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Are China's Internet stocks fabulous or flaky?
Two high-profile experts disagree on the future of China's volatile Internet sector. And if you're intrigued by this risky sector, here are some stocks to watch.
By Michael Brush
Two high-profile veterans of the late 1990s Internet-stock craze recently weighed in on China's online sector. The views could hardly have been more at odds.
Mary Meeker, who follows Internet stocks for Morgan Stanley (MWD, news, msgs), is bullish on China's Net stocks. Meeker recently started coverage of the group with an "attractive" rating. She cites cheap valuations and expected robust annual revenue growth of 25% to 40% for the next several years.
Henry Blodget, the former Merrill Lynch analyst who, prior to joining Merrill, set a market-shaking $400 price target for Amazon.com (AMZN, news, msgs), is a skeptic. "For small investors, I can imagine almost no scenario in which owning these (Chinese Internet) stocks would make sense, the exception being pure speculation," says Blodget, who recently penned pieces on the sector for Newsweek and Slate.com. Blodget cant do much more than write about the stocks these days, as the Securities and Exchange Commission barred him from the securities industry for life and fined him $4 million in 2003 after settling charges of he published misleadingly bullish research reports on Internet stocks.
So who's right about Chinese Internet stocks?
If you dig in to what these two analysts think, you'll find some common ground. It boils down to this: Yes, Chinese Internet stocks hold much promise, but they are very risky. So it is best to devote, at most, a small portion of your portfolio to a basket of these stocks for the long term.
Heres a closer look at the bull vs. bear view, along with a few names from the group worth owning as long-term plays on the sector.
The bull's-eye view
Room to grow: There are just 103 million Internet users in China, or less than 8% of the population. Compare that to 211 million users in the U.S., or 71% of the country, and you get a sense of the potential for the sector in China. That's one reason Meeker estimates revenue at Chinese Internet companies will expand anywhere from 25% to 40% a year for the next three years. "China is the worlds fastest-growing economy, and the Internet is its fastest-growing industry," says Meeker.
The price is right: China's Net stocks trade for 40% to 60% less than their U.S. counterparts, on a price-to-earnings basis, even though their growth rates and profit margins are higher, says Meeker.
Related news and commentary on MSN Money
The urge to connect: A shortage of choices in entertainment and unfiltered news helps explain why online games and news portals are so popular, says Meeker. Because so many young people in China have no brothers and sisters -- after years of a one-child-per-family policy -- many of them feel a sense of isolation and a need to reach out to others, theorizes China-native Cong Li, a portfolio manager at Hamon Asset Management, which manages the Dreyfus Premier Greater China fund (DPCTX). Thats one reason instant messaging and other forms of online communication are so popular there, he says.
Outside interest: Yahoo! (YHOO, news, msgs) recently sank $1 billion into the leading Chinese auction company Alibaba. The search engine company Baidu.com (BIDU, news, msgs) had a wildly popular initial public offering in the U.S., trading as high as five times its IPO price on its first day public. That sort of success is contagious.
The bear take
And the winner is? While the U.S. has clear Internet kingpins like eBay (EBAY, news, msgs), it still isnt clear which companies will dominate in China. "The Yahoo! of China or the Google (GOOG, news, msgs) of China might end up being Yahoo! and Google," says Blodget. If so, their Chinese counterparts would fall like the worst of the dot-bombs in the U.S. after 2000.
Does Tiananmen Square ring a bell? The Chinese government watches the Internet closely, and sudden crackdowns on content or even billing practices could send Chinese Internet stocks reeling. "The government is always a risk there," says Mark Lebovitz, a portfolio manager at Munder Internet fund (MNNAX).
All or nothing: Because of these kinds of risks, Blodget thinks it makes sense for money managers to own a diversified position in Chinese Internet stocks for the long haul. "Several will probably go to zero or close, but the ones that work might work big enough to provide a reasonable overall rate of return."
Meeker echoes these concerns, as do professional money managers. "Each name by itself carries a lot of risk, so we take a pretty diversified approach," says Lebovitz. "These companies have the potential to grow, but they could also be the next Lycos," he says, referring to one well-known flameout.
If you are an individual investor with an appetite for risk and a big enough portfolio that you can put a small portion of it into at least a half-dozen Chinese Internet stocks (or, if you have a gambling itch to scratch), here are some to consider.
Game time
Meekers favorite sector is online games, and its easy to see why. The Chinese are avid fans of the addictive time-killers. That should help support 37% annual revenue growth over the next three years, predicts Meeker.
Instead of going up one-on-one against a computer or a partner, the Chinese prefer what are known as "massively multiplayer online games" with names like "Fantasy Westward Journey" or "World of Warcraft."
In these games, thousands of participants role play inside virtual worlds over the course of several months or more. The games typically have a reward system that lets players gain status by scoring points or acquire special skills and coveted items.
This format has several advantages for the Chinese game companies. First, users pay an hourly or monthly fee to participate, often at Internet cafes, so there is recurring revenue. Second, game companies are shielded from piracy. Gamers download the client software. But they dont have access to the games' source codes, which are stored on the game operators' servers.
These game companies have hundreds of thousands of users logged on at any given moment, and peak usage can top 2 million, says Lebovitz. With so many users, it makes sense that the companies are branching out into advertising and wireless content sales. Meekers favorite in this group is NetEase.com (NTES, news, msgs), a game company that develops content in-house. NetEase and Shanda Interactive Entertainment (SNDA, news, msgs) account for 58% of online game revenue. The9 Limited (NCTY, news, msgs) is a much smaller play on this theme.
Cell phone-related services
While relatively few Chinese have computers for accessing the Internet, they make up for it with cell phones. The Chinese are the biggest cell-phone users in the world. They have about 363 million of them.
Cell phones took off in China in part because computers and computer Internet access are more expensive. "Basically, cell phones have become the major driver for getting online to communicate and get information," says Lebovitz. The Chinese use cell phones for everything from sending text messages and playing games to downloading Internet content and ring tones.
Add-on cell-phone services were hit hard recently after the government cracked down on some off-color content and abusive billing practices. But Meeker thinks this is just a temporary setback. "Despite regulatory concerns, entry barriers are rising and a segment recovery is in sight," she writes. Meeker expects 20% annual revenue growth in this space over the next three years.
One of her top picks in the space is Tencent Holdings (TCEHF, news, msgs), a big provider of cell-phone-based instant messaging services. "They have over 170 million active users," says Li of Hamon Asset Management. "It is a huge community." This means Tencent has a solid revenue base. But it can also branch out into other areas like advertising and selling content.
Other players in this segment include TOM Online (TOMO, news, msgs), Kongzhong (KONG, news, msgs) and Linktone (LTON, news, msgs).
Travel velocity
A solid online commerce play here is the online travel company Ctrip.com (CTRP, news, msgs). Ctrip was early to the game, so it has a large customer base that helps it solidify relations with hotel partners. China lacks the kind of big hotel chains and global reservation system you find in the U.S., so competitors should find it harder to take on Ctrip. Meeker predicts online travel revenue should grow 53% a year over the next three years.
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