A Sick Dragon - An Uncertain Year For China's Tech Investors

by: Adrian Cabanelas

China lowers its target for growth, a rare admission of local economic uncertainties.

Beijing newest batch of measures aims to battle the weaker global economy affecting most tech segments.

With consumer electronics down, infrastructure tech shall bring the most joy to China investors.

The present year is set to be a roller coaster for Chinese investors and technology followers. After the apparent calm achieved when President Donald Trump announced a potential trade agreement between the US and China, the CSI 300 had its best day in 3 years with a 5.6% jump on Monday 25th. Now, the confirmation of a GDP target of 6 to 6.5 per cent by Premier Li Keqiang only reflects the steady deceleration of the Chinese economy.

The current climate of uncertainty has notably affected the tech industry, hit by both US pressures and the end of a consumer electronics growth era. Not only consumer electronics markets have declined, but also commodity tech components such as dynamic random-access memory chips (DRAM), displays or passive components have moved into a downturn cycle.

Although 2019 is likely to continue to see a disappointing demand and volatility across all sectors, some areas will continue to develop and shall benefit from the actions taken by the Chinese government in recent weeks.

Geopolitical risk on the horizon

Beijing posted a 6.6 per cent GDP growth in 2018, the slowest in 28 years. A weaker global economy hit Chinese consumers, and the US-China trade war put a dent on trade exports. While the trade war is far from being over, substantial progress has been made on both sides during the second month of 2019, with US President Donald Trump agreeing to delay imposing further trade tariffs on Chinese goods. China committed to buying up to $1.2 trillion in US goods but remains reluctant to concede to US demands concerning intellectual property rights. It would not be a surprise to see both countries reaching a final agreement, as a trade conflict has proven detrimental for both economies, especially to the less consumerism-centred Chinese one.

Senior officials from three major Chinese institutions announced in early January their intentions to bolster efforts to support economic growth. The three major points, pursuing a flexible monetary policy, cutting tax and fees, and further investing into infrastructure project, propagated a spark of optimism among market participants. The new batch of measures followed the ones introduced in mid-2018 when the Chinese government injected cash into the market through open-market operations, gave funding to support bond issuance by private companies, and allowed the renminbi to weaken.

China personal income tax cuts will boost consumption China personal income tax cuts will boost consumption. Source: FT/Deutsche Bank

The preliminary estimates indicating the scale of Chinese tax cuts could reach 2 trillion renminbi ($295 billion) hit on the spot. Beijing announced a reduction of 3 per cent to the top bracket of the VAT, combined with a 1 per cent cut to the 10 per cent VAT. In total, the VAT cuts are equivalent to as much as 800 billion yuan and are expected to boost corporate earnings.

Current status of China tech

While the aforementioned batch of measures shall have an immediate effect on consumption, the tech market is unlikely to be heavily impacted. A shift on preferences, consumer electronics in decline, the development of newer technology, and the recent regularisation of the gaming industry are among the trends present in the Chinese market, and few areas of the markets are set to perform well.

Tech stocks broke a two-year earnings upcycle in 2018 due to weakness across most sectors of tech demand and falling commodity component prices. The present year is set to see a boost in infrastructure tech, with tech firms aiming to develop the digital infrastructure of the future (cloud computing, 5G, AI, networking, etc.) performing well on the long-term while those focused solely on consumer electronics will see a further discount on their valuations.

China’s logistics industry is gearing up for a significant transformation through the so-called internet of things (IoT) initiatives, with Alibaba (BABA) and JD.com (JD) experimenting on the next way of disruption on the retail sector. This trend is likely to have positive implications for the semiconductor industry, which may turn positive after a bottom cycle in 2H18. If trade concerns disappear, companies that have been cutting orders to deplete inventories may approve capital investment projects, causing a demand pickup for DRAM. Similarly, companies needing foreign supplies to support the increasing adoption of AI in entertainment and education are also linked to the outcome of the trade deal.

Most segments in consumer tech will go down in 2019. Smartphones, TVs and PCs are cooling off due to saturation of the market, and it will not be until 2020 when new consumer electronics categories are meaningful enough. 5G and 3D sensing adoption are the areas to follow.

Projected 5G share of the mobile subscriber base Projected 5G share of the mobile subscriber base. Source: GSM Association

In the automotive industry, electric car sales soared in January 2019 before the incentive phase-out, >50 per cent YoY, while total car sales decreased by 10 per cent during the same period. The industry is growing strong, with Tesla (TSLA) building its Gigafactory 3 in Shanghai, BYD (OTCPK:BYDDY) in control of its critical supply chain and over 400 EV start-ups operating in the country. Furthermore, declines in precious metals price should lower input costs, and help battery makes boost their financial performance.

Source: Electric Vehicle Outlook 2018, BNEF

Finally, gaming companies must adapt to the new regulatory environment adopting a more global approach. On a unique situation is Tencent (OTCPK:TCEHY), that relied 40 per cent of its revenues in games and whose share price fell by a third during 2018. The internet group still has more than 60 games pending approval by the Chinese government and its absence of any list of licenses granted is said to be due to political problems.

Concluding thoughts

2019 is starting with very weak demand trends across most tech areas –most consumer electronics markets are in decline, e-commerce firms are diversifying in the face a decelerating growth and new regulatory environment, and the newer technology still needs time to impact the market. While tech stock valuations are cheap with P/B ratios close to 2015 levels, there is further room for degradation due to disappointing demand and external uncertainties.

Amid negativity, those companies investing in the next wave of disruption and devoting their capital to the long-term development in the infrastructure tech area, –mostly the China digital infrastructure, 5G, EV– will reward the investors keeping their focus on China despite the challenges ahead.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.