China's Huge Internet Stock Runup: Room to Grow, or Ready to Blow?

Strong results have sent major Chinese internet stocks to all-time highs this year, fueled by investors who increasingly believe the China online story has legs and is consolidating around a handful of major players.

Analysts said the rally, which has seen shares for the country’s top five internet companies jump as much as 76% this year, could be real and not just a bubble. Underlying that logic is revenue and profits that continue to grow by strong double-digit amounts despite the huge size already achieved by names like social networking giant Tencent and e-commerce leader Alibaba, the two biggest players.

Such gains look similar to those seen by Western giants like Facebook and Google, which also continue to grow by healthy amounts despite their large size. But while Facebook and Google are largely stealing advertising and marketing dollars from traditional media companies, the Chinese giants are capitalizing on a similar power play combined with new wealth being created by a local economy that is growing far faster than ones in the West.

“There are some stocks pricing in some great expectations, but on average, it doesn’t ring any alarm bells for me,” said Ryan Roberts, an analyst at MCM Partners, commenting on the recent rally. “The technology sector in China is core to not only economic goals, but also policy. Supporting tailwinds we’ve seen thus far could persist for some time to come.”

The rally has made global superstars out of Alibaba Group Holding Ltd. and Tencent Holdings Ltd., which exemplify the type of bullish sentiment surrounding the group. The pair entered the list of the world’s 10 most valuable companies earlier this year, and have continued an upward march since then. At the latest levels, each is now worth nearly $400 billion, making them the world’s eighth- and ninth-most-valuable companies respectively, according to Bloomberg.

That puts them in a league with such titans as Apple Inc., Google parent Alphabet Inc., Facebook Inc. and Amazon Inc., which are all still ranked ahead. China’s entry to that elite club has been fueled in part by a rally that has seen Alibaba shares rise by 76% this year, while Tencent has jumped by an equally enviable 66%. Other big gainers include No. 2 e-commerce firm JD.com Inc., up 74% since January; No. 2 online-game firm NetEase Corp., up 45%; and leading search engine Baidu Inc., up 38%.

Healthy growth ahead

Quarterly earnings reports that continue to wow investors are a major factor behind the results, say analysts who follow the group.

“If you look at their reports, they all beat expectations,” said Elinor Leung, an analyst at CLSA.

Alibaba has been the star of the show, reporting revenue and operating profit that rose 60% and 86% respectively in this year’s first quarter. Tencent wasn’t far behind, reporting revenue growth of 44% and operating profit growth of 55%. Both companies are expected to report their second quarter results later this month.

Equally important are road maps into the future, as the internet giants try to chart where their money will come from to keep the growth alive. All could face some headwinds on that front as China’s internet and mobile markets become increasingly saturated. The nation already boasts the world’s largest internet user base with 731 million web surfers at the end of last year, a hefty 95% of whom do their web surfing on smartphones. But that breakneck growth is showing signs of slowing, forcing companies to chart clear futures for investors.

“I think (the rally) is mainly in anticipation of solid set of upcoming results, and better visibility into growth drivers,” said Karen Chan, an analyst at midsize research house Jefferies.

Tencent has been in the headlines lately for its hugely popular mobile game “Honour of Kings,” which has done so well that the company pre-emptively took steps to curb playing time among young people to avoid negative publicity and gaming addiction. Baidu has sounded a future focused on artificial intelligence, while Alibaba is pinning its hopes on a global expansion for its core e-commerce business.

The hype has driven valuations to relatively high levels, led again by Alibaba and Tencent, which now trade at price-to-earnings ratios of 66 and 55 respectively, based on earnings forecasts for this year. But MCM’s Roberts pointed out that the multiples come down significantly when calculated based on analyst profit forecasts for 2018, closer to still-high but more-reasonable levels in the mid-30s.

“Broadly speaking, I don’t think valuations are excessive for most of the Chinese technology stocks that we’re tracking,” he said. “When considering the double-digit (profit) growth the companies are expected to deliver, (the multiples) may look less extreme.”

Contact reporter Yang Ge (geyang@caixin.com)