Chinese Internet Stocks Relief Rallied But Watch That Dreaded VIE


  • With Chinese internet stocks rebounding, cries of “I should have bought the dip!” and the question of “have they really bottomed?” asked out loud were heard across the world.
  • I discuss several positive developments neglected by the mainstream media, including Tencent seeing little revenue impact from the restrictions on children’s playtime.
  • We look into the curious case of Pinduoduo’s massive ‘donation’ which has instead been cheered by shareholders sending the stock soaring.
  • BABA stock closed the week positive, even mildly so, amid a barrage of negative press surrounding the company should probably be considered remarkable. I will elaborate on this.
  • Last but not least, I delve deep into the risks surrounding the VIE structure adopted by the Chinese ADRs.

After a few tumultuous weeks, many Chinese internet stocks received the long-overdue relief rally shareholders have been waiting for. Cries of “I should have bought the dip!” and the question of “have they really bottomed?” asked out loud were heard across the world.

In the past week, the representative ETFs of Chinese companies (CQQQ)(FXI)(MCHI) outperformed their respective U.S. counterparts (QQQ)(DIA)(SPY) by far, albeit from an oversold position. The Invesco China Technology ETF which is heavy on internet firms like Tencent Holdings (OTCPK:TCEHY)(OTCPK:TCTZF), Meituan (MEIT)(OTCPK:MPNGF)(OTCPK:MPNGY), Baidu (BIDU), and Bilibili (BILI), soared 6.8 percent.

Mainland Chinese were happily lapping up the Hong Kong-listed shares of Tencent via the Southbound Stock Connect program last week. On Monday, the value of the buy trades surpassed the sell trades by nearly three times. Ironically, TCEHY stock rose by only 5.2 percent for the week, way behind Meituan’s 13.4 percent, even though the latter was much less favored by Mainland Chinese, with its sell trades exceeding that of the buy trades, the reverse scenario of Tencent.

Data as of August 23, 2021 (Monday)

The Chinese Internet sector representative ETF, the KraneShares CSI China Internet ETF (KWEB), bounced back with a vengeance, closing up 9.6 percent for the week. Among the key holdings of the KWEB ETF, the share prices of e-commerce players and Pinduoduo jumped 20.1 percent and 22.4 percent respectively. The duo reported second-quarter results that surprised on the upside.

The dismal performance of Alibaba Group Holding among the top holdings of the KWEB ETF is making it stick out like a sore thumb. Nonetheless, closing the week positive, even mildly so, amid a barrage of negative press surrounding the company should probably be considered remarkable. More on this topic in the subsequent section.

As explained in a past issue of the Chinese Internet Weekly, I found the KWEB ETF holding the most representative stocks in the sector. As such, an overview of the week’s share price movements of the top ten holdings of KWEB (as of Friday) as compared with the ETF itself is provided as follows for convenient reference especially for the stocks mentioned in this article.

The bad news has been played up while the good developments were buried

I am often accused of downplaying the negatives facing the Chinese internet stocks. That is exasperating, as a key motivation for my writing is to offer a critique to bearish takes on the sector, especially the frivolous ones. For instance, various media outlets picked up a local article labeling digital games as “spiritual opium” and called for more restrictions on children’s playtime.

The shares of gaming giants Tencent and NetEase tanked following the news as if they would lose substantial revenues from curtailing gameplay from the kids. That’s far from the truth. James Mitchell, Chief Strategy Officer of Tencent, revealed during the earnings conference call that in the second quarter, under 16-year olds accounted for only 2.6 percent of the company’s China game grossing receipts, and under 12-year olds accounted for a mere 0.3 percent.

Thus, even if Tencent restricts under 12-year olds from playing games altogether, its revenue would hardly be dented. Why then, do we not read headlines screaming along the line “Tencent sees little revenue impact from restricting children’s play time”? Why am I considered a Panglossian for simply highlighting a fact neglected by the mainstream media?

I believe readers would also easily recall that ARK Investment dumped its Chinese holdings across its ETFs in the past weeks as Cathie Wood declared the regulatory crackdown in China as damaging for valuations. This is because of the wide coverage in the press on her justification.

Last week, although ARK Invest added back some Chinese stocks, the write-ups on this development were relatively less prevalent, as a cursory look at the search results on Google News showed. Similarly, the statement by Masayoshi Son, the chief executive officer of SoftBank (OTCPK:SFTBY)(OTCPK:SFTBF), that he would put a pause to investing in China until “the situation is clearer” was well-publicized in the media. However, SoftBank’s investment in Chinese driverless delivery van start-up Neolix just a few days later received less attention.

On Sunday, reports surfaced regarding the Chinese anti-graft watchdog investigating the party head of Hangzhou. Several media outlets chose to use “Alibaba’s Home City” or similar in the headlines on this development which some readers pointed out as insinuating an association with the e-commerce and cloud giant.

Ant Group, the financial technology unit of Alibaba Group, promptly released a statement denying online rumors that claimed the senior Hangzhou government official in question bought shares of the company during its IPO exercise. It also denied engaging the lawyer firms or lawyers mentioned in the rumors.

Earlier this month, words spread that Zhang Lei, the founder of Hillhouse Capital was about to face punishment by border control authorities in China. The prominent Chinese private equity giant refuted the reports and referred the case to the police. The malicious fabrication was ostensibly to spook an already jittery market perhaps for the benefit of short-sellers or investors looking to buy the shares at lower prices.

Interestingly, in a sign that market players had enough of negative connotations on Chinese internet stocks with every political move, BABA stock closed positive on Monday and went on to do the same for Tuesday. Investors apparently did not get swayed by additional negative reports, particularly the frivolous ones, in a reversal of the ‘sell first, ask questions later’ mode a few weeks ago.

The curious case of Pinduoduo’s ‘donation’

Pinduoduo announced on Tuesday a massive quarterly revenue growth where sales more than double year-on-year to $3.57 billion. However, the impressive feat missed the consensus expectation by $520 million, a development typically regarded as a cardinal sin for growth stocks. Furthermore, the increase in its average monthly active users [MAUs] was lower than the consensus estimates by 20.7 million.

What probably saved the stock from a sell-off was perhaps Pinduoduo posting its first-ever quarterly net profit as a public company. My article last year Pinduoduo: A Reversal From Colossal Losses Could Be Forthcoming saw many skeptical comments but the largest e-commerce company by MAUs delivered right on cue.

Intriguing, investors shrugged off the revelation by Pinduoduo that it would launch a dedicated “10 Billion Agriculture Initiative” to face and address critical needs in the agricultural sector and rural areas. Profits from the second quarter and any potential profits in future quarters would be allocated to the development of agriculture until it has given away a total of 10 billion yuan (US$1.5 billion).

This commitment by Pinduoduo is more aggressive than Alibaba which said it would only target incremental profits and that is for investing back into its business. Sure, Pinduoduo is increasingly relying on agricultural produce to juice its revenue growth, and developing the sector would benefit its business.

How much its spending would trickle back to the company is unknown at this point, however. In any case, readers of my previous article China Regulatory Shock – What’s Next For Internet Stocks should not be surprised by Pinduoduo’s move. I opined that large companies like Alibaba would be careful about making too much profit in the coming few quarters.

Analysts have duly revised their EPS estimates downwards in response to the tough regulatory environment and the management’s declaration to invest incremental profits back into the business for the current fiscal year. However, I’m afraid Wall Street is too optimistic that the whole episode would blow away by next year.

The 25.6 percent growth in the consensus EPS estimate for the next fiscal year means an additional $6.8 billion in net income for Alibaba Group. That figure is likely too ostentatious to announce without incurring a reaction from the authorities striving to placate the population coping with inflation. Therefore, I anticipate that Alibaba executives would take pains to reiterate their investment of additional profitability and express the undertaking of this course of action over a longer period.

Pinduoduo probably took it a bit too far though but shareholders didn’t seem to mind at all and even cheered the move, judging by the share price jump post-announcement. Perhaps they believe that the management is doing exactly the right thing and are thus more assured of its prospects over the long term.

But, but, but what about the VIE structure?

No matter what positive developments occur at Chinese internet companies, many readers continued to flag the risk of the Variable Interest Entity [VIE] structure adopted by these firms and made multiple requests for my take on this dreaded topic. It is an evergreen issue that cries out for attention when the affected stocks are flying high and especially so when they are in the dumpsters like what we have experienced in the past weeks.

I believe most raised the VIE risk for altruistic reasons, to warn investors who were hitherto unaware of the structure. However, I cannot rule out there were some who were intentionally fearmongering in an attempt to cause share price weakness in American Depositary Receipts [ADRs]. They could potentially be profiting from short positions, hoping to buy the stocks at lower prices, or simply against the notion of investors supplying capital to China, as several commentators had openly declared.

Without knowing the true motive, I generally ignored such invitations to elaborate or provided only short replies, particularly as I had previously assessed the risk to be low. Nevertheless, I think now is the time to seriously reconsider my assumptions regarding the VIE structure.

The Chinese internet sector has sunk into deep pessimism as a result of a series of Beijing’s regulatory crackdowns and abrupt policy interventions. It is thus fair to evaluate now whether the Chinese government would, after choosing to largely turn a blind eye to the VIE structure, decide it is time to stop recognizing this loophole used by certain companies to list overseas.

First, let’s understand why U.S.-listed Chinese firms have to structure themselves into such VIEs. Under Chinese law, full or even partial foreign ownership in most industries in China is prohibited. Thanks to President Trump and his vocal indignation with the addictive short-video app TikTok, which is operated by Chinese-owned ByteDance (BDNCE), we are aware of the importance of keeping user data within the country’s borders.

Putting ourselves in their shoes, it is easy to appreciate why China wants to limit foreign shareholding (and control) in companies like Alibaba, Tencent, and JD which are super rich in data and continue to generate loads more every day. Companies in education, telecommunications, and media are particularly sensitive too. At the same time, these fast-growing but cash-guzzling businesses need funds and the U.S. is the ideal location thanks to its highly developed capital market.

Enter the VIEs (not a Chinese invention, by the way!). How each company chooses to structure the entities can be rather different from another. Nonetheless, the basic concept is the same.

Taking Alibaba as an example, the Chinese headquarter set up a ‘shadow’ Alibaba in the form of a Cayman Islands shell company. The duo then forms various agreements such that the latter, which is the vehicle for listing outside of China, has a claim on the profits derived by the Chinese operations.

Second, why has Beijing been tolerating this circumvention of its intention to keep foreign influence away from these companies? Well, there isn’t anyone sitting in the office of the Cayman Islands shell company that has direct control over the actual Chinese operations to challenge the authorities.

As such, why should Beijing worry? Unfortunately, the TikTok debacle has ostensibly spooked the Chinese authorities into thinking there is a risk Beijing is unable to manage the companies right under its nose. A substantial stake chunk of TikTok was almost sold to U.S. companies as demanded by President Trump whose audacity to extract a ‘commission’ for the deal must have irked the Communist Party of China [CPC] badly.

Yet, the recent regulatory actions on DiDi Global (DIDI), Full Truck Alliance (YMM), and Kanzhun Limited (BZ) demonstrated to the Chinese government that it retained full jurisdiction despite these companies being listed overseas. As such, I doubt Beijing needs to activate the nuclear option of declaring the non-recognition of all these VIEs and thereby rendering the right-to-the-profits contracts invalid.

Like the long-standing U.S. stance of ‘strategic ambiguity’ toward the security issue in the Taiwan Straits, I believe China will not want to fully show its cards on VIEs either. This means that whether Beijing will eventually rock the boat and declare all the VIEs illegal will remain a big question for investors for the foreseeable future.

Nevertheless, there are indications that the Chinese government is not opposed to the VIE structure and is even going to confer future IPO aspirants listing outside of China some legitimacy. China’s securities regulator was reportedly in early July setting up a team to review plans by Chinese companies seeking to list offshore.

Specifically, the China Securities Regulatory Commission’s (CSRC) team would scrutinize companies seeking to list abroad using the VIE structure. Chinese companies looking to conduct IPO overseas will also need approval from the relevant ministry. This implies that once the official go-ahead is given, there is an implicit green-lighting of the VIEs used in the applications.

With the ongoing bad press and poor market sentiment, China’s top cybersecurity brass deemed it fit to reassure investors at a government press conference last Tuesday that a new regulation designed to protect the nation’s “critical information infrastructure” was not targeted at foreign businesses or intended to curtail overseas listings.

Officials from four government bodies – the Cyberspace Administration of China [CAC], the Public Security Bureau, the Ministry of Industry and Information Technology, and the Ministry of Justice clarified that a company’s operations wouldn’t be impacted by the regulation as long as it met the two conditions of complying with state laws and ensuring the security of critical information infrastructure and personal information. These requirements appear reasonable to me.

During the event, CAC deputy head Sheng Ronghua stated that “for a long period of time, we have been supporting internet companies to raise funds in accordance with laws and regulations.” Since the only manner the internet companies could have raised funds overseas was via VIEs, Sheng’s declaration signaled that China has never been against such corporate structure and the relevant authorities have even facilitated the listings.

Should investors be concerned about VIEs?

As long as Beijing adopts the ‘strategic ambiguity’ stance toward Chinese companies using the VIE structure, there will be lingering uncertainty whether the authorities will one day hit on the red nuclear button as elaborated earlier. Hence, the short answer to the question in the sub-header is an unequivocal YES.

However, aren’t readers here to seek alpha and not looking for ‘Sleep Well At Night’ SWAN picks? There is a saying you can’t have your cake and eat it too. If things are as clear as day, would the valuations of the Chinese internet stocks be as low as today?

Investors were shocked by the eleventh-hour suspension of Ant Group IPO in November. Subsequent regulatory clampdowns and penalties meted out spooked market players as well. We also have the passing of the Holding Foreign Companies Accountable Act [HFCAA] in December 2020. These are highly discouraging events for investors who are thinking about holding Chinese stocks.

Yet, according to a study by Goldman, around a third of the funds it surveyed had an investment in foreign-listed shares of Chinese companies at the end of June. This was the highest level the investment bank had ever measured. With the media hype on the U.S.-China tensions and the VIE risk, it is disingenuous to suggest that perhaps some or most of these professional investment firms do not even know about the VIEs and the risks surrounding the structure. Hence, it’s more likely the fund managers assessed the risks to be not as consequential as critics made them out to be.

Taking a leaf from Cathie Wood, shareholders of dual-listed Chinese companies like Alibaba Group and JD may be comforted that the ETFs of ARK Investment have been buying the ADRs (yes, she’s back!) rather than the Hong Kong-listed shares. The ETF managers have the means and resources to easily execute trades over the Hong Kong exchange but are choosing not to.

Taking Wednesday’s trade as an example, the ARK Innovation Fintech ETF (ARKF) bought TCEHY, PDD, and JD. On the same day, the Hong Kong-listed shares of Yeahka Ltd. (9923.HK), Zhongan Online P&C Insurance Co. Ltd. (6060.HK), and Meituan (3690.HK) were sold.

What are US-listed Chinese companies saying regarding VIEs recently?

I pored through numerous recent transcripts and quote a few management takes on the VIE issue here (emphasis mine):

“So far as we’re aware, there have been no recent developments regarding VIEs.” – Dan Newman, Chief Financial Officer, GDS Holdings Limited (GDS), Q2 2021 results earnings conference call

“[W]e’ve disclosed to all of our VIE structures and risks, obviously in the 20-F, as is the case with many of our peers. At this point in time, we have not seen any new laws, regulations from the PRC government since that time. And so, before any new laws are actually adopted, the VIE structures remains valid. And so, obviously we will, along with the rest of the market, keep a very close eye. There have been a number of instances also where I think many of the banks have heard word from CSRC and some other government bodies as to their support for companies to list at the place of their choice. And so, I think that would then also go to an overall positive view on this issue.” – Tim Chen, Chief Financial Officer, 21Vianet Group (VNET), Q2 2021 results earnings conference call

“So there were some reports and some press reports that VIE’s would have to obtain special approvals and the like. And it’s really nothing of the kind. That is rather erroneous reporting in that respect. Insofar as VIE is concerned, overall, I mean, as you [are] well aware, VIEs have been around for a long time. I mean, it’s over 20 years, right now. They’re very widely used, and they have worked well during that time. It’s fully understood by the Chinese authorities.

And as you know, anytime there is a listing that is required, as an example, the approvals of the authorities and the Chinese regulatory authorities are required for that. So they’ve worked well during this time and we’d see no reason for this to change.” – Charles Searle, CEO Internet Listed Assets, Prosus N.V. (OTCPK:PROSY)(OTCPK:PROSF), Q2 2021 results earnings conference call

While to some extent we could say the executives were talking their own books but I believe they had to be careful about what they say because of the legal implications. Their statements might hold them personally liable in class action lawsuits that could be launched.

I also looked at several Form F-1 registration statements submitted in recent months, honing in on the section mentioning “Risks in relation to the VIE structure”. While lengthy even for a mere extract of the full disclosure, I suppose it is important to provide the text here lest I get accused of glossing over the risks (using LinkDoc’s disclosure as the only example to avoid being repetitious):

If the Company’s corporate structure and contractual arrangements are deemed by any governmental authority to be illegal, either in whole or in part, the Company may lose control of the consolidated VIEs and has to modify such structure to comply with regulatory requirements. Further, if Company’s corporate structure and contractual arrangements are found to be in violation of any existing or future PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such violations, including without limitation:

  • revoking the business licenses and/or operating licenses of the Company;
  • imposing fines on the VIEs;
  • confiscating any of the VIEs’ income that they deem to be obtained through illegal operations;
  • discontinuing or placing restrictions or onerous conditions on the operations of the VIEs;
  • placing restrictions on the Company’s right to collect revenues;
  • shutting down the VIEs’ servers or blocking their app or websites;
  • restricting or prohibiting the Company’s use of the proceeds from overseas offering to finance its PRC consolidated VIEs’ business and operations;
  • requiring the Company to restructure ownership structure or operations;
  • or taking other regulatory or enforcement actions that could be harmful to the business.

Now, although as I said the entire section on the VIE structure risks is much longer than the above extract, it is noteworthy what the companies are putting themselves on the line regarding the whole issue (emphasis mine):

“It is possible that the Group’s operation of certain businesses through the VIEs could be found by PRC authorities to be in violation of PRC law and regulations prohibiting or restricting foreign ownership of companies that engage in such operations and businesses. The Company’s management considers the possibility of such a finding by PRC regulatory authorities under current PRC law and regulations to be remote.” – Daojia Limited (JIA) Form F-1

“The Company believes that the contractual arrangements amongst the WFOEs, the VIEs and their respective shareholders are in compliance with the PRC law and are legally enforceable. The shareholders of the VIEs are also shareholders or affiliates of shareholders of the Company and therefore have no current interest in seeking to act contrary to the contractual arrangements.” – Full Truck Alliance Co. Ltd. (YMM) Form F-1

“In the opinion of management, based on the legal opinion obtained from the Company’s PRC legal counsel, the contractual arrangements described below are valid, binding and enforceable upon each party to such arrangements in accordance with its terms and applicable PRC laws currently in effect. … In the opinion of management, the likelihood of deconsolidation of the VIEs is remote based on current facts and circumstances.” – LinkDoc Technology Limited (LDOC) Form F-1

Investor Takeaway

Increased commentaries emphasizing the VIE risks with the Chinese internet stocks in a depressed state is like giving the fallen another heavy kick. There is plenty to worry about the Chinese ADRs but hopefully, I have provided more clarity regarding the VIE issue in this update.

To be sure, Chinese internet stocks are not ‘Sleep Well At Night’ SWAN picks. However, for readers on Seeking Alpha, I suppose you are here for the purpose as the name of this site suggests. Otherwise, it would be prudent to skip such stocks. I am not aware of any guaranteed method of securing alpha without a commensurate level of risks.

As I have presented in the earlier sections, the risks related to the VIE structure are real but probably among the least of mounting concerns facing the Chinese internet sector. There’s much talk about China possibly declaring the VIEs illegal but no one has offered a convincing answer to why the CPC will cut off its nose to spite the face.

I was more concerned that the barrage of negative press and institutional investors reducing their Chinese holdings would depress valuations for a long time, hurting shareholders with opportunity costs. However, I may be unduly worried. Professional fund managers may have begun to think about whether the China regulatory risks are overstated.

Furthermore, funds that have sold out of Chinese stocks are sitting on the sidelines and wondering if they should get back in, lest they miss out on a rebound and underperform their peers, losing clients in the process. After all, the ‘stock goddess’ Cathie Wood has reversed her cautious stance in less than a month and has dipped her toes back into Chinese internet companies.

As a recent The Economist article pointed out, the global economic clout of the U.S. is “diminishing fast” with an overwhelming majority of countries in the world having switched the U.S. for China as their main trading partner. Most global investors are severely underweight Chinese stocks. When the reversal happens for investments like in trade, i.e. the representation of Chinese equities exceeds American ones in investors’ portfolios, few fund managers would want to be left out of the party.

Author: ALT Perspective, Seeking Alpha

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