• The Chinese government has clamped down on various big tech companies. In the near term, investors should expect more volatility as regulatory risk continues to weigh on market sentiment.
• Regulations will impact companies unevenly, and we are most pessimistic on companies whose earnings will be directly affected.
• Diversification is the way forward to tide the near-term volatility, as the long-term growth of the sector remains.
Further crackdown on China big tech
Over the past few days, a series of clampdowns by the government rocked Chinese equity markets. As a result, many Chinese tech stocks tumbled to their year-to-date low as rattled investors scrambled to divest their shares.
The latest salvo against the tech sector saw the government ban Tencent Music (NYSE:TME) from owning exclusive rights in the online music industry. In the private education sector, sweeping reforms were announced which include requiring all private education companies to register as non-profit entities while also putting a stop to vacation tutoring as well as school curriculum teaching for children below six years of age.
In the food delivery sector, authorities issued guidelines to protect the rights of food delivery workers in terms of minimum wages, delivery deadlines, and social insurance. These crackdowns have been ongoing since late last year and markets remain uncertain as to how long it will last.
As a result, since last Friday Tencent (HKEX:700) was down by 15.8%, while New Oriental Education & Technology (NYSE:EDU) fell by more than 63.1%, as of 28 Jul 21. The Hang Seng TECH index, which tracks the performance of the 30 largest tech companies in China is down by -26% year-to-date.
Impact on companies will vary
To navigate such an environment, we highlight that the impact of regulations on companies will be uneven, and we are more pessimistic on companies whose earnings will be impacted.
In the case of Tencent Music (NYSE:TME), the company will be required to end its exclusive music licensing deals with global record labels within 30 days. The company was also fined for unfair market practices having controlled 80% of exclusive music library resources.
While this may seem damaging to its business model, we recognise that Tencent Music has a strong foundation and that the regulatory impact will not take a huge toll on the business. We believe they will maintain their strength in customer retention and acquisition, as they have built a strong ecosystem on its WeChat platform which has 1.24 billion monthly active users (MAUs).
On the platform, there are over 100 mini-programs within the Wechat app, allowing users to conveniently find everything they need on WeChat alone. Mini-programs include popular services such as Didi (NYSE:DIDI), Meituan (HKEX:3690), and PinDuoDuo (NASDAQ:PDD).
This holistic suite of services increases user stickiness across all the apps in the ecosystem. Additionally, users in China already typically use multiple music streaming platforms to access different artists, hence migration of users will not be a huge concern.
We also view this clampdown on unfair market practice as positive as it will allow fair competition, which encourages innovation and growth of the sector. With competition, the risk of pricing pressure remains which could eat into margins. Nonetheless, we believe that a competitive market eventually benefits all stakeholders and Tencent has the advantage of a strong ecosystem.
Tencent Music is significantly larger with over 622 million MAUs as of end 2020 across its three apps - QQ Music, Kugou, and Kuwo Music, while the next largest competitor NetEase Cloud Music stands at 181 million MAUs.
On the other hand, we are more pessimistic about the regulatory impact on the edtech sector. The move to make private tutoring more affordable and even non-profit calls into question the viability of the private tutoring business model, and we think that it could result in these companies losing a huge chunk of their profits.
Related article: Quick Take: What you need to know about China’s edtech crackdown and its impact on the tech sector
Diversification is the way forward to tide near-term volatility
Thus, in light of these troubled times for the tech sector and the varying impact of regulation across different companies, we take the view that diversification is important and that investors who are able to stomach the heightened volatility in the near-term could see this as opportunity to gain exposure to the sector, for future long-term earnings growth.
We reiterate that China does not intend to hamper the growth of the tech sector, but instead safeguard consumers and ensure sustainable growth of the sector. Our recommended ETF for investors who are seeking exposure to China’s technology sector remains as iShares Hang Seng TECH ETF (HKEX:3067).
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