China Internet – 2022 Outlook

Concerns on VIE structure seems overdone

China Internet ADRs fell sharply in the last month of 2021, mainly on news of delisting announcement of a leading Chinese ride-hailing app, as well as unconfirmed reports of Chinese regulators’ plans to ban companies from going public on foreign stock markets through VIEs. 

However, on 24 December 2021, the China Securities Regulatory Commission released a draft regulation that allows companies to list overseas through VIEs if they register with regulators and meet compliance rules, alleviating concerns over a full-on crackdown on the corporate structure. We think there may be further moves by regulators to strengthen operational regulations around VIEs, but we do not think this will encompass something extreme like nullifying the VIE structure, as we think the VIE economy has grown too big to nullify, not to mention that it goes against China’s principle of welcoming foreign investments.

As for delisting China ADRs from US exchanges, we think this may be a matter of time as regulations in this direction have already been passed in the US. However, for dual-listed names there should be minimal fundamental impact as they are dual-listed in HK and HK/ADR shares are fully fungible. On the liquidity front, short-term selling pressure on a delisting scenario will likely be from retail investors/investors with a US-only mandate.

In short, we think the recent sell-off in response to the above news flow looks overdone. But what about fundamentals from 3Q21 results?

Read Hong Kong China Equity Perspectives, December 2021 - Can the fallen angels fly again?

Our view post-3Q21 results

The internet sector’s 3Q21 results were generally muted (either in-line or below consensus), with most companies guiding for a slower 4Q21 and 1Q22 due to regulatory and macroeconomic impact (see Chart 1). Most stocks traded weaker post 3Q21 results.

A key area of deceleration is online advertising, where companies guided for negative growth over the next two quarters. Ecommerce is also slowing down in line with overall China retail sales, but it seems the market leader is bearing the brunt of market share loss. Mobile gaming performance has been dependent on game pipeline. Travel has been impacted by resurgent Covid waves, both domestic and abroad, but should gain more visibility in 2022.

Our preferred segments remain ecommerce, gaming and travel, due to lower regulatory risks going forward, while we think the short-form video/entertainment sector has potential to see more regulatory measures being introduced.

We remain selective in our stock selection within the sector, though we think as a whole, much of the headwinds have already been discounted, given the extreme valuation derating we have seen since the beginning of the year. However, our 2022 outlook for different sub-sectors varies.

China internet – Subsector 2022 outlook

1) Ecommerce

3Q21 results were mixed, with the leader reporting disappointing results while the second largest player beat consensus expectations. The largest ecommerce giant lowered its FY22 revenue growth guidance due to competition and macro weakness in China. Forward guidance was below consensus due to competition and slower growth of online retail sales in China (see Chart 2).

Overall we think valuations have priced in a lot of the negatives, but the core ecommerce business continues to face challenges from slowing macroeconomic momentum as well as intensified domestic competition, while investing in future growth will weigh on margins in the near term. Shares are unlikely to rerate significantly until there is more clarity on potential earnings inflection. Meanwhile, a second-tier player guided for a more robust growth momentum, especially from the supermarket category, and is looking for a sequential improvement in 4Q21.

The food delivery sector is incrementally facing pressure due to the challenging macroeconomic environment, and may see further deceleration. Rider social insurance payments will start piloting in regions in 2022, and will be gradually rolled out, with some impact on margins.

For the largest food delivery player, recent rounds of Covid resurgence will also impact the outlook for its in-store/hotel segment, though 3Q21 has likely seen peak loss for its new businesses. Overall, the company’s near term outlook will be negatively impacted by the macro slowdown as well as Covid resurgence, but we think medium-term potential for its food delivery, in-store and new businesses remains intact.

2) Mobile Games

Mobile gaming performance has been dependent on game pipeline.

The largest mobile gaming company’s 3Q21 results were below consensus, dragged by the slowing online advertising market. Outlook for its online advertising remains weak, likely falling into negative growth in 4Q21 and 1Q22, while gaming revenues could remain muted for the next few quarters, with heavier impact from minor protection policy compared to its peers.

On the other hand, the second-largest player reported in-line results, bolstered by two mega-hit games released during the quarter. We expect its strong games momentum to continue into 4Q21 and 2022, as these hit titles expand overseas.

On the regulatory front, companies do not believe the government will limit game playing time for adults, and expect game approval suspension to be temporary. We view the potential resumption of game approvals to be a key catalyst for the sector in 2022.

3) Online Entertainment/Advertising

Advertising revenue is expected to struggle for the next few quarters given uncertainties in the macro environment, softness in education, gaming and insurance sectors, as well as a high-base comparison in 1Q22. Person Information Protection Law (PIPL) also had some impact, albeit minor – opt-out ratio is at low single digit at the moment. Total online ads will likely fall into negative growth territory in 4Q21 and 1Q22.

Short video companies in general produced in-line or slightly above top-line growth in 3Q21. User base continues to enjoy solid momentum and strong improvement in user engagement. Nonetheless, competition remains intense in this segment and we are more cautious in this space as we expect there could be more regulatory measures in the pipeline.

As for online music streaming, the market leader saw revenues growing modestly, with paid subscription continuing the momentum. Yet, music ARPPU (average revenue per paying user) fell slightly, and could retain a flattish/downward trend due to competition. Social revenue fell due to competition from short-form video platforms, with the revenue trend likely to decelerate further in 4Q21. Looking into 2022, growth will remain muted due to continued competition, a softer macro outlook and tightened regulations. For social entertainment, active users and paying users continue to slide, while monetisation remains capped due competitive and regulatory pressure.

4) Online travel agents

Online travel agents (OTAs) in general reported an earnings beat in 3Q21 on lower-than-expected operating expenses. 3Q21 activity was dampened by renewed Covid outbreaks domestically, even as demand in overseas markets recovered as travel restrictions started to ease. The visibility of China's outbound re-opening timing remains low. The country is likely to maintain strict border control to avoid potential risks brought in by any in-bound travelers. While the strict travel policy around Beijing may remain in place until the Beijing Olympics is over in late February 2022, the companies are confident in seeing a snap-back recovery as soon as travel policy normalises, given strong pent-up demand. Near-term trends are likely to stay challenging given strict travel curbs, but we see good value for patient investors with the stocks trading at undemanding valuation. 4Q21 revenue guidance is below consensus due to the recent Covid outbreak in China.

When can the sector be re-rated?

We would need to see a change in direction of earnings revisions, revenue reacceleration (likely only in 2H22 as macro pressures ease), as well as narrowing investment losses. Investors would also need more clarity on the regulatory front, that there will be no more negative surprises.  

We reckon that all these will take time, hence sentiment and liquidity in China internet stocks would remain lukewarm despite undemanding valuations. Therefore, we only advocate a buy-on-dip strategy on the sector in the near term.