Article / 31 December 2014 at 7:13 GMT

Top five themes for Chinese equities in 2015

China Watcher / Shanghai
China
  • Alibaba is likely to target southeast Asia and India for expansions
  • Qihoo will have to find a healthy balance between growth and monetization
  • Look for consolidation among e-commerce firms taking part in big sales days

By Neil Flynn

Investors will look back at 2014 with fond memories, with the S&P set to end the year up 13%, and milestones such as Alibaba’s record breaking IPO and the end to the Fed’s quantitative easing program. And 2015 looks set to be a fascinating year for Chinese equities, so I have highlighted the five key themes for investors to look out for.

What’s next on Alibaba’s acquisition and development plan?

After the record breaking IPO of Alibaba, Jack Ma spent the rest of 2014 touring the world to discuss acquisition and investment targets. I expect that this will continue in 2015, but it will become apparent that Alibaba is targeting two key areas: expanding its online retail platforms in Asia, and media investments.


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 Alibaba's experience in promoting its services in both developed and rural areas will give the e-commerce giant a key advantage in targeting the vast Indian market. Photo: Thinkstock


Whilst some investors may be expecting Alibaba to expand in the US, the most likely expansion locations are southeast Asia and India. Alibaba has invested in the Singaporean postal and logistics firm SingPost, which will give the firm access to priority logistics networks across southeast Asia. This is important because the emerging economies of the region have growing middle classes and growing consumption demand, similar to what China has had over the past 20 years.

The region’s proximity to mainland China will also allow for goods in the mainland to be quickly delivered to southeast Asia, through Alibaba’s logistics networks in China and its partnership with SingPost. As China's production and wage costs increase, the 'Made In China' age is coming to an end, and southeast Asia is a much cheaper alternative. Expansion there would also give Alibaba access to cheaper products from the region in order to expand its product base.

India has huge potential for online retailers as the country’s billion plus population is experiencing a rapid growth of its middle class. In this sense it is very similar to China 20 years ago, and given Alibaba’s experience in marketing their services to both the wealthy and poor in developed and rural areas, it would have a clear advantage in India over the likes of Amazon. Alibaba founder Jack Ma has met with SnapDeal management, and it is mooted that the two firms will form a partnership to help Alibaba expand its presence in India’s B2C market.

The Chinese government's continued crackdown on the broadcast of Western media is forcing video sites to consider different ways to host top content. The restrictions on western media has seen content prices skyrocket for Chinese media outlets, and all firms have discussed in their conference calls that it simply isn’t sustainable. So firms have begun to produce their own content in order to reduce costs.

Jack Ma has been actively acquiring the content rights to Western media in order to avoid the rising content costs, and also to be able to produce Chinese versions of Western shows. This format of television show has proved wildly popular, with the Chinese versions of The Voice and American Idol being two of the most popular shows in China. So I expect that during 2015, Alibaba will acquire more content and media firms in order to generate stronger advertising revenues through its Youku Tudou video platform subsidiary.

As Qihoo monetises its user base, will Zhou's ethos pay off?

Qihoo’s CEO Zhou Hongyi has built his firm on the ethos that it is integral to firstly build a user base by offering quality products for free. This will not only see the user base grow quickly, but also the users will be much more loyal. In time, monetization can be worked out, but not at the expense of affecting the user experience.

This ethos is all very admirable and original, and in a perfect world it would be the optimal strategy. However, Qihoo is a public company, and because its rivals have been rather quick to monetize every aspect of their operations, shareholders’ patience can only wear so thin.

Qihoo is set to monetize its mobile operations in 2015, and continue to monetize its PC business. But despite its unwillingness to monetize too soon, the firm actually has a healthy net margin, which has been showing signs of improvement throughout 2014.


Qihoo monetized its PC business in 2014 and saw healthy net margin growth

Qihoo's Growing Net Margin















Source: Qihoo  

To illustrate the scope of Qihoo’s monetization potential, in the third quarter Qihoo had a search engine market share of 2.9% in terms of revenues, and 30% in terms of user traffic. Whilst this should be seen as positive, it isn’t new information. Qihoo’s share price had a strong rally until the summer, which saw the firm trading at almost twice the price of its current level. But investor patience for potential has its limits, and both myself and other analysts have noted that investors seem to be waiting for signs that this potential is beginning to be realized.

This month I have discussed Qihoo’s two most recent developments: its partnership with smartphone manufacturer Coolpad, and its new Wi-Fi/3G/4G free voice-calling app. These will likely boost the firm’s mobile user base, but to play devil’s advocate to my previous reports, shareholders may be concerned that Qihoo already has a large user base that isn’t being monetized, so it doesn’t need more.

The key for Qihoo in 2015 is to find a healthy balance between growing its mobile user base and increasing its monetization rate, so that the firm can actually start to fulfill its large potential.

Can Jumei recover from its disastrous second half?

Jumei is one of those unusual cases of a firm that has a strong business model, with the best anti-counterfeit program in an industry plagued by fake products, but it has been managed so poorly. For those unfamiliar with Jumei, let me explain.

Jumei is an online cosmetics retailer in China that has two separate retail platforms. The first of which, called Merchandise, sells products that Jumei gets directly from manufacturers, so that consumers can be assured that the cosmetics are authentic. It has been growing the number of brands that were exclusive to Jumei. The second platform, called Marketplace, sells products sourced from third party merchants, so product authenticity can’t be guaranteed. Nevertheless, to mitigate this risk, Jumei set up an industry wide anti-counterfeit program, which uses a unique barcode tracking system so that consumers can check to see where the product has come from, and hence guarantee its authenticity.

In addition, the firm performs tests on a growing number of products on both platforms, and publishes the results every month. The reason for this strong stance against fake goods is because counterfeit cosmetics are much more harmful to consumers than a counterfeit pair of shoes, due to detrimental health effects. This anti-counterfeit stance is used heavily throughout the site as a marketing promotion, and the firm has been the go-to site for cosmetics.

However, it all started to go wrong when a report surfaced in July stating that a third party merchant had been selling fake designer bags and watches on Jumei and JD.com. Without informing shareholders, Jumei decided to decrease its Marketplace platform from 30% of gross merchandise volume (GMV) to just 2% within the space of six weeks, in order to minimize the possibility of fake products being sold through the site. Naturally, if the source of 28% of GMV is removed, revenue and income are hurt, and Jumei’s third quarter results showed much lower growth than before. As a result, lawsuits mounted against the firm, and they are expected to reach the courts in February. If this strategy had been implemented over a much longer period, shareholders would likely have been glad, but making the change to the business model in such a short space of time has been a large overreaction to the July report.

Jumei’s share price closed last night at $13.74, which is lower than its May IPO price of $27.25, and its August high of $37.99, but further risk factors lie ahead in the first few months of 2015. February is set to be an important month for the firm, because in addition to the lawsuits, the firm will release its fourth quarter results, which will answer these two key questions. Firstly, because the strategic shift ended at the start of the fourth quarter, investors will be looking to see how Jumei’s new business model compares to its previous business model. Secondly, the slowdown in growth has seen VIPshop close on Jumei’s leading cosmetics retailer crown through its LeFeng subsidiary, so investors will be waiting for both firms to report earnings to see if VIPshop has overtaken Jumei. If investors are disappointed in regard to both of these issues, it will likely be very difficult for Jumei to return to the heights that it enjoyed in the first half of 2014.

How will rise in sales events affect oline retailers?

Ahead of the 12.12 online shopping event that Alibaba created, I pondered whether the success of the 11.11 (November 11 Singles' Day) and 12.12 (December 12) events would see future events on January 1, February 2, etc. So true to form, China’s online retailers are preparing for the big sales event on January 1 following their big Christmas sales events, and shareholders may begin to question the effect on revenues if these firms are frequently offering big discounts.

One of the main aims of these sales events is to boost market share. If a firm offers the best discounts and the quickest delivery, then it stands to take customers away from rival sites. The biggest rivalry is between JD.com and Alibaba, which aren’t subtle about attacking each other. During the 12.12 event, Alibaba’s Tmall app featured the slogan “It’s really cheap. If we’re lying, we’re a dog” (真心便宜不然是狗) in reference to JD.com’s logo being a dog.

JD.com countered this with the slogan “Reject fake goods, don’t play with this trick” (拒绝假货不玩猫腻), where the first character in the Chinese word for trick 猫腻 means cat, in reference to Tmall’s logo being a cat. 


Alibaba, left, and JD.com attacked each other over 12.12

Alibaba And JD.com's 12.12 Slogans

























Source: Alibaba and JD.com      

Online retailers tend to offer the same goods, which means that brand loyalty isn’t particularly high. So firms have to offer the best prices and quickest delivery. It seems that the larger online retailers are happy to see a reduction in revenue due to frequent sales events in order to boost market share.

However smaller online retailers that lack the financial strength of Alibaba and JD.com that feel forced to participate will not only find it difficult to offer such low prices, but be unable to invest in infrastructure network or warehousing facilities. I expect that during 2015 we will start to see consolidation in the market after several years of such rapid growth, where the larger firms begin to crowd the smaller firms out of the market. 

Will China’s solar power drive outweigh US tariffs?

China’s big three solar firms – JinkoSolar, Trina Solar and Yingli Green Energy – have enjoyed strong sales both domestically and overseas. But a recent decision by the US Department of Commerce to impose higher tariffs on Chinese assembled solar panels will likely force these firms to alter their international strategy. Yingli Green Energy is currently subject to a combined anti dumping (AD) and countervailing duty (CVD) rate of 29.18%. When the new tariffs are imposed, the firm will be subject to an AD tariff of 52.13% and a CVD tariff of 38.72%.

The US has traditionally been the biggest market for Chinese solar energy firms, but over the past few quarters, the percentage of revenue from the US has decreased as firms focus on projects in Europe, particularly the UK, and the Middle East.

However, whilst I would expect revenues from the US to decrease, Chinese solar power firms may find joy in their domestic market. China has seen a huge growth in its photovoltaic capacity over the past few years, rising from 100 MW in 2007 to 18.3 GW by the end of 2013, with another 13 GW expected to have been added in 2014. The European Photovoltaic Industry Association projects that China’s total installed capacity could grow to between 47 GW and 66 GW, meaning that capacity could double between now and 2017. The government’s National Development and Reform Commission has placed heavy focus on the nation’s solar energy because air pollution is a major problem, particularly in areas away from the east coast.

With the scope of solar energy growth that China is set to experience over the next few years, I expect that China’s solar energy firms will readjust their revenue sources away from the US towards China.

– Edited by Robert Ryan

Neil Flynn is head equity analyst at Chinese Investors. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.

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