China's crackdown on Tech has been nasty, brutish and short, and has tested the resolve of EM investors who have hitherto viewed China through rose-tinted glasses.
The first salvo against Tech was the disruption of the Ant Financial IPO. In April, Alibaba was fined US$2.8bn for anti-competitive activity. Last month, Didi, a newly minted IPO, was hit with a cybersecurity investigation. Almost US$1tn has been wiped out in stock market value since April.
Chinese Edtech and food delivery have now also been targeted. The authorities have banned independent education centres from making profits and, earlier this month, the government mandated that gig workers must be protected, affecting the food delivery sector.
China's crackdown has weakened the Baby Amazon and Food Delivery Indices
China's crackdown seems to have had a negative impact on the tech sector more broadly. For example, Our index of 'Baby Amazons' (EM e-commerce firms) has fallen by 23% since 1 July. And, although our Food Delivery Index has rallied (mainly because of Zomato's strong showing), Meituan Dianping, the largest player, fell by 25% last month.
EM tech stocks outside China, such as Jumia and Sea Ltd, have suffered by association. There is a perception that they could be subject to the same regulatory challenges as Chinese Tech stocks. Moreover, the valuation of these stocks had been driven by the prospect of acquisitions by Chinese Tech leaders, such as Alibaba and Meituan Dianping. The sell-off has taken the wind out of that valuation driver.
The case for EM e-commerce is intact
That being said, the Baby Amazons and food delivery firms still stand out as outperformers of the Covid era versus MSCI EM. And the factors behind this outperformance remain compelling, irrespective of the Chinese crackdown.
The pandemic has accelerated the growth of EM e-commerce. Revenue grew by an estimated 18% CAGR in 2014-19, but rose by an average of 34% yoy in 2020. And the Baby Amazons’ gross merchandise value (GMV) increased by 34% yoy in the same time period. Some EM e-commerce players outperformed Amazon in yoy revenue growth in 2020, and this trend has continued in 2021.
The drivers of EM e-commerce have become stronger during Covid-19. Internet penetration in the EM world has leaped forward, powered by cheap data. For example, in India, Jio cut data costs by c97% in 2020. Smartphones are now the main means of accessing e-commerce.
And these Covid drivers are unlikely to vanish. For instance, in ASEAN, one-third of digital economy users (such as food delivery customers) have adopted a digital service because of Covid, according to a survey by Bain Consulting. The same survey indicates that 94% of new digital users intend to continue using the service they have adopted after the pandemic.
We think the revenue and valuation gap between Amazon and its EM counterparts could narrow in five years. Although EM e-commerce firms have just one-tenth of Amazon’s US$335bn GMV, we expect the ratio could narrow to one-fifth in just five years’ time. The combined value of EM e-commerce firms is currently just 37% of Amazon’s US$1.6tn market cap – in our view, the market is still undervaluing the Baby Amazons.
The Baby Amazons’ big problem – cash flow – is also less worrying because of the low-interest-rate environment. EM e-commerce companies have high costs of goods, opex and capex; hence, they are negative CFO and FCF. However, risk-free rates have fallen by 60% in the main emerging markets, easing the cash burden.
The case for EM food delivery also remains strong
Developed market food delivery companies are on track to generate revenue growth of 15% in 2021. But we expect EM equivalents to record growth of around twice that level.
As the valuation table below shows, EM food delivery platforms seem undervalued in comparison with their developed market counterparts, especially as the sector's growth metrics appear to have much more room for improvement. There is also more upside from higher smartphone penetration and e-commerce in emerging markets such as China, Indonesia, Nigeria, Vietnam and Pakistan. We note that Deliveroo has EM exposure to advanced EMs such as the UAE, Singapore, Kuwait and Hong Kong.
There is also a high likelihood of EM food delivery players attracting the attention of global leaders in the segment, such as DoorDash, GrubHub and Meituan Dianping. These US and Chinese companies have deep pockets, a hunger for growth and a willingness to acquire rivals. And some of these businesses in smaller EMs could become IPO candidates themselves, including players in Nigeria, Pakistan, Vietnam and Indonesia.
But the risk factors in EM tech investing cannot be ignored
However, the crackdown is a sober reminder of the heavy risks associated with EM tech investing, risks that were apparent before the crackdown and should continue to be part of investors' assessment.
For instance, the recent move to treat gig workers as employees could adversely affect food delivery and ride-hailing companies – a risk that was actually highlighted in Didi’s IPO prospectus.
Changes in government policy, such as the recent Chinese crackdown, were always risks, and our valuation of EM tech stocks already incorporated them via the discount factor in our discounted cash flow (DCF) valuation. For instance, the DCF analysis involves discounting a stream of cash flows with a weighted average cost of capital (WACC). The WACC estimates for our valuation of the stocks we cover incorporate the risk of a regulatory crackdown.
EM top picks
Our top picks for EM Tech are as follows: