China’s tech sector took a big beating last year as unfavourable regulatory policies were applied to rein them in. Now the same sector continues to experience volatility because of the war between Russia and Ukraine.
Alibaba Group Holdings, NetEase and Baidu are respective domain leaders in e-commerce, games and search engines respectively. As investors decamped for safer, less volatile sectors, their share prices have come off between a third and two thirds their peaks.
Nevertheless, research firm Morningstar’s team of analysts covering these stocks remain upbeat on their prospects, joining similarly bullish views as indicated by recommendations of these stocks tracked by Bloomberg: All 22 analysts call Baidu a “buy” while all 27 calls for NetEase were a “buy” or equivalent. Meanwhile, 39 out of 41 analysts call Alibaba a “buy” with just two calling a “hold”.
Netease’s game drivers
NetEase, a leading gaming company, enjoyed an earnings growth spurt of 54% y-o-y for the final quarter of FY2021, which brings its total FY2021 earnings to RMB19.8 billion ($4.26 billion), up 34.4% over FY2020. Revenue, in the same period was up 18.9% to RMB87.6 billion. The company has a December year end.
While NetEase has other businesses such as media and advertising, revenue growth for the core gaming business has outpaced the company’s average, led by the popularity of new titles Harry Potter and Naraka: Bladepoint. Estimated game billings grew by a strong 18% compared to the same period last year, suggesting that NetEase has significantly outperformed the overall industry in the fourth quarter.
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The report card, according to analyst Ivan Su, reaffirms his view that the company continues to enjoy competitive advantages, supported by its industry-leading capability at developing and redeveloping renowned video game franchises.
“We are impressed by its ability to consistently deliver high-quality games, which translates to improving financial performance and a record-setting fourth quarter,” writes Su, who has a fair value of US$139 ($188.9) for this stock.
Citing billing trends, Su expects NetEase to at least deliver high-single-digit revenue growth in the next two quarters, even if the government was to continue to withhold new licences. He was referring to China’s National Press and Publication Administration, which has not published the list of approved new video game titles since the end of July 2021.
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According to a Dec 31 report by the South China Morning Post, this marks the country’s longest suspension of new game licences since a nine-month hiatus in 2018 that followed a regulatory reshuffling.
Su adds that while the firm did not discuss the freeze, several leading publishers have shot down rumours of a further regulatory crackdown on games. “We still believe that the approval process is expected to resume, though there remains uncertainty related to the timing of the event.”
Moving forward, Su thinks the uncertainty around new game approvals creates a wide range of possibilities for most gaming companies in China, but not NetEase. He is positive about the firm’s future releases, pointing at factors like a strong player pre-registration for Diablo Immortal, the large global fan base for the Harry Potter franchise — which is expected to gain tremendous traction — and an expected console and mobile launch of Naraka: Bladepoint in 2022 and 2023.
Referring to Naraka: Bladepoint, Su says “For longer-term investors, the global success enjoyed by the game shows NetEase is capable of bringing a competitive non-mobile title to the world stage.”
According to Bloomberg, three months after its launch, Naraka: Bladepoint has sold more than six million copies globally, making it one of the fastest-selling Chinese PC games ever.
Su says this bodes well for revenue growth outside of China, which stands at 10% of the total now but is seen by the management to expand to 30% over the next five years.
He also expects the business to see further margin expansion in the future, driven by a lower percentage of revenue sharing expense as well as operating leverage at both core and noncore businesses like Cloud Village.
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Over a five-year horizon, Su estimates NetEase to record a revenue CAGR of 16%, with profit growth outpacing that of revenue’s, coming in at 21% CAGR. “Investors have not been willing to pay more for NetEase shares due to a perception of it being a low visibility business. However, NetEase’s continued successes across different regions and platforms should lend more credence to the firm’s long-term earnings sustainability.”
Optimism after earnings
Alibaba Group Holdings’ earnings for 3QFY2022 ended Dec 2021 dropped 74% y-o-y to RMB20.3 billion. Revenue in the same period was RMB242.6 billion, up 10% y-o-y.
The earnings drop was primarily due to the impairment of goodwill of RMB25.1 billion and lower fair value gains in its equity investments.
Analyst Chelsey Tam notes that Alibaba’s share price has declined due to renewed concerns of a regulatory crackdown and additional so-called “common prosperity” measures. She says such headline news will continue to weigh on investor sentiment in the near term.
On the other hand, factors like the improved profitability of its new businesses such as bargain marketplace Taobao Deals and virtual grocery store Taocaicai will lead to a rerating, thus prompting her to be “more positive” on the stock.
Other catalysts also include improving consumer sentiment in China, a reduction of share loss to short-form video platforms and e-commerce peers, the listing of Ant Group or any easing of regulatory concerns.
In line with an anticipated economic recovery, better consumer sentiment from the loosening of monetary and fiscal policies this year and next, Tam expects Alibaba to enjoy a corresponding recovery for year-end 2023 with 21% y-o-y revenue growth, a slight pick up from 20% y-o-y in the year ending March.
In addition, Alibaba is seen to reduce merchant support. According to Tam, part of the reduced merchant support is related to getting merchants to use new value-added services through subsidies. She thinks that as the initial subsidies subside and some merchants adopt these services, monetisation will increase.
However, to reflect the long-term risk of intense competition in the e-commerce market in China, Tam has trimmed Alibaba’s 10-year China retail gross merchandise value (GMV) average growth to 8% from 12% previously. She sees Alibaba’s China GMV market share of the online physical goods market drop to 48.5% by March 2032 from 76.8% in the year ending March 2021.
The impact of GMV reduction was offset by an earlier-than-expected loss reduction of bargain marketplace Taobao Deals and virtual grocery store Taocaicai, with adjusted ebita CAGR for the next 10 years remaining at 7%.
Despite the stiffer competition in the long term, Alibaba’s growth is underpinned by the rising income level in China. In addition to its strong network effect, Tam observes that Alibaba covers the largest number of shopping scenarios and consumers’ income levels, and the widest range of categories.
She thinks this positions Alibaba to be an “irreplaceable player” in the omnichannel retail market in China in the long run. “We think it is a good time to add,” says Tam, who has a price target of US$188.
Baidu’s margin decline
Meanwhile, Morningstar is relatively less positive about search engine leader Baidu, despite higher revenue that slightly beat expectations of analyst Kai Wang, who has fair value of US$183 for this stock.
On March 1, Baidu reported revenue of RMB33.1 billion for its 4QFY2021 ended December 2021, which was slightly higher than his estimate of RMB32.5 billion. “While we are encouraged that the outperformance was driven by its newer artificial intelligence, or AI, and cloud businesses, headwinds to core online marketing remain, and margin decline is a concern,” writes Wang in his March 2 note.
He notes that non-GAAP operating margins declined to 6.7% this quarter from 10.5% last quarter, due to the capital intensity and additional research and development expenses required for its new businesses. Furthermore, Baidu emphasised continued investments in these businesses, which Wang expects will likely dilute margins in the near- to mid-term.
Combined with a revenue decline of 5% from online marketing, Wang forecasts revenue of RMB27 billion and operating losses of over RMB1 billion including stock-based expenses, in 1QFY2022.
He believes that Baidu’s shares are fairly valued given the offsetting factors but now that key valuation drivers have shifted toward Baidu’s AI businesses, fair value estimates will likely increase if margins improve as a result of its success in scaling up its AI and cloud businesses.
As a result, he believes that Baidu’s AI and cloud businesses will remain the greater focus, as management appeared to place greater emphasis on their progress and growth than its core online marketing business relative to previous discussions.
Wang observes that the cloud business grew 60% y-o-y in 4QFY2021 and its outlook hinges on the growth of the enterprise and government sector part of this business, which saw over 100% growth y-o-y and includes smart transportation, energy and manufacturing industries.
For now, Baidu’s cloud business is smaller versus existing offerings by Ali Cloud, Huawei Technologies, and Tencent Holdings, which all have entrenched positions. Nevertheless, Wang expects Baidu’s cloud business to take market share by growing at a faster pace than the industry average of 23%.
As for its online marketing business, he expects continued headwinds into the first quarter of 2022, given macro-headwinds with the coronavirus and soft demand from travel, education, and real estate.
In the near term, margins will still be stable and above the industry average but Wang warns that there are expectations of normalisation in the second half of 2022. This means that while the core business will remain the cash cow of the company that supports the cash burn in its new initiatives, greater competition for advertising from newer platforms such as Douyin will likely reduce its market share and could dilute margins further.
