China's Tech Giants Aren't So Hot This Earnings Season

(Bloomberg Gadfly) -- This time last year -- heading into March quarter earnings season -- Baidu Inc. was the dunce of the China internet party and its three closest competitors were clear winners.

Shares of Alibaba Group Holding Ltd. and Tencent Holdings Ltd. were both up more than 25 percent for the year to date and JD.com Inc. was the belle of the ball with a gain of almost 34 percent. Baidu was the token guest with an advance of just 7 percent.

Driving these stocks was a sense of invincibility and optimism. They were riding high on China’s growing consumer spending with very little standing in their way. Things were so good that even JD.com was about to announce its first quarterly profit.

By year’s end, Tencent shares had doubled and a second-half boost saw even Baidu finish up 42 percent.

This year investors are far less sanguine. JD.com returned to losses, and cracks have started to appear in the armor of both Alibaba and Tencent. Baidu’s turnaround story continues, but investors are yet to be convinced. That’s led to declines across the board, with JD.com the biggest loser and Baidu the relative outperformer.

A month ago, when Tencent’s stock was bubbling near record highs, I warned of margin pressure at the operating level. Tencent boosted operating income by bundling in one-time gains, which I think it shouldn’t. The stock has since dropped 15 percent although there’s a dearth of sell-side analysts brave enough to blow the whistle on this structural change, one which calls into question economies of scale for its business model.

I have similar concerns about Alibaba. The company’s R&D budget continues to fall while its marketing spending skyrocketed in the December quarter. That’s a sign founders Jack Ma and Joe Tsai are desperate to pump web users through its internet machine and Alibaba needs to pony up more money to make that happen. Technology is secondary. And lest we forget, Alibaba is a content company -- making money from ads -- not an e-commerce firm built on commissions from transactions.

As for Baidu and JD.com, well they're both still searching for business models that will bring long-term stable growth. 

If you look at long-term price-earnings trends, this recent share-price decline doesn’t make them seem undervalued. In fact, it appears investors have knocked these stocks back a few pegs but aren't yet ready to desert them entirely. Capital Research & Management Co. is a good example. It trimmed the Alibaba stake in its Growth Fund of America by 15 percent by the end of March, but still held more than 6.2 million shares, according to data compiled by Bloomberg.

As China’s internet giants report earnings, investors should watch closely to see if any more cracks appear or whether management has found a way to patch holes in their business models.

Tim Culpan is a technology columnist for Bloomberg Gadfly. He previously covered technology for Bloomberg News.

  1. I'm using Tencent's U.S.-listed ADRs.

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