Increased regulation of Chinese technology companies is something that has been taking place for a while. Tencent went through a similar regulatory scare in 2018 around its gaming business where new game approvals were halted for months while regulators imposed new rules on game content, targeting of young gamers and excessive time spent gaming by children. More recently there has been a focus on stamping out anticompetitive behaviour, protecting against reckless lending and protection of data.
This wave of regulation has resulted in the cancellation of the high-profile fintech IPO of ANT Group services, the dramatic fall in ride services company Didi just days after listing (see chart below), the levelling of large fines to some companies for abusing dominant market positions, and requiring others to open up platforms to competitors. Uncertainty around these new regulations has caused Tencent to gradually underperform since reaching a new all time high in February this year.
This current selloff has been sparked by new regulations published over the weekend targeting the education tech sector. The introduced regulations will require the following:
- Companies teaching school curriculums must be non profit
- Such institutions are banned from pursuing IPOs
- Banning of foreign ownership
- Banning of holiday tutoring
- Banning online tutoring for children under six years of age
- Banning of foreign teachers
The impact of these regulations essentially draws a line through a $100 billion market cap industry and we believe it is the dramatic impact of these regulations that have spooked investors in almost all Chinese tech stocks.
Further pressure on the stocks following new rules affecting the food delivery sector which were published on Monday afternoon and require drivers to earn at least the country’s minimum wage, protecting drivers from unreasonable demands placed on them by algorithms, and requiring that these workers have access to social security and are placed in a union. Meituan, one of the largest Chinese stocks in the sector, closed down 30% from its Friday close.
Tencent has responded by temporarily halting registrations to its messaging platform WeChat, so that it can implement security upgrades by early August.
While investors might fear that China may be wanting to end its internet sector, our view is this wave of regulation is aimed at stamping out exploitative behaviour and protecting Chinese national interests. To be clear the education sector has been guilty of creating some negative social consequences by pushing up tutoring prices, thereby exploiting the pressure on Chinese parents to ensure their children “get ahead”. This doesn’t mean however that all technology is viewed as negative in China. Chinese state media has recently quoted the often claimed “four great modern inventions of China” (ecommerce, mobile payments, high speed rail and bike sharing) as a modern echo of the historically claimed four great inventions of paper, gunpowder, printing and the compass. We do not believe that China wants to destroy all consumer-facing tech companies but rather that the government is putting in place regulations to 1) not undermine its national strategic objectives and 2) create sustainable economic growth and not chase capital gains at all cost. The result is a set of regulations that protects its citizens better and protects China’s nationalist agenda.
There is also some concern about VIE’s (Variable Interest Entities) which are the vehicles by which foreign investors have gained access to mainland Chinese stocks. VIE’s do not own the operating assets of the companies but have a profit share agreement with the domestic company that owns the operating assets. These vehicles have been tacitly sanctioned for many years by the Chinese authorities but some are concerned that may be about to change. This is not our base case given the 1.5tn USD of market cap listed using these vehicles which would make this a serious global event if they were disallowed, likely to cut China off from the global financial community (potentially via sanctions etc.) but nonetheless, it may also be contributing to some of the anxiety in markets.
In conclusion, the speed and the extent of the regulations of the Chinese education sector, as well as the fact that additional regulation is expected, will likely continue to weigh on the Tencent share price and hence Naspers/Prosus, but in our view the Tencent ecosystem and business model is intact and the current valuation presents an attractive level for sound returns in the longer term.
