No doubt, China's regulatory crackdown hasn't been great for China-based tech stocks. The KraneShares CSI China Internet ETF is down nearly 50% on the year.
Yet could there be a silver lining to the new clampdown? Last Thursday, tech giant Tencent (TCEHY 1.12%) announced it would spinning off most of its roughly 17% stake in JD.com (JD +8.30%) to shareholders. While JD.com stock fell about 6% on Thursday, Tencent was actually up by a similar amount.
It's possible Tencent's divestiture was a pre-emptive move to please regulators, yet the action was deemed positive for the stock. If more divestitures are coming, here's why it could be a boon for Tencent shareholders.
Tencent's decline has made it cheap
Tencent has actually fared better than the China tech index this year, and is only down some 20% in 2021 after Thursday's rise.
KWEB Year to Date Total Returns (Daily) data by YCharts
Tencent's relative outperformance could be due to a few things. It has a highly diversified business, with profit centers across video games, the WeChat social network, fintech, cloud computing, streaming, and others. It also appears to have an excellent relationship with regulators, as evidenced by its lower fines and other measures relative to rival Alibaba.
However, a 20% decline is still large, as is Tencent's 42% decline from all-time highs reached in February. After the decline, Tencent only trades around 25 times next year's earnings estimates -- and keep in mind, those earnings estimates are likely lower than normal, since the company is stepping up investments and operating expenses this year, and China's economy has slowed.
Twenty-five times earnings also seems like a pretty good valuation for Tencent's core businesses alone. Meanwhile, those earnings don't factor in Tencent's enormous investment portfolio, which the company estimated was worth roughly $188 billion at the end of last quarter. That's about one-third of the company's market cap today.
Image source: Getty Images.
The JD spinoff could lead investors to reassess Tencent's sum of the parts
The JD.com spinoff may therefore seem like a bonus to Tencent shareholders. Based on the value of the spinoff (or cash equivalent), Tencent shareholders stand to reap about a 2.7% dividend based on the market value of JD.com. And if you receive shares and not cash, those JD shares themselves are down about 37% from all-time highs, and could appreciate if China's tech stocks' fortunes turn around. Of course, that value was always present within Tencent, but may not have been appreciated by investors who just look at the company's operating earnings alone, and not the investment assets that don't show up on the income statement.
While Tencent did not say that the spinoff was a pre-emptive move to please regulators who are worried about market concentration and market power, it could very well be the reason behind the divestiture. After all, Tencent has never spun out an asset of this size before.
Paradoxically, if Tencent spins out more stakes across its investment portfolio, it's quite possible Tencent's own stock value won't move at all, if investors had been disregarding the investment assets anyway. Yet shareholders would receive other assets of significant value, such as the JD stake.
Amid regulatory pressure here in the U.S., some have speculated that if the government ever forced Alphabet or Amazon to break up, their stocks would actually go up, since many investors believe each of these FAANG stocks are worth more than the sum of their individual units. Amazon's AWS cloud computing unit as a stand-alone company could very well be worth nearly all of Amazon's market cap today, while Alphabet seems to be valued based on its advertising business alone, without much credit given to its own cloud unit or "other bets."
It looks as though Tencent shareholders are about to find out if that proposition is true. If Thursday's stock price action is any indication, it appears that sum-of-the parts thesis for large-cap tech conglomerates may very well be correct.
