Can the fallen angels fly again?

Summary

Not easily. China’s policy and regulatory tightening has sent many high-growth sectors from heaven to hell in the past year. We still believe a sharp policy U-turn remains unlikely in the near term. As such, most of these fallen angels will continue to struggle. Near-term upside would be capped by:

1. Continued negative news headlines as more policy implementation details are revealed,
2. Conservative outlook guidance by corporates in the forthcoming earnings season, and
3. Rising restructuring costs and capex to comply with new policies.

Amongst these sectors, healthcare technology and Macau gaming are two of the hardest hit ones with substantial de-rating.

China healthcare tech – Short-term pain, long-term gain

• Share prices of Chinese healthcare tech players have fallen by 60% to 70% from their peak in February 2021 as authority drafted guidelines on online healthcare. We believe these new measures will inevitably slow down growth, hurt margins, extend the breakeven timeline and challenge the existing business model of China’s online healthcare platforms.
• Despite this, we believe the new guidelines should be positive to the long-term healthy development of the industry, as it has been growing at light speed in the past few years at the expense of creating certain serious social issues.

Macau gaming – Light at the end of tunnel?

• We argued in our September 2021 issue that Macau gaming stocks had already priced in the worst case scenario, and share prices had rebounded approximately 30% since then. However, in late November 2021, the new COVID variant Omicron and the arrest of Alvin Chau, head of Macau's leading junket operator, once again hurt market sentiment.
• We continue to see value in the sector, and believe that fundamental pent-up demand is intact and the government is approaching the concession renewal process reasonably. The current low gross gaming revenue (GGR) should also set the stage for FY2023e* Earnings before Interest, Taxes, Depreciation, and Amortisation (EBITDA) to recover back to 2019 levels, with current sector valuation still lower than long-term averages.
• However, renewed concerns over further crackdown, especially on the VIP segment, could bring about potential negative earnings impact. We believe sector valuation may remain distressed until we see improving visibility on 1) how Omicron derails the re-opening path (with test results expected by the end of December 2021), and 2) whether there will be further arrests and/or crackdown after Chau’s arrest.

Can the fallen angels fly again?

Over the past 12 months, China’s policy and regulatory tightening at various levels has sent many high-growth sectors from heaven to hell, including education, property, internet, Macau gaming and healthcare tech. Many of them have lost 50% of their market capitalisation, with some even losing more than 90%. Most of them are still struggling with share prices hovering at 3-year (if not all-time) lows. While regulations remain tight, we see that policy tone has started to turn less stringent. However, we still believe a sharp policy U-turn remains unlikely in the near term, as the march towards “Common Prosperity” requires structural reforms in various social and economic aspects, which will take decades to complete. As such, we believe most of these fallen angels will continue to struggle. Near-term upside would be capped by:

1. Continued negative news headlines as more policy implementation details are revealed,
2. Conservative outlook guidance by management in the forthcoming earnings season, and
3. Rising restructuring costs and capex to comply with new policies.

Amongst these sectors, healthcare technology is one of the hardest hit industries experiencing substantial de-rating. Selling pressures are particularly fierce when these companies are still at an investment stage and are expected to stay loss-making in the next few years.

China healthcare tech – More regulatory tightening to come

The share prices of all three major Chinese healthcare tech players listed in HK have fallen by 60% to 70% from their peak in February 2021, making healthcare tech plays the worst year-to-date performer in the Hang Seng Tech Index.

On 26 October 2021, the National Health Commission (NHC) released draft guidelines on online healthcare and solicited public opinion until 26 November 2021. The draft outlines the accountability of online healthcare participants, as it re-emphasises the patient's responsibility to show proof of "non-first consultation". It further stipulates that artificial intelligence engines and robots cannot be positioned as “doctors” on the online platforms during consultation. Registration under provincial-level regulating bodies is also required for doctors practicing on the platforms. Consultation records are required to be maintained for 15 years, and all data will be transmitted to provincial platforms.

Growth will be slowed down

All these new measures will inevitably slow down growth and hurt the margins of China’s online healthcare platforms on the grounds that:

1. First-time medical appointment must be in-person and not online;
2. Medical judgement must be made by a registered doctor, not an AI-powered robot;
3. Higher compliance cost is required to get into the list of approved providers endorsed by local governments;
4. Online medicine sales should not be linked to the doctor’s compensation. Commission/sales rebate is also prohibited; and
5. Data are required to be transmitted to the provincial government, making them non-exclusive anymore.

Short-term pain, long-term gain

The healthcare tech industry has been growing at light speed in the past few years, yet at the expense of creating certain serious social issues, such as unreasonably high drug prices and over-prescription of some unnecessary medications. If these new policies are properly executed, in the future, online healthcare platforms can only sell drugs based on doctor’s prescription at fair market prices, leading to a margin rationalisation of the platforms. The breakeven timeline of these companies will inevitably be lengthened.

These stricter regulations also bring key challenges to the current business model of the existing online healthcare players, which rely mainly on sales and distribution of medicine via digital healthcare services. Many of the earlier investments in AI-driven robots, for example, also need to be adjusted or even abandoned in order to be compliant. Despite this, we believe the new guidelines are positive to the long-term, healthy development of China’s healthcare tech industry, especially the market leaders.

Macau gaming – Light at the end of tunnel?

In our September 2021 issue, we argued that Macau gaming stocks were starting to see light at the end of the tunnel, as share prices had already priced in the worst case scenario when the border to China was closed once again on renewed COVID cases. In November 2021, share prices of classic reopening trades from airlines to casinos saw a rebound after Pfizer claimed its Covid-19 pill could reduce hospitalisation and deaths in high-risk patients by 89%. This development boosted hope and positive sentiment for travel normalisation and border reopening in the region. Along the same line, HK Chief Executive Carrie Lam said she expected the border with Mainland China to largely reopen in February 2022.

There were also media reports suggesting that Beijing and HK have reached “consensus” on HK-Mainland reopening and quarantine-free travel, which could begin in December 2021, first with the Guangdong province with an initial daily quota of 1,000, and a circuit breaker in place if local cases emerge. Over in Macau, Chief Executive Ho Iat Seng also hoped that as soon as the city achieves an 80% vaccination rate, it would be easier for the local authorities to negotiate with other regions, and in turn revitalise tourism.

In view of such hope, Macau gaming stock prices had rebounded by approximately 30% since September 2021 (see Chart 1).

However, in late November 2021, two pieces of negative news hit the sector again. 

First, it was the discovery of the new COVID variant Omicron in South Africa, which renewed uncertainty about the reopening timeline and roiled global equity markets in late November 2021. Market concerns are not unfounded, given that the variant could be more transmissible and more capable of evading vaccines due to its high number of mutations. We believe it is still too early to make a conclusion, as more details about this new variant would only be disclosed by the scientists by the end of December 2021.

Arrest of junket operator – Beginning of another storm?

Secondly, and more importantly, there were news that Alvin Chau, head of Macau's largest junket operator, had been arrested in relation to offences under Macau law, including alleged money laundering and illicit gambling. This came after Wenzhou approved an arrest warrant for Chau for organising “cross-border” gambling for Chinese customers, a crime under Mainland China law.

The arrest is related to the VIP segment, but some investors could perceive it as a signal of policy risk in the sector, especially during this critical license renewal period. Meanwhile, the impact of Omicron on travel restrictions is unclear at this point, though we have noted that the preparation work for HK/China/Macau reopening is in progress.

We believe the negative earnings impact of the news is likely limited given the already low market expectations in particular for the VIP segment, where sell-side analysts are expecting the market to shrink. The EBITDA contribution from junket VIPs was around 15% pre-COVID and almost negligible now. The market is currently expecting mid to high single digit contribution (c5-10% mix in total EBITDA) from the VIP segment post-COVID recovery in 2023e, suggesting that any earnings downgrades should be limited.

If there is a silver lining to the ongoing crackdown on cross-border gambling and pressure on the VIP segment, it would be that government policies would likely become more aligned to drive the mass segment to compensate for the likely loss in VIP tax revenues.

Valuation remains supportive, but recovery path has been prolonged

In a nutshell, we continue to see value in the sector, and believe that pent-up demand is intact and the government is approaching the concession renewal process in a reasonable way. The current low GGR should also set the stage for FY2023e EBITDA to recover back to 2019 levels. Trading at 10x FY2023e EV/EVITDA# (see Chart 2), valuations are still lower than long-term averages of 12-13x EV/EBITDA, implying low expectations.

However, renewed concerns over further crackdown, especially on the VIP segment, have not only hammered investor sentiment in the near term, but could also bring about potential negative earnings impact, as gamblers start to worry being investigated after the authority acquired customer lists from the junkets. We believe the sector’s valuation may remain distressed until we see improving visibility on 1) how Omicron derails the re-opening path (with test results expected by the end of December 2021), and 2) whether there will be further arrests and/or crackdown after that of Chau.