Buying on the Dip in China

The Shanghai Composite is down about 20% in 2018, and a casual glance at headlines about China's economy or the U.S.-China trade war can clue you in on why. Some of the biggest and brightest companies in the world are being pulled under by the tide, and long-term investors might want to take a closer look at these beaten-up gems.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Danny Vena dive into iQiyi (IQ 6.26%) and Tencent (TCEHY 3.56%), two companies with massive, enthusiastic user bases and huge long-term potential. Tune in to find out how these tech giants have been performing lately, what's behind their sell-offs, the biggest risks to watch out for, and much more.

A full transcript follows the video.

This video was recorded on Nov. 9, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, November 9th, and we're going to try to figure out what's got Chinese tech stocks down. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Danny Vena. Danny, what's going on?

Danny Vena: It's another sunny day in San Diego. I'm still trying to recover from the change in time. 

Lewis: The change in time gets us all. I'm happy to have you back on the show. We talked about some of the companies we're going to be discussing today a couple months back, it only seems natural that I bring you back on to make that conversation whole.

Vena: Happy to do it. 

Lewis: The reason we're chatting is, Danny, the popular Chinese tech stocks have gotten absolutely hammered so far in 2018. You look at some of the major companies, and their year to date returns. Alibaba, down 20%. Tencent, down 30%. Baidu, down 20%. These are names that a lot of Fools follow. They're some of the big players in the Chinese tech space. Meanwhile, the S&P 500 is around a 1-2% gain for the year. A huge delta there. There's a lot to unpack. Why don't we talk a little bit about what's going on with the sell-off of Chinese stocks, and what's leading to this landscape that we've seen so far in 2018?

Vena: There are a number of things that are affecting Chinese equities. Generally speaking, there's been a lot of fear for a while now about the potential for a slowdown in China's economic growth. That's likely been exacerbated by the ongoing saber rattling that's happening between Washington and Beijing, the escalating trade tensions. Evidence of that, last week, President Trump tweeted, "Just had a long and very good conversation with President Xi Jinping of China. We talked about many subjects with a heavy emphasis on trade, and those discussions are moving along nicely." In response to that tweet, a number of Chinese stocks jumped significantly, between 5-15%, many of them. Even after that jump, the Shanghai Composite Index is down 20% so far in 2018. Between the potential for a slowdown in China's economic growth, the increasing trade tensions between the United States and China, and then also, there's some heightened regulation that has been happening in China around some of the segments that are core to these companies in their home country of China. We're going to talk more about that later. 

Lewis: The big picture story here is, there are some macro changes that are happening, some that have run a little counter to the narrative that investors have gotten used to for quite some time. For a long time, we've been sold this pitch of, "There's this emerging middle class in China. Purchasing power is going up. We're going to see them move more and more to a consumer-oriented economy. That should bode very well for a lot of companies in the e-commerce space, a lot of companies in the gaming and social media space, because of the ad opportunity there." Then, on top of that, maybe some of the less expected but now a very real element of the macro picture, the tariff situation, and the escalating potential trade war that has been going on, and the uncertainty surrounding all that. A lot to unpack, and maybe a little bit of some stuff that might catch investors off-guard a bit.

Vena: There's a lot going on. A lot of this has been talked about before, and it's just really coming to a head now with the significant slowdown in Chinese stocks over the past few months. 

Lewis: The two companies that we really want to drill down into on today's show, one of the ones I mentioned earlier, Tencent, and then a relatively new company to investors, iQiyi. Two slightly different stories there, but two companies that are both exposed to some very niche, specific issues, as well, when it relates to China. Why don't we start out talking about iQiyi? In the time since we first talked about this company -- this is going back five months or so -- iQiyi has doubled and then slowly worked its way back down to earth. If you look at the stock price today, shares are basically trading where they were when we first discussed the company, Danny.

Vena: That's true. If I remember correctly, the stock IPO-ed somewhere around $18 a share. In that first day of trading, it sunk down to about $15 and change. Then it skyrocketed somewhere around 170-180% in the months that followed and since then. I think it's currently trading around $21 a share. It's up several percentage points from where it IPO-ed, but not the stratospheric gains that we had seen previously. 

Lewis: As a reminder for anyone that hasn't heard of this company -- though coverage has been pretty hard to avoid -- this is the Netflix of China. It is really the leading video streaming company out there. It has some pretty big backing, when you think about the Chinese tech space.

Vena: That's true. The company that most investors would be familiar with in China is Baidu, which is often called the Google of China. iQiyi is a company that was spun off earlier this year from Baidu, although Baidu still owns a controlling stake in the company.

Lewis: So, you have this spin-out. Investors have historically done quite well following company spin-outs. Then, you also have this very powerful, very large parent company, and a company that has exposure, is basically a pure-play, on one of the most compelling growth stories of the decade in the streaming and decentralization of entertainment. All of that builds to huge hype after shares hit the public market. I think that's really why we've seen what we've seen in 2018. As we talk about new IPOs, and investors getting their first chance to get their hands on shares, we often say that it's good to wait a little bit, and that if you're going to invest, it's good to do it with small bites over time. The reality is, when you have a new issuance like this, particularly one with so much hype behind it, there's going to be a lot of volatility. You have the pent-up demand, which is a huge part, for sure; but you also have very low supply. In the case of iQiyi, right now, only 29% of shares are available for trading. That's the float of the stock. That's after a 180-day lockup for insiders that came with the IPO process. So, for a very long period, you had a very short supply and some outrageous demand. That was doing some really funky things with the share price. That's why we saw that really astronomical double so quickly.

Vena: Whenever you call a company "the X of China," whatever that is, whether it's the Google of China or the Netflix of China, that drums up a lot of interest from investors. It bears noting here that actually iQiyi, while it does have a subscription-based service and exclusive original content, it also has an ad-supported segment for people that are not interested in paying the monthly subscription fee. This model is actually more akin to Hulu than it is to Netflix. But it still gets all the Netflix hype. 

Lewis: Yeah, absolutely. While we're a little removed from the crazy days of iQiyi's trading, we have seen some recent sell-offs over the past month or so. I think a lot of that was tied to some of the news that came out with the company's most recent results when they reported earnings. Frankly, I thought the numbers looked pretty good. The immediate reaction from Wall Street, though, seems to disagree.

Vena: Let's look at some of the numbers first. When you look at the revenue, overall revenue was up 48% year over year. Subscription membership revenue was up 78% year over year. But advertising revenue was down 4%. That seems to be one of two things that investors focused on. Now, the reason that advertising revenue is down 4%, there were two big factors that played into that. The first was the FIFA World Cup Soccer Championships that not only captivated the United States, but also all across Europe, across China, across the world, really. There were a lot of ad dollars on linear TV as a result of the FIFA World Cup. 

Lewis: The story there, Danny, is that in lieu of ad money going to this streaming company, it was instead going to more traditional broadcasts.

Vena: That exactly right. There was another thing that the company reported. They said certain high-risk profile sectors. We'll talk a little bit about this later. Essentially, many of the video game companies in China have been laying off some of their advertising dollars. We can talk about why that is here shortly. 

Lewis: That's really just the natural continuation of what we've been seeing in the ad market in China over the last couple of years. This is something that has bitten a lot of these companies where I think the regulatory environment is realizing more and more "We really need to be a little bit more careful about what people are being served up." This started with a lot of the health and wellness products that were being promoted on some of these major social media platforms. It seems like the government has turned its gaze to gaming and the impact that that's having on people's lives. A little different, but clearly something that they are focused on, as well, and it's having an adverse effect on the advertising revenue coming in for iQiyi. 

But if you're the optimist, and I am here, you go back a year, membership Revenue and Advertising revenue, were basically where iQiyi was making all of its money. You fast forward now, their Content Distribution segment is up 220% year over year. Their Other segment, which is where they get their online gaming revenue, content merchandising, all that kind of stuff, up 150% year over year. So, instead of this business being super reliant on two segments to drive most of their results, we are now seeing that they have four segments that each contribute over 10% to revenue. I view that as a pretty good thing. I look at those growth rates, and I'm like, man, that's pretty strong growth we're seeing.

Vena: I've been excited about iQiyi ever since -- in fact, one of the first articles I did when I started writing for The Fool was about the opportunity that existed for Baidu in this streaming segment that it had, which at the time was relatively unknown outside of China, iQiyi. I thought that was a huge opportunity then, and it has grown gangbusters since then. 

The other thing that threw investors off about their report was the fact that its cost of revenue grew 66% year over year. That's a huge bump. But it's all got to do with content costs. They're taking a page from the Netflix playbook, and they're investing huge amounts of money in their owned original content, building out that library of things for the future. It costs a lot of money up front, but it pays dividends down the road.

Lewis: Yeah. If you were a little worried about this, I can understand that. But you can also look so easily to the Netflix model and say, "This has worked pretty darn well for this company." It's easy to buy into this strategy long-term, especially when you're operating in an economy that has a huge addressable market and a government that's pretty keen on protecting the local companies. 

Vena: That's why a lot of the companies that we see in China -- Baidu and Tencent are both great examples of companies that have a large captive market. They get very little competition from companies in the United States. That's a huge competitive advantage for them. 

Lewis: Yeah. Another point of strength from this earnings release, and maybe something that can give investors that bought shares maybe at higher cost basis a little reason to relax here is, you look at the company's subscriber base, it grew almost 90% year over year. It's up to 80 million now. They have a very high monetization rate on those subscribers. 98% of subscribers are paying members. Increasingly, the company is relying on them to help fuel this content spend, very much like Netflix did in early days.

Vena: Absolutely. And it doesn't hurt them that they have this free ad-supported segment. They use that as a funnel to entice these free ad-supported members, people that are watching it without paying the fee. They see some of the premium content that's available to subscribers, and that helps them to make the decision to pony up the several dollars a month it costs them to become full-fledged paying subscribers. 

Lewis: I actually wound up ponying up a couple of dollars this month myself, Danny. I decided to buy my second batch of shares shortly after the company reported earnings. I looked at the results and said, "The stock sold off 10% on this, but this really does not seem to be nearly as much of a problem as the market is making it out to be." My long-term commitment with this stock in particular was, "I'm going to add opportunistically over time, understanding that the price is going to move around quite a bit, and my cost basis might swing pretty wildly. By doing small bites over time, I'm going to dollar-cost average into a position that I'm going to be pretty happy with over the next couple years."

Vena: I think that's a wise way to go about it. I bought a large tranche just going in, watched it more than double, watched it come back down. I'm watching the metrics. I think the subscriber growth is going to be key going forward, just like it is for Netflix. As the company learns other ways to monetize that content through merchandise, through content distribution, through partnerships that it has with other outlets, I think iQiyi has a really long runway ahead of it. 

Lewis: Yeah, and so many of the growth levers for this business are not as impacted by the regulation that is hampering one of its specific business segments. One of the things we come back to is, yes, advertising is struggling, but so many of these other segments are doing very well. It seems like the company's able to post really strong growth even in spite of that, which keeps me pretty optimistic.

Danny, we mentioned that while the results haven't necessarily been as blistering as maybe some investors would like for iQiyi, the company has been able to stay afloat and post some pretty awesome growth thanks to a lot of other segments that are outside of the scope of current Chinese regulators. Not necessarily the case with Tencent.

Vena: This is true. Reports emerged earlier this year that the regulatory body that was in charge of video game approval in China had frozen those approvals and there hadn't been any new video games approved since March, if memory serves correctly. Now, there were a number of reasons that were given for that at the time. What we have since found out is that there is a new regulatory body that is responsible for video game approvals, the State Administration of Press and Publication. That is a change. It used to be that video games were approved by one large regulatory body that was in charge of all media in China. Now, that division has been broken down into multiple different regulatory bodies. Courtesy of the South China Morning Post, it's reporting that the agency will implement controls on the total number of online video games, control the number of new video games operated online, explore an age-appropriate reminder system in line with China's national conditions, and take measures to limit the amount of time minors spend on games. 

Lewis: That's a lot of government speak right there, Danny. That sounds like regulators telling them how it's going to be.

Vena: It is, indeed.

Lewis: The reasons this has hit this company so much is, video games and mobile gaming was seen as one of the major growth drivers for them. They have a lot of they have access to a lot of very popular and successful franchises that they were hoping to bring to the Chinese market, and investors were really hoping that they would go to the Chinese market, because they've proven so successful in other markets. We've basically just had to hit pause on that.

Vena: Right. Just to put this into perspective, Tencent is the world's largest video game producer. A large chunk of their revenue comes from the publishing and the ongoing revenue that comes from the sales of these video games for add-on updates, etc. What has happened is, with this massive pause, this freeze in the approval of video games, Tencent has really taken it on the chin. If you look at their results from the quarter that ended about three months ago, and they're due to report here on the 14th of November, what you see is their revenue was up 39% year over year. At first glance, you go, "39%? Companies would love those results." However, that's down from 57% year over year growth in the prior year quarter. At the same time, their adjusted profits only grew 24% compared to the 43% that they did in the year ago period. That's a big deceleration of their revenue growth, and it's all related to them not being able to put out new video games.

Lewis: Danny, to me, this is the kind of thing that reminds me of a hardware company saying, "We thought we were going to release it in this quarter, but actually, we're going to release it next quarter." The core thesis for this company more or less remains the same, so long as this is a short-term issue. I think that by and large, Chinese regulators would like to allow these companies to bring in massively popular titles and let their citizens play them. I'm sure the citizens are certainly vying for that. I think about this, I'm like, "Well, if we're going to have to wait until approvals come in maybe mid-2019, maybe late 2019, it's really more a matter of timing." I think the reality is that the video game segment for Tencent, while it hasn't posted the growth that we would have liked to see, will return to some pretty solid growth down the road. And oh, yeah, by the way, they happen to own one of the most important social media platforms in the meantime.

Vena: That's true. One thing I did want to point out that we unpacked from that government speak that we reviewed earlier, one of the things that has resulted from that, Tencent announced earlier this week that it plans to verify the identities of all of its players. Then, it's going to begin limiting playing time. Children that are 12 years and younger are going to be limited to one hour of gameplay per day. Those between 13 and 18 years old will only be allowed to play for two hours a day. This is China's opportunity to step in. They've been looking at how much children are playing video games, and looking at the growing levels of gaming addiction that's being reported around the world. This is their way to combat that. 

Now, in all fairness, that there have been reports that other countries like Korea have tried to implement similar measures. What they've found was that kids were borrowing family members' phones and other devices in order to bypass the regulation. We'll see what comes of it. But that is one important aside there. If you start limiting the game-playing time of some of the younger members, that may have an impact on their growth going forward. 

Lewis: Yeah. If spending the holidays with my younger cousins is any indication, if you try to separate a kid from technology, they will find a way to make it happen. I do think we might see a more deliberate approach, like you mentioned. We might see growth that is capped at a certain ceiling. But once these really popular titles start working their way back into the country, I think that will really reignite growth for this company.

We focused this conversation on Tencent, but I think you could apply a lot of the logic here to Baidu and Alibaba, as well. For these three companies in particular, there's a snap test element. This is something that goes around The Fool. I think I've heard David Gardner and the investing team talk about this. If you snapped your fingers, and this company disappeared overnight, would people notice? In the case of Tencent, Alibaba and Baidu, absolutely. These companies are so entrenched in consumer culture and everyday life there. They're not going anywhere. I think this is really just a matter of timing. They've had an unfortunate run recently, and that's really hit the stocks. But that's just a testament to buying over time and slowly working into positions.

Vena: To put that in the perspective of investors that are more U.S.-focused, if you think about it, that would be similar to companies like Google, companies like Activision, Netflix. If those companies disappeared off the face of the earth, yeah, absolutely, investors would notice. These companies are the standard in China. 

Lewis: As I'm gearing up for the weekend, Danny, I hope that those companies don't go anywhere, because I have plenty of content that I want to see. Thanks for hopping on the show today. Anything else before I let you go?

Vena: No. Have a great weekend! We'll talk again soon.

Lewis: Catch up with you soon, Danny. Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes, or you can check out the videos of these podcasts over at our YouTube channel. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Steve Broido for all his work behind the glass today. For Danny Vena, I'm Dylan Lewis. Thanks for listening and Fool on!