Has China’s big tech crackdown depressed valuations?

Despite China’s technology sector outperforming its US counterpart last year, Beijing’s broad regulatory crackdown on big tech companies, such as Alibaba [BABA], Baidu [BIDU] and Tencent [TCEHY], has weighed down returns since the start of the year.

The Global X MSCI China Information Technology ETF [CHIK], which tracks the large- and mid-cap securities held in the MSCI China Information Technology Index, is down 5.2% in the year to date (through 22 July). In comparison, the Invesco QQQ Trust ETF [QQQ], which tracks the Nasdaq-100 Index, climbed 16% in the same period.

The underperformance in Chinese technology stocks so far this year is in stark contrast to the outsized gains the sector reported in 2020. Global X’s China Information Technology ETF had rallied 68.1% last year, while Invesco’s QQQ ETF rose 48.4%.

  

Other funds that track China’s technology sector have also registered lagging performances in the year to date, with the KraneShares CSI China Internet ETF [KWEB] and Invesco China Technology ETF [CQQQ] down 21% and just short of 5%, respectively through 22 July.

As regulatory pressures continue to mount in an effort to stop a range of issues such as data security, consumer privacy and anti-competitive practices, what impact will this have on technology stocks’ valuations? 

 

China’s big tech crackdown

While antitrust cases in the US over recent years have battered big tech companies, such as Google parent company Alphabet [GOOGL], Apple [AAPL], Amazon [AMZN] and Facebook [FB], China’s technology companies had largely been unencumbered by regulatory efforts.

Last year, some analysts had even suggested that antitrust investigations would have less of an impact on Chinese technology stocks than their US peers. However, since the start of the year, there has been a tightening of regulations.

Alibaba was one of the first to come under the scrutiny of China’s State Administration for Market Regulation (SAMR). Regulators had opened an investigation into the e-commerce company’s monopolistic practices in December 2020 and by April 2021 had fined the company RMB18.2bn on grounds of market dominance.

  

The fine was set at 4% of Alibaba’s 2019 revenues. But a series of amendments that were made last year to China’s Anti-Monopoly Law will see harsher penalties, including fines as high as 10% of a company’s revenue from the previous year.

Since then, the country’s competition regulators have opened investigations into several other companies, including Baidu, JD.com [JD], Tencent and Didi Chuxing [DIDI] for failing to report past mergers and acquisitions ahead of an antitrust review. The SAMR fined each company the maximum penalty of RMB500,000 at the end of April.

In early July, the South China Morning Post reported that the country’s market regulators had imposed an additional 22 fines of half a million yuan to its big tech giants, including Alibaba, Tencent and Suning.com [2024.SZ], for irregularities in mergers dating back to 2011.

 

Are China’s tech stocks undervalued?

Tencent lost $32.71bn in value from its US listing in the first half of the year. Meanwhile, Facebook has added $207.69bn in value in the same period.

Jonah Lupton, founder of Lupton Capital and a fund manager at Social Capital, believes some of these stocks are trading at a premium discount compared with US companies, despite strong fundamentals. For example, Futu [FUTU], a financial services company in which he has invested, has proven to be significantly more profitable than its US equivalent.

He describes Futu as “the Robinhood [HOOD] of China” and pointed out that Robinhood lost $1.4bn in the first quarter. In comparison, Futu saw revenue growth of 349% year-on-year in the same period, he says.

“Total number of customers was up 230%, gross profit was up 372% and then net income was up like 550%. I mean, just crazy numbers,” he told Opto Sessions, adding that while Futu is not likely to maintain that level of growth, he expects net income to be between 180% and 200% for the full year. “But this is where the story gets good. Their gross margins are about 80% but their net income margins are 50% — that’s the big difference.”

“Total number of customers was up 230%, gross profit was up 372% and then net income was up like 550%. I mean, just crazy numbers. But this is where the story gets good. Their gross margins are about 80% but their net income margins are 50% — that’s the big difference” - Jonah Lupton, founder of Lupton Capital

 

Meanwhile, Robinhood’s net income margins are between 10% or 11%, indicating that Futu is growing faster and trading at 40 times earnings. 

While Lupton believes that Robinhood could end up trading at a valuation of more than $50bn, he says that Futu could easily be a $100bn company in a few years. Futu had a market cap of $20.9bn as of 20 July, while Robinhood is said to be seeking a valuation of up to $35bn in its upcoming IPO.   

China’s business practices often lead big tech companies to have numerous subsidies, said Lupton: “They really keep everything completely separate. There are different regulators in every country and there’s just so much regulation in the financial services industry, so it’s probably smart to have these different names, versions and entities for their different apps in different countries.”