Chinese tech IPOs are very hot in New York these days, leading some commentators to invoke comparisons with the US dot-com bubble of 1999. The primary point of superficial similarity is the initial IPO performance. During the US bubble, the average first-day return on an IPO soared to 73%, up from 17% in 1996: Chinese dot-com IPOs have displayed similar exuberance.
Much of the similarity stops there, however. In the US, many of the companies that thrived in the halcyon days of the dot-com boom were capital-intensive businesses that quickly burned through IPO proceeds. Some investors even reasoned that losses were a sign of future value, since most of the IPO money raised was being spent on research and development. Analysts and investors also convinced each other that fundamental valuation analysis no longer applied to their new economy. By the end, a merchant fleet of internet companies had sunk, leaving little more than cutesy marketing collateral in their wake.
Chinese tech IPOs are a different story. For one thing, many of the firms receiving huge valuations aren’t so much internet companies as companies that use the internet. To most tech investment geeks, a “dot-com” is a company whose business model and point of customer interaction is overwhelmingly focused on the world-wide web, not simply any company that uses the internet as a data communication layer.
Almost all companies now have some web presence. Looking at Chinese internet giants like Tencent, Baidu and Alibaba, however, perhaps only search engine Baidu is a dot-com according to this definition. Tencent’s primary user layer is the QQ instant message software, a client program that resides on the user’s local machine and communicates with internet servers at arm’s length. Alibaba.com is really an offline coordination system for trading, facilitated by a simple website for matching directory listings.
There is a new generation of Chinese internet companies that are more similar to classic dot-coms, like Renren, Taobao and Sina’s microblogging service, Weibo. All of these services reside more formally within a browser-based experience. However, they are far better off financially than the American dot-coms of the late ‘90s.
In the US, earnings from a typical dot-com-era company accounted for only 3% of its listed market value, according to one study from the University of California, Berkeley. Another study showed that the fraction of issuing firms with negative or zero earnings rose from 44% in 1996 to around 80% in 1999-2000. But Sina, Tencent and Baidu, consistently report double-digit growth in profits, and even small firms like Renren and Qihoo 360 have proven core businesses. In addition, almost all of China’s internet firms have low-cost models.
This does not mean there is no risk for investors buying in at current multiples. The assumption built into triple-digit valuations for Chinese dot-coms is that the Chinese internet growth story will deliver guaranteed returns. Not so.
Getting users and making money is easy compared to the challenge of getting – and keeping – government approval. A popular website can lose its operating license without warning. The regulatory system is opaque and riven by turf wars.
Companies also continue to fight for territory in online dating and video, social networking and group shopping – all markets which have yet to determine a dominate player.
Another problem is the graying of the population. Although China’s potential online market is huge, young people are the main revenue drivers of many business models and the most valuable audience for advertisers. Chinese gaming companies are already expressing concern that their target market is growing more slowly.
Nor are overseas markets likely to offset declining growth at home. Since Chinese internet companies are protected from foreign competition by cultural and regulatory barriers, their ability to expand beyond China is highly suspect. Chinese technology companies have only managed to win market share abroad by providing a lower cost option. But of course many competing internet services – like Twitter and Facebook – are already free.
It may not be as inflated as its US forebear, but China.com still has plenty of hot air to vent.