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Tuesday, 07/06/2021 4:53:05 PM

Tuesday, July 06, 2021 4:53:05 PM

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Can Alibaba And iQIYI Overcome The Onslaught Of Innuendos? You Bet

Jul. 04, 2021
Seeking Alpha

Market commentaries generally blamed the weakness of Chinese equities last week on the lackluster June PMI readings and missed the big elephant in the room: China's aggressive posturing.

With the yawning gap between BABA share price and the consensus price target, the question is whether the stock would recover or the analyst targets would be revised down further.

The same goes for the embattled iQIYI. I share my thoughts having reviewed their revenue and EPS revision trends.

Several significant developments, including an investment tie-up with a provincial government, suggest Alibaba Group remains the go-to internet giant for mega deals and careers.

iQIYI is making real business progress that deserves better communication to investors.

Lackluster PMIs and harsh presidential speech likely spooked market players

Chinese equity indices slumped last week even as the country was in a celebratory mood due to the 100th anniversary of the founding of the Communist Party of China.

Market commentaries generally blamed the stock weakness on lackluster purchasing managers' indices [PMI] that were released over the week.

The official manufacturing PMI announced on Tuesday showed the June reading dipped slightly to 50.9 versus 51.0 in May. That was, however, a tad better than the consensus analysts' forecast for a worse slowdown to 50.8. Any relief that might bring was negligible as the official PMI for China's non-manufacturing sector in June reflected a steep deceleration to 53.5, down from 55.2 in May.

Further disappointment came on Thursday as the privately compiled Caixin-Markit China manufacturing sector PMI also eased from 52.0 in May to 51.3 in June. To rub salt to the wound, the June reading was quite off the consensus estimate of 51.9. Total new business expanded at the slowest rate in three months while new export work was broadly stagnant in June.

In my opinion, a key factor for the fall in Chinese stocks that had been overlooked is the increased likelihood that the U.S. could toughen its measures aimed at containing China's rise. This is because Chinese President Xi Jinping doubled down on rhetoric to warn foreign countries that 'bully' China of 'bloody' consequences in a graphic manner and extolled the developments the country has achieved.

Market players likely read in between the lines and reckoned the Biden administration could be compelled to act quicker and firmer to thwart China's economic progress, implicating Chinese equities in the process. In the past week, the representative ETFs of Chinese companies (CQQQ)(FXI)(MCHI) tumbled even as their U.S. counterparts (QQQ)(DIA)(SPY) closed with healthy gains.

The Chinese Internet sector representative ETF, the KraneShares CSI China Internet ETF (KWEB), was worse off than the broader Chinese ETFs, closing down 5.5 percent for the week. Among the key holdings of the KWEB ETF, the share prices of Pinduoduo (PDD), Meituan (MEIT)(OTCPK:MPNGF)(OTCPK:MPNGY), and KE Holdings (BEKE) declined more than the ETF. NetEase (NTES) was not only the odd gainer, it also climbed by a hefty 6.1 percent.

As explained in a past issue of the Chinese Internet Weekly, I found the KWEB ETF holding the most representative stocks in the sector. As such, an overview of the week's share price movements of the top ten holdings of KWEB (as of Friday) as compared with the ETF itself is provided as follows for convenient reference especially for the stocks mentioned in this article.

BABA stock has likely priced in the negatives

There's no denying that Alibaba Group Holding Limited (BABA) has been down in the dumps since its dramatic fall from grace in November. BABA stock is up a mere 2.74 percent in the past year while other tech stocks have been going like gangbusters. Its regulatory woes are well known and the recent management's decision to invest any incremental profits has left investors worried about returns.

However, with the sharp decline, the share price of BABA has pulled far away from the consensus price target of Wall Street analysts, despite the latter having been reduced substantially already since the start of the year. With the yawning gap between the two, the question in investors' minds is whether the stock would recover or the analyst targets would be revised down further.

I have opined last month in Can Alibaba Stock Hit $1,000? What's The Outlook my belief BABA stock can recover and hit fresh highs. This leaves the question of whether analysts would continue to lower their price targets on BABA. For professional analysts, each downgrade typically comes with a downward revision in the financial forecast, rather than simply blaming a change in sentiment.

In the past three months, Alibaba Group Holding's consensus EPS estimate for the fiscal period ending March 2022 and March 2023 has been lowered by 12.3 percent. Compared with six months ago, the reductions are steeper at more than 20 percent for the upcoming two fiscal periods.

Looking further ahead into March 2026, the current consensus EPS estimate is 36 percent lower than six months ago. Unlike the forecasts for the near years 2022-2024, the estimates for 2025-2026 were shaved off more recently, suggesting that the analysts had finally capitulated and lost hope that the reduction EPS growth would be topped up in the later years.

The unrecoverable EPS estimates out until 2026 suggest the analysts believe the heightened antitrust scrutiny is not something ephemeral and has curtailed Alibaba Group's earnings potential permanently. With the EPS estimates chopped by 20-37 percent across the next five years, could we expect further reductions to come?

I think it's unlikely, as the forward price-to-earnings ratio of BABA stock would compress to an incredulous 11.3 times if the share price stays flat for the next five years as the business continues to grow. How much lower can it go? Already, the analysts have reflected the management's guidance for zero profit growth (-0.23 percent) in the consensus forecast for the fiscal period ending March 2022.

Investor sentiment on Alibaba may be turning positive with favorable developments

Meanwhile, prominent cheerleaders of Alibaba have emerged of late. Hong Kong-based Oliver Cox, who co-manages the $1.48 billion JPMorgan (JPM) Pacific Technology Fund, revealed he's buying into China's internet stocks as he shrugged off the "noise" around regulatory tightening by the "very pragmatic" Chinese authorities.

Hyomi Jie, a fund manager at Fidelity International Ltd., suggested the regulatory clampdown could be at the tail's end "as key industry players have agreed on what needs to be done." Meanwhile, the three ARK Invest funds (ARKQ)(ARKX)(ARKF) that hold BABA shares have increased their holdings of the tech giant since mid-June.

The leading fund titans likely have solid ground intel guiding their China investments. They may have realized beforehand that despite the relentless media bashing, Alibaba was the preferred choice of employer among students of business and commerce at mainland Chinese universities for the second year running, according to a recent survey by Stockholm-based employer branding specialist Universum. This ensures that the internet giant continues to have a solid pipeline of young talents to keep the business humming along.

Furthermore, although Alibaba abandoned its exclusivity demand on its sellers, the latter still placed their largest stock on Alibaba's Tmall. According to Protocol, two-thirds of the surveyed businesses considered Tmall their key platform for the 618 mid-year online sales extravaganza, with 40 percent of them expecting more than half of their 618 sales to come from Tmall.

In a clear refute to critics harping on the stale allegation that the Chinese government has been picking on Alibaba, the internet giant is reportedly leading a consortium of investors including the Jiangsu provincial government on a deal to buy a stake in one of China's biggest retailers of appliances, electronics, and other consumer goods.

Once more investors are able to pick up such subtle hints of Alibaba's healthy developments, BABA stock could see clamoring among market players again.

iQIYI is another downtrodden stock with concrete business strengths
iQIYI (IQ) is another Chinese internet stock that is experiencing a large gap between a reduced consensus analyst target and its collapsed share price. Despite a market price rebound from the May trough and a price target that underwent a steep discount last month, there is still a $5.42 upside representing a whopping 36 percent appreciation potential.

Similar to the Alibaba discussion, if the price target for iQIYI continues to be eroded, the fluid price gap is meaningless. However, there are already six downwards revisions in the last three months. Analysts have not been asleep. The headwinds have been considered and possibly factored in. The consensus EPS estimate for the fiscal year ending December 2022 has flipped from a healthy positive number more than two years ago to firmly in the negative.

The revenue estimates for iQIYI have also been watered down, especially for 2023 which is 29 percent lower than six months ago. The video-streaming platform fondly referred to as the Netflix (NFLX) of China is projected to grow a tepid 8.6 percent this year, followed by low double-digits percentage growth in the next two years.

The current gradual revenue growth estimates as compared to the exponential rise in the past suggest the analysts have all but given up regarding iQIYI as a tech-type growth company. The price-to-sales on a forward basis will decline further from an already low 2.36 times to 1.85 times.

You say IQ stock deserves its low valuation - its shows are mediocre with weak viewership. That is, however, far from the truth. iQIYI's original drama Story of Yanxi Palace released in 2018 was the most viewed Chinese drama series for 40 consecutive days during its run, receiving 700 million daily views at one point and eventually becoming the most google drama series of 2018.

I can personally attest to the quality as I found myself binge-watching the entire series in a few days. The popularity was despite the lack of an A-lister cast and the absence of fancy but costly scene-making in the likes of the Fast and Furious series. The show was nearly entirely shot in a palace setting.

In 2019, The Thunder, another iQIYI original realism drama production topped China's national TV ratings ranking for 22 consecutive days upon its release and received a Douban rating of 8.5. Douban is an influential Chinese social media platform known for its movie and TV show reviews. It is the Chinese equivalent of Rotten Tomatoes.

iQIYI bettered the feat last year with The Bad Kids scoring a rating of 9.0 on Douban and becoming the highest-rated drama series produced in mainland China over the 18 months before July 2020. Hashtags related to the drama have appeared on Weibo's (WB) trending topics list 51 times, of which five hashtags have been ranked number one on the list. Weibo is known as the Chinese Twitter (TWTR).

iQIYI has also achieved success in theaters. Its jointly produced movie Break Through The Darkness reached a total box office exceeding 200 million on the ninth day of screening after topping the attendance chart for six consecutive days. The accomplishment is commendable as the show was released on the Labor Day holiday, a highly competitive season when dozens of films were launched.

iQIYI's productions are not just blockbusters. They are also recognized for their quality by the professionals. The company, which prefers to be known as an innovative market-leading online entertainment service in China, won four prizes (content in Chinese) at Digital Media Awards China 2021. iQIYI received the Digital Media Innovator of the Year and Best Digital Marketing Team awards as well as Bronze awards for Best Use of Integration and Education.

iQIYI's contents have also achieved international acclaim. The Bad Kids series mentioned earlier won the "Best Creative" award at the 2nd Asia Contents Awards, the first Chinese TV series to do so, and beating Netflix's huge South Korean hit Crash Landing On You.

The Awards were organized in conjunction with the 2020 Busan International Film Festival held in South Korea on October 25, 2020. Rong Zishan, who was featured in the TV show, won the "Newcomer Actor" award. This was a testament to iQIYI's strength in relying on lower-cost, non-celebrity castings to produce quality blockbusters.

Killing a Superstar, an interactive virtual reality film produced by iQIYI, scored the Best VR Story Award of the Venice VR Expanded category at the prestigious Venice Film Festival, representing the first time an original VR production from mainland China received an award from a major international film festival.

A total of 31 VR productions, including those from the directors of top films such as The Lion King, Iron Man, and Madagascar, were shortlisted in the Venice VR Expanded category. The Venice Film Festival was founded in 1932 and is considered as one of the three major international film festivals in Europe alongside Cannes International Film Festival and Berlin International Film Festival.

Killing a Superstar, winner of Best VR Story Award of the Venice VR Expanded category at the prestigious Venice Film Festival 2020

I have suggested in a previous write-up that shareholders of Chinese companies who want to access the latest updates should venture to the Press Releases or News sections of their websites in Chinese. This is because the English option typically is slower on the updates or may just show a sample of the developments published on the Chinese version.

iQIYI's website is an example case, with 22 pieces of updates in June on the Chinese portal as compared to just one on the English version. The company may yet populate the English website for June, so I looked at May for a fairer assessment. The Chinese version showed 34 news articles for May, versus just two in the English section.

From the Chinese website, investors would be able to see that IQIYI's self-developed Digital Rights Management [DRM] technology won a national patent award (content in Chinese), based on the news posted on June 29. The DRM system has been certified by ChinaDRM Laboratory, the authoritative radio, film and television digital rights organization in China. iQIYI became the first Internet video platform in China to receive this certification.

iQIYI also revealed that it obtained over 4,500 patents as of the end of 2020, with more than 390 of these granted in 2020 alone, ranking it among the top 57 in China. Readers may be puzzled as to why a content-based company like iQIYI would bother about technological innovations.

The reason is that, with all the heavy investments made in creating shows, iQIYI needs to protect its intellectual property rights. Besides DRM, the company said it needed to "deepen the application of multiple core copyright protection technologies, including anti-leech, video fingerprinting, copyright blockchain, and network-wide monitoring."

The move is important as users on popular short video operators in China such as Kuaishou Technology (OTCPK:KUASF)(OTCPK:KSHTY) and ByteDance-owned Douyin (BDNCE), the Chinese version of TikTok, upload copyrighted clips on these platforms, sometimes even without any additional creative inputs. In April, over 70 Chinese film and television show makers and associations demanded short video platforms to immediately remove any of their content that was being used without authorization. The group included iQIYI, Tencent Video (OTCPK:TCEHY)(OTCPK:TCTZF), and Alibaba's Youku.

Being able to identify unauthorized usage of its creations, iQIYI would be able to claim royalties from those infringers. More importantly, it could secure additional income from the legal licensing of contents. iQIYI could also potentially profit from the licensing of its patented copyright protection technologies, opening up another source of income.

A blessing in disguise for iQIYI is that while it is the leading player in the long-form video space, its inability to enact monopolistic practices meant that it would most likely be safe from regulatory scrutiny. However, it could be indirectly impacted as the crackdown on the after-school tutoring industry diminishes one of its key advertising sources significantly.

It is also hampered by societal pushback over unintended outcomes from certain practices it offers its advertisers. For instance, in May, the authorities took issues with fans buying and then discarding contents from bottles of dairy products while retaining the caps. Turns out, the fans had spent large sums of money to procure the bottles in order to obtain the QR codes printed on the inside of the caps that could be scanned to vote for contestants on the highly popular talent show Youth With You 3 that is produced by iQIYI.

With Beijing having ordered the show to be suspended to "rectify the existing problems," it is clear that advertisers would unlikely be able to achieve the same monetary returns as before. Tim Gong Yu, the CEO of iQIYI, said during the Q1 2021 earnings conference call in May that the new guidance forbid viewers to vote through purchasing goods or buying membership plans. Consequently, advertisers could reduce their payments to iQIYI if they are seeing diminished outcomes from their sponsorships.

Nonetheless, as I bring readers back to my poser earlier, it's not that difficult to acknowledge that analysts have low expectations for iQIYI even as the company continues to improve on its businesses. Xianghua Yang, President of Membership and Overseas Business Group at iQIYI, advised during the earnings call that iQIYI's ARPU growth in the first quarter of 2021 on a sequential basis and also on a year-on-year basis to be around 10 percent. Most importantly, he believed "this trend will continue."

iQIYI has continued to entrench its position in the entertainment business and let the results counter short-sellers' allegations against it. We shall see if the company can be a good example of 'what doesn't kills it, make it stronger.'


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