Please find belowour key excerpts and Most critical pointsfrom a brilliant blogpost published by "Guru of Valuations" - Mr. Aswath Damodaran.(Emphasis Ours)
1. China's immense growth and infrastructure investments have sustained commodity prices, and altered the balance of world economic power. That growth has come (or should have come) with the recognition that in almost every venture in China, public or private, the Chinese government is not just a player, but often the key player determining the venture's success and failure.
2. The Rise of China
a) While China's rise in the last two decades has been meteoric, it is worth remembering that China was a dominant part of the global economy centuries ago.
b) The United States, which used to account for close to half of global GDP in 1960 has seen its share drop go global GDP drop to 25%, while China's share has climbed close to 20% in 2020.
c) Put bluntly, without China, the world economy would have tread water for the last decade, since China accounted for close to two thirds of global GPD added on during the decade.
d) Chinese equities have risen from a negligible share of global market capitalization, in 2000, to more than 10% of global market capitalization, in 2020.
e) At the end of 2010, of the fifteen largest market cap companies in China, only two were tech companies (Tencent and Baidu), and they were towards the bottom of the rankings; banks and insurance companies dominated the list. By the end of 2020, six of the top fifteen were technology companies, and Tencent and Alibaba topped the rankings.
3. Chinese Tech Plays - The Lead In
a) Let's understand the business models of biggest tech companies of China
b) Tencent - It is the most versatile of the four companies, in terms of its business mix, and while it has been in existence for 20 years as a publicly traded company, its growth in the last decade has converted it from a minnow to a whale.
b) Alibaba - It is the second largest Chinese tech company in 2020, I drew on a blog post that I wrote ahead of its IPO in 2014, where I described it as “the Real China Story”, because so much of Chinese retail traffic travels through its platforms (Taobao and TMall), with the company collecting a slice of the transaction revenues, in return for its intermediation services.
While Alibaba is sometimes characterized as China's Amazon, it is closer to Google in its business model.
c) JD.com - It operates more as a online retailer, selling goods and services through its platforms. While posting strong revenue growth rates for much of the last decade, has had trouble generating significant operating profits and Cash Flows.
d) Didi - Didi's acquisition of Uber China has given it dominance over the Chinese ride sharing market, but it is difficult to see the payoff in the numbers. Revenues have stagnated between 2018 and 2020, and was tepid even in 2019. The company has also shown an almost unparalleled capacity to lose money and burn through cash, even by ride sharing company standards.
4. Chinese Tech Plays - Valuation Stories
There are some commonalities across these companies that I will explore in this section.
a) Big Markets (Squared)
China was the engine that drove global growth over the last decade, and with that growth has come a surge in buying power for Chinese consumers. With tech companies that are disrupting conventional businesses, there is an added allure of growth occurring at the expense of the status quo. You could argue that this combination of China and disruption creates growth stories on steroids, as investors load on dreams of one big market (from disruption) on top of another (China).
As with any steroid-driven story, there are downsides. First, I have had multiple posts on the big market delusion, where I argue that investors often over estimate the likelihood and payoffs of success in big markets, because they fail to factor in new entrants, and changing technology fully.
b) Attuned to the Chinese Market
Note that these companies were very much part of the pack, competing with foreign and domestic players, just a decade or two ago, but have managed to separate themselves from their competitors, in the years since. While there are many factors that may have contributed, one in particular stands out. Rather than copying what successful US tech companies were doing to gain market share and profitability, these companies tailored their business models and product offerings to the Chinese market, adapting to what Chinese consumers cared about and wanted.
In my IPO post on Alibaba, I argued that the reason it was able to vanquish eBay and more established competitors was because it created what the Economist called the "world's greatest bazaar" and a payment mechanism that Chinese consumers felt comfortable using online. Tencent not only built a gaming platform specifically focused on Chinese consumers, but was well ahead of its US tech competitors in building the world's leading social media platform in WeChat.
c) Corporate Governance Nightmares
Big China tech companies are also incorporated in the Cayman Islands, and Tencent began its corporate life as a Cayman Island listing. In fact, the structure (called a variable interest entity or VIE) used by these companies essentially means that shareholders are technically owners of shell companies rather than the Chinese enterprises that they they think they are buying.
Why do Chinese tech companies favor this convoluted structure? The answer lies in Chinese laws and regulations that restrict the types of business that foreign investors are allowed to own shares in, and technology is one of those restricted businesses. Variable interest entities are a technicality that allows Chinese tech companies to get around the law, but they hold up only because the Chinese government has looked the other way.
5. Beijing: A Silent (or not-so-silent) Partner!
The notion that governments are neutral arbiters who don't affect company value is utopian, since governments in every market affect almost every dimension of value, sometimes positively and sometimes negatively. In the figure below, I have used my value drivers framework, where I connect the value of a company to key drivers of value (revenue growth, operating margins, capital intensity and risk), to examine how government action (or inaction) can affect each driver:
If this is true for all companies, why make this an issue with just Chinese tech companies? There are two reasons.
First, the Chinese government can not only change the competitive balance and business more decisively than democratic counterparts, where making laws involves trade offs and bargains, but also make the changes more permanent, since a change in government is not in the cards.
That calculation, though, does miss the other quality that the Chinese government has always valued, which is control, and the tussle between the two (growth and control), in my view, explains much of the crackdown on Chinese tech. As Chinese tech companies have become larger and more valuable, they have also become repositories for data on their customers, and that data is what Beijing not only fears, but covets.
As investors bring in the downside of the government effects on value, markets have reassessed the pricing of all four of the companies that I am valuing, dropping market capitalization by 17% for Tencent, 46% for Alibaba and 7% for JD.com in 2021, over the most recent year, and providing a frosty reception to Didi’s IPO, with the stock price dropping 42% from its offer price of $14 a share , just a few weeks ago.
6. Valuing Chinese Tech Companies
As I noted in the last section, investors have priced Chinese tech companies for much of the last decade, on the presumption that the Chinese government would be a net plus for these companies, stifling competition from foreign companies and easing the pathway to growth to profitability. It is for that reason that investors have been shocked by the realization that what governments can give, they can take away. I have summarized the key inputs and valuations of each company, under three scenarios, built around views of the government - the government as benefactor, the government as a net-negative and the government as adversary - in the table below:
In making my assessments of how government affects value, I believe that almost all of the effect will be in the cash flows for the companies, since most of the restrictions are on growth (constraints rising from anti-trust moves) or on margins (costs associated with meeting privacy needs).