China’s Tech Growth Is Getting More Expensive

(Bloomberg Opinion) -- China's consumer growth is a key plank underpinning the investment thesis for many of the country's big technology companies.

But the torrent of revenue from domestic customers is getting expensive, forcing the likes of Tencent Holdings Ltd., Alibaba Group Holding Ltd. and Sina Corp. to pony up more cash just to keep the numbers humming along at the accustomed pace.

As a result, margins are being squeezed and old assumptions need to be reevaluated. In some cases, managements are blaming one-time items for weaker earnings, almost as if to paper over changes in structural profitability. 

Alibaba's second-quarter numbers, released last week, are a case in point. Revenue grew 61 percent, in line with recent averages. However, 12 percentage points of that growth came from consolidation of two units. At the same time, the company blamed its weaker bottom line on investments. Executives want us to notice the upside — strong revenue — and ignore the costs: the purchase of unprofitable businesses. That's like telling us not to talk to that weird uncle at the dinner table, and forgetting to mention he's the guy who brought all the holiday gifts.

Don't worry about that massive hit to operating profit, Alibaba told investors; it was just because of share-based compensation for Ant Financial, in which Jack Ma's flagship company finally bought a stake after years of denying it was even a subsidiary. Alibaba is very happy to take the boost from Ant, which is why it made the investment, after all. And the company says that impact may be repeated.

Investors are going to have to learn to take the good with the bad, and at some point executives will need to fess up that there can actually be a downside to all that spending. Let's not even dare whisper the word “goodwill.”

Sina has its own tale to tell. The internet portal and owner of microblogging service Weibo trumpeted 50 percent growth in sales for the latest period:

We had another good quarter … Weibo continued to record healthy growth in both user base and monetization despite more intensified competition.

The press release included references to growth rates in various units, but failed to point out that sales and marketing expenses climbed by 120 percent — more than double the rate of revenue growth. That wasn't a one-time effect: Sina's marketing budget has outpaced revenue for each of the past four quarters. Were it not for the promotional push, it's arguable whether Sina could keep sales looking so hot.

Over at NetEase Inc., China's second-largest games company, e-commerce is becoming a growing component of revenue. That's helped the top line, but the company had to offer incentives and discounts to get there, raising the cost of revenue. Marketing expenses also climbed over the past year, peaking at 18 percent of revenue in the first quarter as NetEase pushed its online game offering.

If you take a four-quarter average of marketing spending and combine it with the cost of revenue, you can see that the expenses incurred to drive that top line are 23 percentage points higher than where they were three years ago. The inevitable result is a continued erosion in NetEase's operating margin.

Then there's Tencent. It's popular to blame a halt in new game licenses for revenue disruption. That looks like a smokescreen for structural issues at the games and social-media company. Cracks started appearing back in the December quarter, well before its struggles with bureaucracy. In fact, the company had just announced it would bring the popular PUBG Mobile game to China, helping developer Bluehole Inc. get around regulatory hurdles: No sign of any licensing struggles then.

At the time, I noted that gross margin hit a record low and Tencent was spending more on marketing than it was on R&D. That problem hasn't eased, with marketing growth exceeding revenue growth for the past two quarters.

There's nothing the least bit wrong with spending more on marketing, or investing idle funds in new and growing businesses. That's exactly what savvy managers should be doing. But investors who buy into the China growth story need to understand that things have changed, and rapid growth now comes with higher costs.

To contact the editor responsible for this story: Paul Sillitoe at psillitoe@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Culpan is a Bloomberg Opinion columnist covering technology. He previously covered technology for Bloomberg News.

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