Chinese Internet Stocks Are Rebooting

The beginning of the year was not kind to most anything that resembled a China-related investment.

As worries mounted that the country’s long-chugging economy was slowing down, nearly all global asset from commodities to U.S.-traded stocks classes began to tumble – and most certainly also Chinese equities, which fell about 25 percent in the span of six weeks.

The meltdown also dragged down sectors that had previously found ardent supporters of growth stocks in emerging markets. The China Internet motif, for example, fell by more than one-third from late December 2015 to early February of this year.

For those with a longer-term perspective, however, a buying opportunity was suddenly at hand, amid a report published last month by JPMorgan analyst Vivian Hao, suggesting a significant upside lay ahead for many of the sector’s well-known names.

Specifically, Hao said she saw a rise of 34 percent for shares of Alibaba Group Holding Ltd BABA, 29 percent for JD.com JD, 21 percent for Weibo Corp WB, and 20 percent for Ctrip.com International, Ltd. CTRP.

Combined, those four stocks comprise more than 37 percent of the weighting of the China Internet motif.

For Alibaba, Hao noted that the stock’s weakness was owed in part to a 23 percent growth in merchandise volumes in its most recent quarter which was the slowest pace in three years and a sign that even the country’s e-commerce giant wasn’t immune to the country’s weakening economic growth.

But Hao mentioned that Alibaba’s revenue rose 32 percent, and the volume slowdown might be tied to an effort to crack down on merchants faking transactions to improve their rankings.

Alibaba also has expanded beyond retail into other ventures like cloud computing and online payments. Indeed, Alibaba’s foray into so-called fintech may wind up delivering a significant part of its growth. A recent Barron’s article reported that analysts expect the three key segments of online payments, peer-to-peer lending and online wealth management to grow between 30 and 60 percent annually in China over the next three years.

The ability to gain new users easily and cheaply, combined with lower competition from non-internet finance providers and the launch of innovative new online-to-offline products, could see China’s leading Internet finance providers, like Alibaba, “eclipse their U.S. peers on many fronts,” according to a recent Credit Suisse research note cited by Barron’s. The broker argued that valuations could increase to levels on par or even higher than those of leading U.S. online finance stocks, which trade at considerably richer multiples.

Meanwhile, Alibaba’s chief e-commerce rival JD.com specialized early on in electronics sales, but now sells a vast array of merchandise. Hao pointed out that JD.com controls much of its shipping infrastructure, which gives it better ability to deliver packages on time, and it has expanded that infrastructure into smaller cities where there are fewer brick-and-mortar stores. While that helps to generate high customer satisfaction, it also produces high costs, so the company is merely flirting with profitability, and isn’t expected to bring in hefty free cash for another few years. That said, Hao wrote, it is growing revenue faster than Alibaba.

So far, Hao’s position has turned out to be fairly prescient as the rise of oil and other commodity prices has helped give credence to optimism that China’s economy can avoid a meltdown. Since her bullish report, shares in Alibaba and JD.com have both risen 11 percent.

The China Internet motif has gained 23 percent in the last month compared to the S&P 500’s 8 percent gain. Over the last 12 months, the motif has risen 6 percent, while the S&P 500 is down nearly 2 percent.

It also didn’t hurt the sector recently when Baidu Inc BIDU – the “Chinese Google” – recently beat expectations for revenue and profits in its fourth quarter.

Investors had become increasingly concerned about the company’s prospects amid the broad switch in online behavior away from desktops to smartphones. As the Financial Times noted, advertisers are reluctant to pay the same rates for mobile ads as they are for desktops.3

However, while Baidu’s full-year profits were down about 9 percent, the company said the gap between the cost of a mobile ad and a PC ad has narrowed to 20 percent from roughly 40 percent a year ago.

Most important perhaps, Baidu continues to face no competition from the real Google due both to Baidu’s local language advantage and the government’s blockage of Google’s service in mainland China (though some users in Hong Kong are able to access its services).

Baidu’s piece of the Greater China market is 80 percent to Google’s 12 percent; as 24/7wallst.com’s Douglas McIntyre noted, that’s not very different from five years ago.

Baidu’s shares are up more than 19 percent in the past month (they have a 21 percent weighting in the motif). Assuming the company and its Chinese Internet peers can continue posting strong growth numbers, the sector’s new momentum may have room to run.

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