After being shuttered for more than a year, China’s Initial Public Offerings (IPOs) window is wide open. Autohome, the Chinese auto website, made its successful debut on the New York Stock Exchange last week, reviving other Chinese Internet stocks that went public in the US some time ago.
But before jumping on the bandwagon, investors should take a close look at the performance of seven popular Chinese Internet companies.
|Company*||12-month performance||5-year Performance|
|E-Commerce China Dangdang E-Commerce China Dangdang Inc.||+100||-5|
|Renren Renren Inc.||-10||-85|
|Youku Tudou Youku Tudou, Inc.||+88||-5|
What haunts Chinese Internet companies?
Two problems, in our opinion. First, excessive competition—a common facet of China’s entrepreneurial sector. “The downside of Chinese entrepreneurship is the vicious cycle of commoditization: its relentless focus on cost reduction highlights the price competition for products and services, which leads to more cost reductions,” writes Edward Tse in TheChina Strategy(New York: Basic Books, 2010). “This has raised questions about the long-run viability of the low-cost strategy.”
Indeed, price competition has taken its toll on operating margins, especially among the companies that have been poor performers over the last five years. Sina’s operating margins, for instance, have shrunk to 0.12%, down from 22.30 % a year and a half ago. Renren’s at -65.44, down from 5.42 (see Table).
|Company*||Operating Margins (as of 9/23/2011)||Operating Margins (as of 12/12/2013|
|Baidu, Inc.||39.30%||52.18 (%)|
|E-Commerce China Dangdang Inc.||-5.93||0.32|
|Youku Tudou, Inc.||-26.39||-20.41|
The second problem is corporate accounting and governance issues—a general problem for Chinese companies. In fact, it was accounting issues that killed the rally of early Chinese IPOs companies— during which Baidu Inc (NASDAQ:BIDU) was up 1000 percent; and Sohu.com (NASDAQ:SOHU and Sina (NASDAQ:SINA) was up 300 percent.
One of the corporate governance issues is a controversial Chinese corporate structure, Variable Interest Entity (VIE). This structure has allowed Chinese companies to list their shares in US Exchanges through “reverse mergers”—a practice that drew the scrutiny of US regulators three years ago, due to a string of accounting irregularities among these companies.
Eventually, VIEs have come under the scrutiny of Chinese regulators, a cause for shuttering the IPO window.
Recently, however, Chinese regulators have approved new IPO guidelines to improve transparency.
Will they work?
We cannot say. What we can say, however, is that investors should be very selective in buying Chinese Internet companies, taking a close look at the business model of each company and its ability to fend-off competition to maintain profit margins.