Sun, 1 Sep 2013
As China seeks to rebalance to a consumer-led economy, several Internet firms in the country are poised to gain from higher advertising spending, says Morningstar's Dan Su.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With concerns about growth in China continuing to mount, should investors completely steer clear? I'm here today with Dan Su, an equity analyst at Morningstar, to look at some Internet companies that could still have some growth ahead of them.
Dan, thanks for joining me today.
Dan Su: Thanks for having me, Jeremy.
Glaser: We talked to Dan Rohr, one of your colleagues, earlier about some of the challenges China is having with rebalancing its economy a little bit, and he thinks that's going to cause some drag on growth for some time. But that being said, are there any opportunities you're seeing in China right now?
Su: Yes, that's a great question, Jeremy. I think with the rebalancing what the Chinese government is trying to do is to put more focus on consumer spending, and that's good news for the broader consumer sector, and specifically for the Internet stocks that I'm covering because these Internet stocks definitely benefit from two tailwinds. Number one, with rising consumer spending there is going to be more advertising dollars chasing after consumers. That's good for overall ad spend. The other thing is, as more people move their activities from offline to online, the advertisers are following suit allocating higher spend on the Internet. That's definitely good for Internet companies.
Glaser: During the last few years how have the Internet firms been coping with this changing macroeconomic environment?
Su: I would say that they are in a good position in terms of the secular tailwinds kind of providing them a buffer from the broader economic environment. Obviously, if the overall economy is not doing well and that persists for a longer time, that's not good for everybody. But so far what we have been seeing is that online advertising spend as overall spending is growing steadily every year. People are doing more entertainment and other activities, online shopping, et cetera, online. That creates a lot of revenue opportunities for the Internet companies, as well.
Glaser: How much runway is there left for growth though? Is this is a story that everyone is online? How much more penetration can there be in the Chinese market?
Su: Right. For penetration, if you looking at the number of Internet users who are already on the Internet, we are probably looking at a penetration of close to 70%. It's already pretty high. The runway in terms of the pure numbers is probably that much. But in terms of the revenue opportunities, the monetization opportunities, there are still a lot of things that these companies can do because still online advertising as overall spend of ad dollars from the corporations is a very, very low number right now. Even after the strong growth over the past five years, it's still at the most maybe in the low teens as corporations continue to spend heavily on traditional media like TV and newspaper. There are still a lot of things. As long as these Internet companies can prove that they add value to their advertising customers, they will continue to get more spend.
Glaser: Let's look at some individual names. What firms do you think have the best competitive position right now?
Su: We do have a couple of favorites. Over the longer term we think two companies, Baidu and Tencent, are very well-positioned to benefit from the secular trends in the Internet space in China. Baidu is the Google of China. It's traded in the U.S. as an ADR, ticker BIDU. It has about a $50 billion market cap. Tencent is China's largest Internet firm in terms of messaging, advertising, gaming, and social networking. The ticker is 00700.HK. It's traded in Hong Kong with the market cap of about $88 billion.
Glaser: What about those companies do you like?
Su: Both of these two companies are very well-positioned in their specific subsegments of the Internet space. For Baidu, it's well-positioned in the search advertising space, where currently their customers, basically the small business owners, only about less than 2% of the small business owners are advertising on a paid-search engine on Baidu. So there are a lot of opportunities for them to recruit more advertisers and help them spend both on PC Internet and on the mobile platform to drive their growth opportunities.
Tencent is a very interesting growth story, in that it started off providing free messaging services, and then built a massive user base that it is able to monetize traffic in different revenue models from advertising and gaming. It quickly became the top firm in terms of gaming, though it was not one of the earlier players in the space, and it did the same in advertising. We particularly like Tencent's position on the mobile Internet, given its wildly successful for mobile app WeChat that has already signed up about 400 million users both in China and outside of the country.
Glaser: How about valuation? Do these stocks look cheap right now?
Su: That's a great question. That's something we'll always have to focus on. Unfortunately, these two are well-understood growth stories, well-followed by investors, and both stocks have really run up a lot this year. Right now I think they are trading around our fair value estimates. During the longer term, I think their stories remain very attractive, but for now I would think that investors probably need a wider margin of safety.
Glaser: Another thing to keep in mind, you mentioned that one of these firms is an ADR--Baidu is an ADR--and another trades in Hong Kong. How should investors wrap their heads around some of the governance risk, the stewardship risk, or the structure risk of investing in Chinese companies?
Su: These are definitely great questions that investors need to really understand and be comfortable with before investing in those companies. In terms of Chinese companies, I think a couple of things that investors should look at is, number one, the ownership structure. A couple of names come to my mind, state-owned telecom carriers such as China Mobile, China Unicom, et cetera--these are very strong names, with very strong branding and solid businesses. The thing that investors need to really be careful about is that [these companies] are majority-owned by the government, so they are probably sometimes given mandates that serve the national interest, but they are not the best in terms of shareholder value. So that's something that investors need to watch out for.
The other thing for many of the Internet companies that I cover is that they use a variable interest entity structure to bypass policy restrictions on foreign investment in regulated sectors. This is not something new and is a GAAP-compliant practice used by not only the Chinese ADRs, but a lot of the global companies that have operations in China. Don't just run away just because this company uses this structure. That said, you want to read through the 10-Ks and other filings to make sure that they have well-constructed structures to help protect international investors. You want to have a management that has been around for at least seven to 10 years with a strong track record, and we tend to like companies that are audited by the big four [accounting firms]. That gives an additional layer of credibility to some extent.
Glaser: Dan, I really appreciate your insights today.
Su: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser.