClick, the online ad purchasing marketplace that connects ad inventory on platforms with ad purchasers at agencies and companies. Google would lose the ability to observe pricing trends in real time and thus adjust its own Google Search pricing to control the price of its own product.

GROWTH POTENTIAL

Where does all this leave South African investors? Naspers, which has a large stake in Tencent, has followed the latter company’s share price down this year. Investors should be aware of the ever-present regulatory risk in China, but should also remain cognisant of the long-term growth potential still evident in this sector.

It should be noted that Tencent has fared well in terms of regulatory changes compared to other tech firms and compared to its own experience with gaming regulation, as mentioned above. Furthermore, the regulator in one way actually helped Tencent by approving its merger with Sogou from 2020. Sogou, China’s second largest search engine after Baidu with a 6% market share, has been integrated into Tencent’s super-app, WeChat. This has enhanced WeChat’s monetisation by creating social search functionality – this would be akin to WhatsApp or Facebook having embedded search queries within their apps, thus circumventing Google.

Moreover, Tencent continues to innovate in other new verticals beyond social search. For example, WeChat Channels is a direct competitor to Douyin (the sister company of TikTok). Short video has taken China by storm, with over 500 million daily active users and 40% ad revenue share within the online video segment already. While Douyin is the largest company in this space, Tencent should benefit (via WeChat Channels) from the strong projected growth in ad revenue for short video over the next few years.

Another high-growth vertical is, of course, fintech. China has by far the largest online payments market in the world, with 770 million users using their mobile phones as their primary method of payment. TenPay has a 40% market share in this annuity income vertical.

COMPELLING INVESTMENT CASE

Considering its strong competitive position and a more attractive valuation post the recent sell-off, Tencent (and thus Naspers) is offering a compelling investment case at present. Tencent’s forward price-to-earnings ratio has declined to 22 times, versus its historical average of around 30 times. Excluding the estimated fair value of its investee portfolio, this ratio drops to 17 times. Subtract another 50% discount when investing through Naspers, and the valuation really starts to look appealing.

Meanwhile, Tencent’s earnings have continued to display both impressive growth and quality. First-quarter 2021 core earnings grew 22% year-on-year, while free cash conversion was at 100%. All of this speaks not just to the value that Tencent generates for shareholders, but also for its consumers as well the government. The company remains a national champion and strategic asset in China, despite the pressures from policy changes.

Regulation, like death and taxes, is a guaranteed feature of life. As investors, we can only try to understand the underlying motives of political actors and plan accordingly. The discount rate that investors apply to these internet companies is likely to rise while these regulatory developments occur, but the vital role this sector plays in our daily lives has not changed at all.