The Chinese Internet Bubble Bursts

Corporate governance issues lead to problems for some Chinese Internet stocks by Bradley Gardner

China’s Internet bubble burst in June， with even the best performing companies dropping over 10%.

Baidu (百度)， China’s largest search engine — and an investor favorite after Google shut down its Chinese mainland search engine last year and began re-directing users to its Hong Kong site — dropped 11.8% between May 18 and June 16. No surprise there as the stock was running at a bubbly price/equity ratio of 95 a few months back. Tencent (騰訊)， which runs China’s largest instant messaging system and a number of related platforms， dropped 11.5% between May 18 and June 17. Alibaba (阿里巴巴)， which is facing considerable domestic pressure due to contract difficulties it is having with Yahoo!， dropped 20.8%. Youku (優(yōu)酷)， China’s largest online video-sharing website， fell a screaming 44% between May 18 and June 16. Internet portal Sina (新浪)， home to the popular micro-blogging site Sina Weibo dropped 25.8% over the same time period.

China’s Internet is one of the more interesting sectors for investors interested in Chinese companies. China currently has more Internet users than any other country in the world， and one of the fastest growth rates of new Internet users. E-commerce penetration is still in the early stages， and foreign Internet companies have had a notoriously hard time in China. The sector also benefits from better media coverage than other big China stories (such as commodities).

So what went wrong? For starters， investors have become much better informed. Also， events in the last six months that have reflected poorly on the Internet sector and Chinese company stocks in general have made investors more cautious.

First there was the massive number of IPOs coming through in China’s Internet sector in a relatively short time. In November 2010 there were 15 Chinese Internet companies listed on American stock exchanges， seven of which were in the online gaming area. Another 15 or so companies announced plans to launch IPOs on US stock exchanges this year.Sky-Mobi (斯凱)， Youku， DangDang (當(dāng)當(dāng))， Mecox Lane (麥考林)， ChinaCache (藍汛)， Renren (人人網(wǎng))， Taomee (淘米網(wǎng)) and Jiayuan (佳緣交友網(wǎng)) all went public in recent months， and many other companies have actively talked about plans for IPOs. Suddenly investors had a plethora of potential places to put their capital.

As investors became more educated on the sector， they realized there was more to know about Chinese Internet companies than just a shorthand comparison to an American company. Youku could not be the Youtube of China as it splits its market share with Tudou (土豆). Renren could not be the Facebook of China when it only had a market share of 7% of the total Internet users， with the rest shared among numerous competitors. Chinese Internet users are notoriously more adventurous than their Western counterparts， with little brand loyalty to keep them from jumping to a competitor that they happen to find interesting， it’s much harder to find Google-like profits if you don’t have Google-like users.

The other issue was continuing revelations concerning large scale fraud among smaller Chinese stocks. The research firm Muddy Waters has made a name for itself exposing reverse-listed Chinese firms (firms which list on stock exchanges through the acquisition of shell companies)， which are engaging in various forms of fraud (see Obizuary in this month’s issue). The research firm has in the past year provided evidence in this direction for Orient Paper (河北省保定市東方造紙有限公司)， RINO International Corporation (大連綠諾環(huán)境工程科技有限公司)， China MediaExpress Holdings (中國高速頻道)， Duoyuan Global Water (多元環(huán)球水務(wù))， and most recently Sino-Forest Corporation (嘉漢林業(yè)國際有限公司). There is ongoing debate over whether all of these companies are engaging in fraud， but the evidence in each case is strong enough to have prompted a massive selloff， while encouraging other research firms to strengthen their due diligence.

The scandal has hit all Chinese stocks. Not because investors believe that major Chinese Internet companies are engaging in fraud， but because investors are realizing that when they buy a Chinese stock， poor transparency means that they often don’t know what they are buying.

The other reason for the selloff in Internet stocks is simply that they were overvalued. As mentioned previously， Baidu was running a P/E of nearly 100 at one point， and still has a P/E of 65. Many of the other big stocks are still running at a P/E over 30， including Alibaba which has been on a generally downward trend since 2009.

The China Internet story is still solid. Now is a good time to research the competitive landscape， while waiting for prices to return to sanity.