Category: China Stocks

Semiconductor Stocks Exposed To China With Tariffs Incoming

Posted on by io-fund

This article was originally published on Forbes on Dec 12, 2024,02:47pm ESTForbesForbes on Dec 12, 2024,02:47pm EST

Semiconductor stocks will come into focus in 2025 as geopolitical tensions rise. China is likely to retaliate following Trump’s most recent threats of 10% additional tariffs to all Chinese goods. This escalation in tariffs and retaliation is expected to have an impact on semiconductor sales in China, particularly affecting chipmakers with higher exposure to China.

Nvidia, AMD and Micron have some of the lowest exposure among the leading chipmakers, while wafer fab equipment (WFE) manufacturers and Qualcomm have some of the highest exposure.

Tariffs to Impact Chipmakers, WFE Spending

Tariffs have not yet been implemented, yet the risks to the semiconductor industry and supply chain are already becoming visible.

A report from the Commercial Times highlighted that the supply chain is scrambling to secure product prior to early 2025, with segments such as “display panels, IC design, memory, and optical communications” seeing an increase in rush orders.

Optical firm Lianyi highlighted that telecom customers have “increased their efforts to replenish inventory at the end of the year, adding a wave of demand.” Additionally, to mitigate impacts of potential tariffs, some Chinese firms are attempting to shift production to Thailand and Vietnam, leading to longer supply times and additional order placements to secure enough supply. This comes as the US is continuing to implement stricter export restrictions on US-made chips to China, with the Commerce Department announcing restrictions on 24 types of chipmaking equipment, as well as bans on numerous Chinese firms.

As a result, wafer fab equipment (WFE) spending in China is expected to take a rather large hit next year. Wafer fab equipment (WFE) refers to the equipment used to process wafers into chips, through processes like etching, deposition, and through ultraviolet wavelengths in a process called EUV lithography.

Through the first half of 2024, China’s spending on WFE totaled more than $25 billion, putting it on track to spend $50 billion this year for the first time ever. For 2025, WFE spending is projected to drop below $40 billion, in line with 2023’s levels, and tracking for a -20% to -25% YoY decline. Some of the WFE manufacturers that are heavily exposed to China include ASML at nearly 50% of systems revenue year-to-date, and Applied Materials, KLA and Lam Research at 37% to 43% of revenue.

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WFE Firms at Risk from Elevated China Exposure

In 2024, chipmaking equipment manufacturers had some of the highest exposure levels to China in the broader semiconductor industry, with ASML seeing China contribute nearly half of its systems revenue.

Here’s how the leading WFE manufacturers stack up in terms of exposure to China.

Chipmaking Equipment Manufacturer's China Exposure

Chipmaking equipment manufacturers had some of the highest exposure levels to China in the broader semiconductor industry, near or above 40% of revenue. Source: I/O Fund

More than 48% of ASML’s systems revenue year-to-date has come from China while Lam Research and KLA both see China contributing ~42% of total revenue. Applied Materials’ China exposure in fiscal 2024 was slightly lower at 37%. This is a rather steep increase from the 26% to 29% range from fiscal 2023 for all four companies.

This year-over-year surge in China revenue to elevated levels presents significant risk as export restrictions and tariffs combine as two primary headwinds. As a result of these two threats, as well as declining WFE spending and declining domestic utilization rates weighing on the equipment market’s growth, China exposure is expected is decline dramatically next year.

Take ASML as an example. So far in 2024 (Q1 to Q3), China has accounted for $7.06 billion of its $14.56 billion in systems revenue. For the full year, China is expected to maintain this contribution level in the high-40% range, before dropping to 20% in 2025. This suggests China revenue could decline approximately -33% YoY to ~$7 billion. Applied Materials has just over $10 billion in revenue from China, Lam has over $6 billion, and KLA has over $4 billion, exposing the trio to hundreds of millions to billion-dollar losses in revenue streams should China revenue decline in the double-digits next year.

On the other hand, some of the market’s leading AI players have the lowest China exposure, with less than 20% of revenue from China.

Nvidia Among AI Favorites with the Lowest China Revenue

Despite being the subject of some of the strictest export restrictions for its leading AI GPUs, Nvidia has some of the lowest exposure to China as a percentage of revenue, alongside competitor AMD and key suppliers Micron and TSMC.

In its most recent quarter, Nvidia’s China (and Hong Kong) revenue rose 34.4% YoY to $5.42 billion, as it “ramped new products designed specifically for China that do not require an export control license.” As a percentage of revenue, China accounted for 15.4% of revenue, up from 12.2% in Q2 and 9.6% in Q1.

Nvidia China Revenue

China accounted for 15.4% of revenue for Nvidia in Q3, up from 12.2% in Q2 and 9.6% in Q1. Source: I/O Fund

Even with this acceleration in China revenue since Nvidia was hit with export restrictions in Q4 2023, China’s contribution remains lower than historical levels, in the low 20% region. Nvidia’s upcoming GB200 NVL36, NVL72, and B200 all face export restrictions and require licenses to ship to China, while the A100, A800, H100, H800, L4, L40, L40S, and RTX 4090 have already been restricted. This means that moving forward, China’s growth will continue to primarily come from China-specific products rather to those that could be subject to restrictions.

AMD and Micron similarly have low revenue exposure from China and restrictions in place preventing sales of certain chips to the region. Certain variants of AMD’s Instinct GPUs and Versal FPGAs are restricted from being sold to China, while China banned Micron from key infrastructure products in 2023 due to national security risks.

For fiscal 2023, AMD’s China revenue was approximately 15% of revenue, down from 22% in fiscal 2022. AMD has not provided any quarterly updates on China revenue through FY24, though management said last quarter that they are “underrepresented in China market in the server CPU side,” with opportunities to gain share.

Micron’s China exposure has hovered in the 16% of revenue range for FY22 through FY24, due to bans from China limiting its growth in the nation. While the low exposure to China may seem like a positive, Micron faces competitive headwinds and pressure from Chinese firms in its primary markets. Analysts questioned management about China capacity hitting the market, and if it would have any impacts on Micron’s business. Management acknowledged that there has been China capacity in the market, saying that it is “primarily limited to China-oriented, China-exported customers who are using some of that supply or attempting to use it” for lower performance categories such as DDR4, LP4 and lower end NAND. However, they noted that they are focusing on the “higher profit pools” of DRAM and NAND such as HBM, LP5, and data center SSDs, so the “portion of the business that's exposed to those kinds of trends in China are really becoming smaller as a percent of our revenue over time.”

Taiwan Semiconductor (TSMC) is exposed to a different realm of geopolitical risk due to its concentration in Taiwan, though it has faced some pressure from the US to restrict sales to China, which are quite low. Earlier in November, TSMC halted advanced chip shipments of 7nm and below to Chinese AI and GPU customers, viewed as a temporary strategy to comply with the United States government. The US reportedly believed that a sanctioned Chinese firm placed orders with TSMC via a middleman, and is attempting to crack down on this; TechNode reports that if these loopholes are closed, TSMC will be one of the most affected. Additionally, the US is seeking to place blanket restrictions on 7nm and below shipments to China, which TSMC is hoping will only be for Chinese AI customers, and not smartphone, as that would have a more substantial impact – Apple and Qualcomm are two primary customers with large smartphone revenue streams in China.

In FY23, China accounted for just under 12.5% of TSMC’s revenue, up from the 10-11% level from the prior two years. Of the major semiconductor players in the market, TSMC has the lowest exposure to China, less than Nvidia, AMD and Micron.

Here’s how the four stack up against some of the other more-AI exposed chipmakers.

Chipmaker's China Revenue Exposure

Nvidia, AMD, and Micron are among the leading AI-exposed chipmakers with the lowest revenue contribution, while Qualcomm and Broadcom are among the highest. Source: I/O Fund

Two names stand out here for its elevated exposure to China – Qualcomm and Broadcom.

In FY24, Qualcomm generated nearly 46% of its revenue from China, a significant improvement from China’s contribution of 67% of its revenue just three years ago. Qualcomm is seeing strong growth emerge from China from both smartphone and auto customers, noting that in Q1, QCT handset revenue is expected to grow single digits YoY driven by “greater than 40% sequential revenue growth from Chinese OEMs.”

Broadcom generated over 32% of its revenue from China in FY23, down from the 35% range it had seen in three of the prior four years — much of this exposure to China stems from Apple. What’s interesting about Broadcom’s situation is that it believes that a majority of the products shipped to China ($11.5 billion revenue in FY23) are included in devices shipped back to the US or Europe, exposing it potentially to two-way tariffs, to China and from China.

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What Tariffs Mean for Semiconductor Stocks

As tariffs risks rise with additional tariffs likely to be placed on China, and China threatening to retaliate with a 20% price cut advantage for domestic goods. Experts say the new policy will also affect US products sold in China, potentially impacting chipmakers with substantial Chinese revenue streams if they cannot outcompete domestic alternatives.

What this means is that not only will semiconductors face geopolitical risks from tariff threats and a possible trade war, but they will also face a tougher selling climate in China as the country pushes for more domestic production towards its goal for 70% semiconductor self-sufficiency by the end of 2025.

For Nvidia, although its share of China revenue is quite low at 15%, the country is a $20 billion plus market for them due to their rapid revenue growth, whereas for AMD, China was not even a $3.5 billion market in FY23. Though China’s 20% price advantage policy aims to promote domestic alternatives to US products, China is still hard-pressed to find a suitable alternative to Nvidia’s GPUs, with Huawei’s Ascend 910B only rivaling Nvidia’s A100 released four years ago.

For companies like ASML, and its peers in WFE manufacturing, where China contributes 40% or more of revenue, the backdrop gets a bit more challenging as WFE spending in China is estimated to dry up slightly next year, with spending potentially dropping -25% YoY. These companies will in turn have to rely on growth in the Americas and leading-edge nodes to offset declining (or normalizing) China contribution.

This is a scenario that brings a lot of ‘what-ifs’ to the table, as it’s impossible to predict what exactly will happen come 2025 when it comes to tariffs and when it comes to Chinese revenue streams. At the moment, the geopolitical risk is rising for semiconductors from these retaliatory threats, and it could create some better entry points for AI semis next year. To navigate this difficult territory, join Portfolio Manager Knox Ridley next Thursday, December 19 at 4:30 pm EST to discuss semis, SOXX versus the S&P 500, and what he sees ahead for some of the leading AI chip stocks in the market. Learn more here.

Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund own shares in NVDA at the time of writing and may own stocks pictured in the charts.

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Baidu Q1: ERNIE Growing Rapidly, AI Cloud Accels

Posted on by io-fund

Last month, Aljazeera reported that Ernie Bot has 200 million users compared to Chat-GPT’s 180 million users. In the earnings call, Baidu management stated Ernie Bot handles 200 million queries per day, up from 50 million in December. According to the call: “This considerable growth indicates that increasing adoption of ERNIE can point to strong future revenue potential from model inferencing […] We believe ERNIE ecosystem will over time contain millions of applications […]”

On the fundamentals, Baidu reported 1.2% growth in RMB yet this translates to a YoY revenue decline of (-3.75%) USD on a weaker exchange rate. AI cloud revenue increased 12% as Ernie Bot users and API requests continue to rise. Margins improved sequentially, with Baidu’s management emphasizing a near-term focus on optimizing operational efficiency while maintaining AI-related growth.

Revenue and EPS:

FX exchange rates between the RMB and dollar require nuanced approach for Baidu’s growth rates – the company reported YoY growth in local currency, but given that the RMB has weakened more than 5% against the dollar, US$ revenue declined.

  • Revenue in Q1 was $4.37 billion, representing growth of 1.2% for RMB 31.51 billion. This represents a YoY decline of (3.7%). 
  • Baidu Core revenue was RMB 23.80 billion for an increase of 3.5% YoY. This equals $3.30 billion USD for a decline of (1.5%) YoY.
  • GAAP EPS was $2.07 in Q1, a YoY decline of (10.8%). Adjusted EPS of $2.76 increased 17.9% YoY.
  • Adjusted EBITDA was $1.14B for a margin of 26%. This represents a nominal decline from $1.19B in the year ago quarter.

Margins:

Margins improved sequentially, as Baidu reiterated a focus on maintaining a healthy operating margin while still investing in its AI growth engine.

  • Gross margin of 51.5% was flat YoY yet up 130 basis points QoQ
  • Operating margin of 17.4% was up 140 basis points YoY and up 200 basis points QoQ from 15.4%. This equals operating profit of $760 million. Adjusted operating margin was 21.2%, up from 20.6% in the year ago quarter.
  • Net margin of 17.3% was down 140 basis points YoY yet is up 990 basis points QoQ from 7.4%. This equals a net profit of $755 million. Adjusted net margin was 22.3% up from 18.4% last year and flat QoQ. According to the call, weighing on overall net margin, Other Income was down 52% to RMB 2 billion due to “a decrease in favorable gain from long term investments, partially offset by the increase in net foreign exchange gain.”

Cash Flow and Debt:

Cash flow is in line YoY yet down QoQ.

  • Operating cash flow of $861 million this quarter for a margin of 19.70% is up 100 basis points YoY yet is down considerably QoQ from 30.4% in Q4.
  • Free cash flow of $579 million this quarter for a margin of 13.3% was down 130 bps from last year and down 660 bps QoQ.
  • The company has $26.6 billion in cash and $11.3 billion in debt.

Stock based compensation was 3.6% of revenue. Baidu returned US$229 million to shareholders since the beginning of Q1 2024, bringing the cumulative repurchase to US$898 million under the 2023 share repurchase program. Per management: “we have consistently repurchased our shares on the market over the past four years, averaging around $1 billion annually. In total, we have allocated around 37% of our free cash flow towards the share buyback progress.”

Key Segments:

Revenue from Baidu Core grew 4% YoY to RMB 23.8B, which equals USD $3.3 billion. In March of 2024, Baidu’s monthly active users (MAU) on the search engine reached 676 million, up 3% YoY. This compares to 4% growth last year and was up 1.3% QoQ. Revenue from QiYi declined (-5%) YoY to RMB 7.9B, which equals $1.1 billion.

AI Cloud Revenue grew 12% YoY to RMB 4.7 billion and delivered “operating profit on a Non-GAAP basis.” AI cloud revenue has accelerated from a YoY decline in the third quarter of (-2%) to an increase of 11% in the fourth quarter, to a 100 bps acceleration QoQ to 12% this quarter. As stated, the revenue growth was “mainly driven by gen-AI and foundation models. In the first quarter, such revenue accounted for 6.9% of total AI Cloud revenue.”

Regarding scarcity of GPUs, the company stated they are creating GPU clusters of hundreds or even thousands of GPUs across various vendors into a unified computing cluster to train LLMs.

Online marketing revenue grew 3% YoY to RMB 17B, which equals USD $2.36 billion. According to management, this will eventually accelerate with AI: “we have been pushing hard to transform the user experience from a traditional mobile product to a generative-AI experience. This transition is ongoing and monetization has not yet started.” It was also stated macro weighed on the results: “In the first quarter, advertiser sentiment in some verticals, such as real estate and franchising, remained weak. Specifically in the real estate industry, not only was ad spending from developers and agencies muted, but the impact also extended to both upstream and downstream sectors.”

Perhaps most importantly, it was stated this will remain soft in the near-term: “As we enter the second quarter, we have not seen improvement in advertiser sentiment. Given the limited visibility for sentiment improvement and paired with tough comps in Q2, our online marketing revenue should remain fundamentally solid but from a growth perspective soft over the next few quarters.”

Non-online marketing revenue grew 6% YoY to RMB 6.8B for USD $935 million.

Apollo Go Rides were up 25% YoY to 826,000 rides. According to a recent statement, the AV unit will be break even by the end of this year and profitable next year. The robotaxis go for $27,697 USD and operating costs will be reduced by 30% once a robotaxi network is established.

For the outlook across key segments, management stated the following: “We expect our cloud business to accelerate and the loss of our robotaxi business to narrow for the rest of the year. We expect mobile business to be soft in the near term and start to recover when gen-AI becomes the new core of our existing products next year.”

More on ERNIE:

Similar to Chat-GPT, ERNIE has a family of models with the flagship models being ERNIE 3.5 and 4.0. Since March of last year, ERNIE’s training efficiency has improved 5X and the inference cost has been lowered drastically to 1% compared to the March 2023 models. The company offers a set of tools, such as AppBuilder and ModelBuilder, to entice developers to use Baidu’s models. Most recently, the company has released AgentBuilder, which helps developers create AI agents, which by using natural language programming, even those who can’t code can build an AI agent. The long-term goal for ERNIE (and Chat-GPT) is that millions of applications are built on top of these foundational models, ultimately locking AI development into the ecosystem. To do so, these companies will have to create very affordable models to compete with open-source models. Baidu discussed the following efforts: “In addition, our mixture of experts, or MOE approach can partition a user query into distinct tasks, assigning the most suitable models to handle each task and use ERNIE 3.5 or 4.0 only for the most complex tasks. This approach allows for faster responses and lower inferencing cost while maintaining similar performance levels to using more advanced models.”This approach allows for faster responses and lower inferencing cost while maintaining similar performance levels to using more advanced models.”

Being the largest search engine in China, Baidu Search with ERNIE improves search results similar to Chat-GPT/Bing and Gemini/Google. ERNIE will launch across Samsung, Oppo, Vivo and Xiaomi smartphones. APIs are also used across PCs and electric vehicles including Nio. The company has saw “double-digit YoY increase in paying users in the first quarter” for Baidu Wenku, which helps with document creation.

Brand advertisers and SMEs (small to medium sized enterprises) are also adopting ERNIE agents to serve as virtual storefronts, service desks and 24/7 assistance.

China’s GPU Restrictions:

Export controls prevent China from buying Nvidia’s most powerful GPUs. The company has created less powerful GPUs specifically to export to China, such as the A800 and H800. According to SemiAnalysis, Nvidia is also exporting the H20, L20 and L2 GPUs. Naturally, this brings up questions around Baidu’s ability to progress it’s ERNIE family models if the GPUs are less powerful than what’s available globally.

According to Baidu: “For the AI infrastructure layer, a key factor contributing to our high efficiency in model training and inference is our superior capability in GPU cluster management. We have recently made a breakthrough by integrating GPUs from different vendors into one large scale, unified computing cluster, allowing us to use less advanced chips for highly effective model training and inference. Our deep learning framework, PaddlePaddle, has through continuous innovation and enhancement helped reduce the cost of model training and inferencing on a constant basis. PaddlePaddle is compatible with over 50 different chips, many domestically designed, and the developer community has grown to 13 million […]”

“In the long run, I think China will form an ecosystem of its own, probably with less powerful chips but most efficient home grown software stack. There is ample room for innovation in the application layer, model layer, and framework layer […] We believe that the chips we have in hand are sufficient to support earnings for the next one or two years, and because of an ability of high performance chips in China in this year, 2024, we expect our capex to be smaller versus last year.”

Conclusion:

Per our last write-up, the I/O Fund team believes that Baidu could make for an interesting momentum play. We define a momentum position as one where technicals lead, where we respect the stops, and where the fundamentals may not be perfect for one reason or another. For Baidu, risk from China is too high for the stock to be considered for anything more than momentum. Given the emphasis on AI in the markets combined with China pushing for its domestic tech to be the predominant tech used by its citizens, we foresee a scenario where Baidu emerges as a decent choice for those who want to participate in lower valuations.

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Tencent Q1 Earnings: Margins Continue to Expand, AI-Powered Ads Grow while Gaming Declines

Posted on by io-fund

Tencent reported before market open and beat estimates today, with the advertising segment accelerating nicely year-over-year by 9-points. Where Tencent is stronger than it appears is on the margins, which we had outlined in our analysis last month.

The beat on revenue was marginal at 159.5 billion Chinese yuan (RMB) reported ($22.5 billion USD) compared to 158.4 billion yuan (RMB) expected. However, the beat on the bottom line was more than double digits. On a Non-IFRS basis, the company reported 50.3 billion RMB, which was up 54% YoY. On a IFRS basis, CNBC is reporting a 14% beat on the bottom line. Due to currency conversion differences, USD estimates are not as reliable as the RMB expectations.

Across the board, we have strong margin expansion. Despite strength in advertising, Fintech and Business services posted weaker growth YoY as did Revenues from VAS (gaming) and social networks. Overall, gaming is weighing on the revenue whereas AI is helping to drive the acceleration we are seeing in advertising. We break this down for you below with key points from management commentary.

Revenue and EPS:

As stated, gaming is weighing on Tencent’s revenue yet the bottom line is expanding.

Revenue:

  • Revenue growth of 6% compares to growth of 11% in the year ago quarter. This is also a 100-bps contraction from last quarter, although it’s common to see seasonality in consumer facing companies.
  • The 6% RMB revenue growth and 3% USD revenue growth should mark a near-term bottom for Tencent. Estimates for the next three quarters show growth sustaining at 9% to 10%. These are rough approximations due to fluctuations in currency exchange.

Earnings and EPS:

  • The company reported GAAP EPS of 4.39 RMB compared to 2.64 RMB last year, up 66% YoY.
  • The company reported non-GAAP EPS of 5.26 RMB compared to 3.35 RMB last year, up 57% YoY.
  • Profit attributable to shareholders, non-IFRS basis was at RMB 50.3 billion or US$ 7.1 billion, up 54% YoY. Profit attributable to shareholders on a IFRS basis was RMB 41.9 billion or US$ 5.9 billion, up 62% YoY.  
  • EBITDA was $9.2B USD. Adjusted EBITDA margin was 43% for RMB 69.3B (USD $9.8 billion) compared to a margin of 39% in the year ago quarter.

Margins:

The margin expansion in the earnings report shines, and has been steadily improving since 2021.

  • Gross margin of 53% expanded 800 bps from 45% in the year ago quarter. This equals gross profit of RMB 83.9B or USD 11.8B, up 23% YoY.
  • Operating margin of 33% was also up 800 bps from 25% in the year ago quarter. This equals RMB 52.6 billion or USD 7.4 billion, up 38% YoY. Adjusted operating margin was up 700 bps for RMB 58.6 billion or $8.3 billion.         
  • Net margin of 27% was up 900 bps from 18% in the year ago quarter for net income of RMB 42.7 billion or US$6 billion. Adjusted net margin was up 1000 bps for RMB 51.3 billion or USD of $7.2 billion.

Cash and Debt:

The company reported very strong cash flows with margin expansion. There is net cash of $13 billion although the company is a large shareholder in other companies with a portfolio value of USD $73.6 billion. United States investors may recall a company like Shopify that sees drastic fluctuations in cash depending on the value of their investments (Affirm, etc). However, due to the sheer size of Tencent’s holdings, there is considerable value to this portfolio at the current moment, which was discussed on the call and is detailed more below.

  • Operating cash flow of RMB 72.3 billion or USD $10.2 billion reported a margin of 45%.
  • Free cash flow of RMB 51.9 billion or USD $7.3 billion for a margin of 33%. This represents “stable” growth YoY and was up 52% QoQ. Stock based compensation was 3.8% of revenue.
  • There is USD $62.8 billion in cash on the balance sheet and debt of USD $49.7 billion for net cash of $13 billion.

Operating Capex of 6.6 RMB was up 557% YoY and Non-Operating Capex of RMB 7.8B is up 127% YoY. Total Capex was up 226% YoY to RMB 14.4B, up from RMB 4.0B in capex in the year ago quarter. The rise in capex was mainly due to the increase in investments in AI. The CFO said in the earnings call, “Operating capex was RMB 6.6 billion, up 557% year-on-year from a low base quarter last year, mainly driven by investment in GPUs and servers to support our Hunyuan and AI recommendation algorithms. On a quarter-on-quarter basis, operating capex was down 1%. Non-operating capex was RMB 7.8 billion, up 127% year-on-year due to acquisition of land use rights during the quarter. As a result, total capex was RMB 14.4 billion, up 226% year-on-year.”

The fair value of shareholdings in listed investee companies is at USD $73.6 billion, up from USD $68.8 billion in the year ago quarter. As you can imagine, this depends on the health of the Chinese stock market. The book value of unlisted investments was a $46.3 billion USD, which is flat YoY and fluctuates less due to infrequent reporting on private valuations.

During the quarter, the company repurchased 51 million shares on the Hong Kong stock exchange for HKD 14.8 billion. The company also made 3.7B RMB in payments for media content and lease liabilities of 1.5B RMB.

Key Metrics:

VAS or value-added services is comprised of gaming and social networks. This segment is 49% of revenue and declined 0.9% YoY to RMB 78.6B compared to RMB 79.3B. However, this was up 14% QoQ from RMB 69.1B. In. In that regard, Q4 could be the bottom for gaming. VAS gross profit increased 5% year-on-year to RMB 45 billion, representing 54% of total gross profit.

  • International gaming revenue was up 3% due to a “lengthy revenue deferral cycle for Supercell’s games.” This compares to 25% growth in the year ago quarter.
  • Domestic games receipts “returned to growth” and was up 3% YoY. However, domestic games revenue declined 2% YoY to RMB 34.5B “due to revenue deferral.” As stated, the receipts returning to growth may be indicating the early signs of a bottom for gaming (we will see).
  • Social networks revenue declined (-2%) by RMB 30.5B. This compares to 6% growth in the year ago quarter. Music subscription revenue increased 39% year-on-year, reflecting growth in subscriptions and ARPU. According to management: “Revenue from music subscriptions, video accounts live streaming, mini games and video subscriptions increased, while revenue from music and games related to live streaming services declined sharp.”

Fintech and Business Services is 33% of revenue and decelerated YoY with 7% growth reported this quarter compared to 14% growth last quarter. Fintech and business services gross profit increased 42% year-on-year to RMB 24 billion, contributing 28% of total gross profit. Fintech and business services gross margin increased to 46%, up 11 percentage points year-on-year. This is being driven by wealth management services, which translates to money market accounts where users are holding their cash, plus ecommerce technology fees and monetization of business services.

Online advertising is 17% of revenue and was up 26% YoY for RMB 26.5 billion, which is a 900 bps acceleration from 17% growth in the year ago quarter. The highlights were Weixin video accounts growing over 100% YoY and mini programs revenue growing 40% YoY. Online advertising gross profit increased 66% year-on-year to RMB 15 billion, contributing 17% of total gross profit. Online advertising gross margin increased to 55%, up 13 percentage points year-on-year driven by growth in video accounts and Weixin Search.

Overall, this segment has been accelerating on a YoY basis over the past few quarters, although can be lumpy on a QoQ basis. Per management: “The first quarter for us is a slightly unusual quarter because it’s a small quarter for advertising due to the Chinese New Year effect, and so sometimes the accelerations or the decelerations get magnified as a result. We would expect our advertising growth to be less rapid in subsequent quarters of the year than it was in the first quarter, more similar to consensus expectations for our advertising revenue growth for the rest of the year.”

AI is showing initial signs of impacting advertising revenue growth. According to the earnings call: “Ad spend from all major categories except automotive increased year-on-year, particularly from games, internet services, and consumer goods sectors. During the quarter, we upgraded our adtech platform to help advertisers manage ad campaigns more effectively and we made generative AI-powered ad creation tools available to all advertisers.”

There are additional, smaller segments that are too small to breakout in terms of revenue: business services “grew at a teens rate year-over-year,” Tencent Cloud Media grew “over 50% YoY,” and within business services “WeCom revenue tripled” and “Tencent Meeting also doubled.”

Risks:

The risks are plentiful with this stock, and thus we use technical analysis fully to determine our entries and exits. The setup could fail in as soon as 1 day or it could remain intact for a few months. The fundamental analysis helps to identify the probability of a technical setup remaining in tact. In this case, we think the margin story helps support the risk of entering while adhering to all stops.

As a reminder, United States stocks have less risk than Chinese stocks. The first risk to consider is United States-China tensions, the second is that Tencent’s financials are unaudited, and third that Tencent is an over-the-counter stock which means the stock is not traded on an exchange.

Earnings Call:

How AI Can Help Social Networks:

Since are in the first inning for how AI will impact Big Tech, and we have many innings to go on how AI will impact all industries, it’s worth our time listening to a broad range of management teams on the subject. Here are a few comments from Tencent’s vantage point on how AI can provide a lift to social networks:

[…] historically as a social media platform, our click-thru rates were low, and so starting from that lower base, we have seen we can double or triple click-thru rates in a way that’s not possible for ad services that are starting from much higher click-thru rates.”, we have seen we can double or triple click-thru rates in a way that’s not possible for ad services that are starting from much higher click-thru rates.”

“[…] We believe that tools like Advantage Plus are extremely important in terms of helping social media companies, whether it’s Meta or ourselves, grow into being all that they can be on the advertising front, because they simplify and automate the advertising buying and advertising targeting processes so that the social media companies can deliver experiences to advertisers that are more competitive with those that had already been delivered by search engines and by ecommerce platforms.so that the social media companies can deliver experiences to advertisers that are more competitive with those that had already been delivered by search engines and by ecommerce platforms.

But with the advantage that the social media platforms have much greater time spent, user engagement than search engines or ecommerce platforms, and so to the second part of your question around–a number of competitors are obviously applying AI as well, and we believe that all of them will benefit from AI too, but we think that the biggest beneficiaries will be those companies, of which we are one, that have very substantial under-monetized time spent and are now able to monetize that time spent more effectively by deploying AI, because the deployment of AI enables an upward structural shift in click-thru rates, and that shift is most pronounced for those inventories where the click-thru rates were lower to begin with, such as the social media inventory.”the social media platforms have much greater time spent, user engagement than search engines or ecommerce platforms, and so to the second part of your question around–a number of competitors are obviously applying AI as well, and we believe that all of them will benefit from AI too, but we think that the biggest beneficiaries will be those companies, of which we are one, that have very substantial under-monetized time spent and are now able to monetize that time spent more effectively by deploying AI, because the deployment of AI enables an upward structural shift in click-thru rates, and that shift is most pronounced for those inventories where the click-thru rates were lower to begin with, such as the social media inventory.”

The Value of Tencent’s Portfolio:

Below is a discussion on how Tencent’s holding are valued according to the non-IFRS associate income and the stocks current multiple. If PE Ratios are based on GAAP earnings, then one could argue that Tencent is undervalued given the “several hundred billion renminbi” in profits its holdings contribute.

Ronald Keung (Goldman Sachs)

Okay, and then my follow-up question is on our investment portfolio. Given it’s very sizeable, nearly US $130 billion in value, do we have any thinking on consistent or any distribution policies after the JV and Meituan distributions in the past? I’m thinking about any predictable policies so that the market will more actively value this part of the value, given the substantial market value within Tencent. Thank you.

James Mitchell (Chief Strategy Officer)

On that front, we have been working with some of our investee companies, and many of them have been working unprompted by themselves to enhance their profitability, and so if you look at the non-IFRS associate income that we reported this quarter of a little over RMB 5 billion, that’s up very sharply year-on-year and it annualizes to a number in the 20s of billions renminbi. To the extent that investors are valuing Tencent’s overall earnings at a certain multiple, then implicitly they’re now valuing our investment portfolio at several hundred billion renminbi. 

There is still a gap between that implicit valuation through our multiple and the associate income contributing to our multiple of several hundred billion renminbi, versus the intrinsic value or the market value of the portfolio, which is substantially higher, but as the associates–you know, as companies like Pinduoduo become steadily more profitable, then more and more that gap will narrow itself as the profitability of the associates gets directly reflected in our own net income.

Conclusion:

Tencent came in as expected with notable strengths within the report. Margins are expanded, there is promising signs of AI-powered advertising, and key metrics point toward a bottom in gaming (needs to be confirmed). Our most recent technical analysis can be found here. Advanced Members can expect to hear more in the weekly webinar and also in Knox’s next Positions Report ETA last week of May or first week of June.

Royston Roche, Equity Analyst for the I/O Fund, contributed to this analysis

Recommended Reading:

Baidu: An Emerging China-AI Momentum Play

Posted on by io-fund

The I/O Fund team believes that Baidu could make for an interesting momentum play. We define a momentum position as one where technicals lead, where we respect the stops, and where the fundamentals may not be perfect for one reason or another. For Baidu, risk from China is too high for the stock to be considered for anything more than momentum. Due to the emphasis on technicals, we only release momentum plays to Advanced Members.

Liquidity and Valuations

By Knox Ridley

China’s property sector accounts for nearly 30% of their GDP. This is far greater than any other developed nation, and exposes them to broad based deflation as their real estate market continues to unwind.

The Chinese property downturn is in its 3rd year, as new housing starts are down 60% compared to pre-COVID levels. This is a shocking slowdown in a short amount of time, yet, due to centralized control of the economy, we have yet to see housing prices fall in accordance with demand. While we have seen eight straight months of house prices decline in China, with recent data showing a 1.4% YoY drop, which is an acceleration to the downside from last month’s 0.7% YoY drop, the Chinese government is providing a wide range of defensive measures to prevent a full scale crash in the housing market.

For example, developers and lenders are allowed to delay recognizing bad loans in an effort to avoid bankruptcies, which is helping overextended banks stay solvent. We are also seeing rules on how listings must be priced in an attempt to prevent price discovery based on an oversupply in the face of decreasing demand.

How these measures will play out is yet to be seen. However, the one measure that is of interest to Chinese risk assets is how the People’s Bank of China (PBOC) has reacted. We have seen a large expansion of their balance sheet, which increases liquidity in the Chinese economy. This matters, as Chinese equities have a high correlation to liquidity expansions and contractions.

This correlation to expanding liquidity in China is one reason why we are interested in a small momentum allocation to Chinese equities. It is apparent that the CCP is adamant about preventing contagion from their struggling real estate markets. Furthermore, they have announced their inflation, growth and employment targets for 2024, which is highly supportive of a continuation of easing liquidity.

The other reason can be seen in the fundamentals. Since topping in February of 2021, the popular Chinese ETF, FXI, is currently down 52%, while the tech focused Chinese ETF, CQQQ, is down nearly 70% from its 2021 highs.

This has created some appealing valuations within Chinese tech. Baidu is trading at a 13.2x trailing PE ratio and a 8.9x forward PE ratio, as well as a 2x PS ratio and a 7.4x price to free cash flow ratio. Compare this to American search and generative AI rival Alphabet, which is trading at a 26.2x trailing PE, a 19.3x forward PE, and a 6.6x PS and 28.2x P/FCF ratio.

Baidu is trading at a significant discount relative to its three-year medians for these valuation metrics, though revenue growth next quarter risks declining and EPS growth is expected to be negative in two quarters this year.

However, as a whole, Chinese stocks have been deeply discounted, and the variegated risks from the economic risks discussed here, along with mounting geopolitical risks, has investors looking elsewhere for gains. This has created some attractive valuations within a market that is not correlated to the US markets.

Technical Outlook

How these risks and reactions from the Chinese government are getting baked into the price is interesting.  For one, the Shanghai Composite Index (SSE) has broken a trendline that has been in place since 2006. Price has reclaimed this trendline, which is another reason why we are interested in this sector. When this trendline breaks, and if a retest had failed, then it would be a rather large problem for Chinese equities.

As of now, if SSE can break above the 3315 resistance, then we could see a nice swing higher into 2024/2025. How this pattern can be counted is in two general ways. The most bearish one would have us in a large degree 2nd wave. This count would have us, likely, test the 3315 region before rolling over. The other count I’m tracking would have us in a large degree B wave. This count would have us breaking above 3315, at minimum. Both counts do not look favorable for the Chinese markets on a long-term basis, which is why any plays we initiate will come with stops and targets.

My interpretation of the price action can be best counted in 2 general ways. The red count is the most bearish. It has us completing the A wave of a larger 2nd wave. The green count has us in the start of a new cyclical bull market within a larger secular bear market. Both scenarios can account for the setups we are seeing within the Chinese stock market.

Baidu’s Chart:

There are two counts that I am tracking in BIDU:

  • Green – we are about to start the C wave of a Zig-Zag correction. Long-term, this would be a bear market rally; however, the C wave is targeting ~100% gains, from current levels.
  • Blue – We have a first and now second wave in place in a large degree 5 wave move higher. This would be wave 5 of a very large 5 wave pattern.

The bounce off of the October 2022 low appears to be a 5 wave move. This has been followed by and overlapping, messy correction that is making a higher low, so far. This favors the two bullish counts listed. If we do see a breakdown below $73.50, it will invalidate these two bullish outcomes. Furthermore, the next breakout bounce must be a 5 wave move higher, and it needs to break over $114. This would likely be our signal to buy, with a stop to sell our position if we then move under $93.

ERNIE Versus ChatGPT: Baidu Quickly Catching Up

By Damien Robbins

Baidu is making strides in generative AI, evidenced via rapid growth in its generative AI offering ERNIE Bot. This rapid growth in consumer adoption of its ERNIE chatbot and strong initial adoption of its enterprise APIs are a positive sign for AI cloud helping drive a revenue acceleration for Baidu. We’re already seeing strong interest from leading consumer firms to integrate ERNIE – Samsung will integrate ERNIE in its S24 smartphones, Apple is in discussions to use ERNIE in devices in China, while Great Wall Motors will use ERNIE for an in-vehicle assistant.

Daily queries on ERNIE rose 190% QoQ to more than 50 million. Baidu noted that queries in the first half of November were 50% higher month-over-month relative to October, while daily queries had reached tens of millions. For context, ChatGPT had 60 million daily queries in August last year with over 1.4 billion monthly visits.

For Baidu, what’s important to watch is the growth trajectory of ERNIE, and if it can continue to show strong growth trends in both enterprises adopting APIs as well as within daily queries, as that suggests usage remains high.  Baidu is expecting to see more enterprises build LLMs using ERNIE’s APIs, which will serve as a growth driver for AI cloud revenue as model deployment and usage increases.

OpenAI has shown signs of successfully monetizing ChatGPT via both APIs and a consumer-facing subscription to unlock more advanced features. OpenAI reached $1.3 billion in ARR in October,  which then rose to $2.0 billion in December. Baidu’s generative AI and foundation model revenue was just $90 million (RMB656 million) in Q4, so there’s still a lot of catching up needed with OpenAI in terms of revenue.

Apollo Go: Moonshot Project Making Steady Progress

Baidu is quickly establishing itself as one of China’s outright leaders in autonomous driving via Apollo Go, and while the robotaxi services continue to expand, it remains at a small scale.

Apollo Go announced two significant milestones in 2024 alongside the 5 million cumulative rides: it launched a 24/7 driverless service in Wuhan and launched a highway pilot in Beijing to Beijing Daixin Airport, the world’s first robotaxi airport service in a capital city. Expanding service hours, fleet size, testing in new cities and expanding testing zones within cities are all necessary steps for Apollo Go’s expansion; however, fleet sizes do still remain small, and its geographic presence has not yet proliferated rapidly.

Management has signalled a willingness to push forward with a more rapid expansion path once it reaches UE (unit equivalent) breakeven in Wuhan. Robotaxis are operating in only 10 cities at the moment, and Wuhan’s fleet size reached just 300 vehicles in September, so a swift expansion to more cities with larger fleets opens the door for substantial revenue generation; however, given the small current scale, this is more of a moonshoot bet for 2024 (much in the sense that Tesla’s FSD is a moonshoot) rather than a contributor to the near-term thesis.

Baidu’s Revenue

By Royston Roche

Baidu’s Q4 revenue grew by 2.6% YoY to $4.92 billion. Revenue in local currency grew by 6% YoY to RMB 35 billion. Analysts expect revenue to be flat next quarter and is expected to accelerate to 7.3% YoY growth in Q2 and 7.6% in Q3. It’s clear with the chart below that Baidu’s revenue growth will bottom in Q1, barring any unforeseen issues.

  • Revenue from Baidu Core grew by 7% YoY to RMB 27.5 billion or $3.87 billion. Baidu Core includes online marketing that grew 6% YoY to RMB 19.2 billion or $2.7 billion and non-online marketing revenue that grew by 9% YoY to RMB 8.3 billion or $1.17 billion, primarily helped by the growth in AI cloud revenue.
  • Revenue from streaming service iQIYI, popularly known as ‘Netflix of China’ grew by 2% YoY to RMB 7.7 billion or $1.09 billion.

The company’s investment in AI has started yielding results and is expected to contribute more meaningful to revenue in 2024.

AI cloud revenue grew by 11% YoY to RMB 5.7 billion or $802.8 million, accelerating from a (2%) decline in Q3, helped by the strong demand for large language models.

Robin Li, co-founder and CEO said in the earnings call, “AI Cloud revenue grew by 11% year-over-year to RMB5.7 billion and continue to improve profitability in the fourth quarter. Revenue from Gen AI and foundation model represents 4.8% of our AI Cloud revenue in Q4. The increasing demand for model building played a significant role in this accelerated revenue growth, along with increasing distributions from inference.AI Cloud revenue grew by 11% year-over-year to RMB5.7 billion and continue to improve profitability in the fourth quarter. Revenue from Gen AI and foundation model represents 4.8% of our AI Cloud revenue in Q4. The increasing demand for model building played a significant role in this accelerated revenue growth, along with increasing distributions from inference.

We have seen a growing number of enterprises, in particular, tech companies turning to our public cloud to build their models. Additionally, the AI cloud revenue generated by Baidu Core, other business groups, such as the Mobile Ecosystem Group and the Intelligent Driving Group was about RMB2.7 billion in Q4. Within the Q4 internal cloud revenue, Gen AI and foundation model accounted for about 14%. On a combined basis, the total internal and external AI Cloud revenue was RMB8.4 billion in Q4, with Gen AI and foundation model contributing around RMB656 million.” On a combined basis, the total internal and external AI Cloud revenue was RMB8.4 billion in Q4, with Gen AI and foundation model contributing around RMB656 million.” The total from both internal and external AI cloud revenue was $1.18 billion in USD and Gen AI and foundation model contributed around $92.4 million.

Margins

The gross margin and the operating margin have improved on a YoY basis, but sequentially, there is a dip due to the higher costs in the AI cloud business. Management believes that the margins will improve in the long-term in the AI cloud business as revenue increases. The net margin was down mainly due to the equity method investment adjustments, which vary each quarter and there was one-time adjustment related to preference shares. However, we saw an uptick in the adjusted net margin sequentially and on a YoY basis.

The gross margin was 50.2% compared to 48.8% in the same period last year and 52.7% in the September quarter. The gross margin partially benefitted from lower content costs, but the higher costs in the AI cloud business were a drag. Management believes that the AI cloud margins will improve in the long term and replied to an analyst question on the margin trend for 2024.

“We are pretty confident in maintaining profitability for our AI Cloud. For Enterprise Cloud, we should be able to consistently improve gross margins for the legacy cloud businesses. As for Gen AI and LLM businesses, the market is still at a very early stage of development. So we should hold a pretty dynamic pricing strategy to quickly educate the market and expand our penetration into more enterprise customers. So we believe over the long term, the new business should have higher normalized margins than the traditional cloud businesses.”As for Gen AI and LLM businesses, the market is still at a very early stage of development. So we should hold a pretty dynamic pricing strategy to quickly educate the market and expand our penetration into more enterprise customers. So we believe over the long term, the new business should have higher normalized margins than the traditional cloud businesses.”          

The operating margin was 15.4% compared to 13.9% in the same period last year and 18.2% in the September quarter. The SG&A expenses remained flat YoY, but R&D expenses increased 11% YoY due to the higher server depreciation expenses and server custody fees related to Gen AI R&D.

The net margin was 7.4% compared to 15% in the same period last year. The net margin was down primarily “due to a pickup of losses from an equity method investment as a result of a modification of certain terms of the underlying preferred shares.”  The adjusted net margin was 22.2% compared to 16.2% in the same period last year and 21.1% in the September quarter. GAAP EPS was $0.95 compared to $1.97 in the same period last year. Adjusted EPS was $3.08 compared to $2.21 in the same period last year. The analysts expect adjusted EPS to grow 2.3% YoY in Q1 and decline (6.3%) in Q2.

On an annual basis, Baidu is expected to grow fiscal year EPS (-2%) in FY2024 and then 10% over the next two years before EPS is expected to rapidly accelerate in growth in fiscal year 2027 to +33%. Overall, analysts are not expecting any further negative growth beyond FY2024.

Cash Flow and Balance Sheet

The operating cash flow was $1.5 billion or 30.4% of revenue compared to $1.14 billion or 23.8% of revenue in the same quarter last year. The free cash flow was $980 million or 19.9% of revenue compared to $859 million or 17.9% of revenue in the same quarter last year. Management attributed to “Mobile ecosystem exhibited solid performance across revenue margin and cash flow.” They expect mobile ecosystem (includes Baidu App, Ernie bot, Haokan, and Baidu Post, among others) to continue to generate steady profits and cash flows in 2024.

Cash, restricted cash, and short-term investments were $28.93 billion, and debt was $10.77 billion, compared to $27.78 billion and $10.93 billion at the end of the September quarter. The company repurchased $318 million worth of shares in Q4 and totaled $669 million under the 2023 share repurchase plan.

Earnings Call

  • The company’s investments in AI are expected to yield several billion RMB revenue in 2024. Robin Li said in the earnings call:

“Since Q2 2023, we have actively utilized ERNIE to revolutionize our products and services, creating AI native experiences. We believe real applications are essential to unleashing the full business potential of ERNIE and ERNIE Bot. Recently, we began to generate incremental revenues from ERNIE and ERNIE Bot. In the fourth quarter, we earned several hundred million RMB primarily from ad technology improvement, and helping enterprises build their own models. I'll provide a more detailed explanation in the business review section.Recently, we began to generate incremental revenues from ERNIE and ERNIE Bot. In the fourth quarter, we earned several hundred million RMB primarily from ad technology improvement, and helping enterprises build their own models. I'll provide a more detailed explanation in the business review section.

Looking into 2024, we believe this incremental revenue will multiply to several billion RMB primarily from advertising and AI cloud building.”Looking into 2024, we believe this incremental revenue will multiply to several billion RMB primarily from advertising and AI cloud building.”

  • The company launched a new version of AI model Ernie 4.0 in Q4 2023, which it claims will rival Chat GPT-4. Management mentioned in the earnings call that the Ernie API is used in Samsung S24 and Honor Magic 8.0 (Honor was spun off from Huawei in November 2020).

“As the front runner in AI, Baidu probably became the first public company globally to launch a GPT model with our EP 4.0 standing high as the most powerful foundation model in China. ERNIE continues to gain market recognition, as evidenced by ERNIE API calls from multiple well known companies.

Notably, Samsung uses ERNIE API on its Galaxy S24 5G sales. Honor uses ERNIE API in its Magic 8.0 and Autohome using ERNIE API to power multiple AITC apps.”

The management also highlighted the increasing use of Ernie by enterprises as the CEO stated, “In December about 26,000 enterprises are actively using ERNIE through API on a monthly basis, increasing 150% quarter-over-quarter. And ERNIE is now handling more than 50 million queries every day. That's up 190% quarter-over-quarter is a significant rise in third party quality.”

  • The company is using AI to increase revenues in advertising.

“In the fourth quarter Baidu’s core online marketing revenue increased by 6% year-over-year, driven by verticals in travel, healthcare, business services, and others.

In Q4, we generated several hundred million RMB incremental ad revenue due to improvements in ad tech.”

  • The company expects to achieve operational break-even in 2024 for Apollo Go.

“Our intelligent driving business continued to focus on achieving new breakeven for Apollo Go. In Wuhan, Apollo Go's largest operation, about 45% of our orders were provided by fully driverless vehicles in Q4. This metric surpassed 50% in January. The increase is because we intensified operations during peak hours in areas with complex traffic conditions and further expanding our operating area in the past few months. This development resulted from our ongoing efforts to improve technology through safety — through safely operating Apollo Go on public doles.

In China, Apollo Go provided about 839,000 ride in the public in Q4, marking up 49% year-over-year increase. In early January, the cumulative rides offered by Apollo Go exceeded 5 million. The substantial data collected from operations will further help us enhance the efficiency of safe operations.

Looking into 2024, we will remain focused on getting closer to Apollo Go's UE breakeven target and managing our costs and expenses to reduce losses in intelligent driving. Upon reaching UE breakeven, we plan to swiftly replicate our successful operations in Wuhan to other regions.”

Other Key Metrics

Baidu’s PaddlePaddle AI developer community has reached 10.7 million developers by the end of 2023. Developers created 860,000 models on PaddlePaddle by the end of last year.

Enterprises actively using ERNIE’s APIs on a monthly basis increased 150% QoQ to 26,000 in Q4. Baidu opened ERNIE APIs to enterprise customers at the end of August after receiving approval to deploy ERNIE on a larger scale.

Daily queries on ERNIE rose 190% QoQ to more than 50 million. ERNIE also reached a 100 million user milestone in December, less than five months after launching in August. OpenAI reported in November that ChatGPT had approximately 100 million weekly active users.

Baidu App’s Monthly Active Users (MAUs) grew by 3% YoY to 667 million in December 2023 and has been slightly lower than 5% growth in September 2023.

In Q4, Apollo Go rides grew by 49% YoY to 839,000. The company achieved 5 million cumulative rides from Apollo Go in January this year, marking a major milestone.

Conclusion:

Given the emphasis on AI in the markets combined with China pushing for its domestic tech to be the predominant tech used by its citizens, we foresee a scenario where Baidu emerges as a strong choice for those who want to participate in lower valuations. China’s population can be a catalyst for ERNIE to exceed Chat-GPT in user adoption. With that said, China is risky, ERNIE’s success is still quite speculative given the low revenue, and this is not a stock we can consider as quality. We will use technical analysis to its fullest as we attempt to participate.

Royston Roche and Damien Robbins, Equity Analysts at the I/O Fund, contributed to this article.

Recommended Reading:

Tesla’s China Market Share Continues To Slide

Posted on by io-fund

This article was originally published on Forbes on Dec 7, 2023,10:58pm ESTForbes Forbes on Dec 7, 2023,10:58pm EST

Tesla’s China struggles are persisting, as the American OEM saw its monthly sales decline substantially year-over-year in November, continuing a string of weak growth that began in August.

Tesla’s primary China rival BYD continues to see solid vehicle sales growth, and is poised to potentially become the market share leader in Q4. In an analysis last month “Tesla Sells 33% of Vehicles Below Average Cost, BYD Pulls Ahead,” our firm had reported that BYD more than doubled Tesla’s China sales in October and that BYD “is set to overtake Tesla in terms of quarterly BEV deliveries.”

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Tesla Falls Further in China

In November, Tesla’s China-made EV sales fell about (-17.8%) YoY to 82,432 vehicles, marking the largest YoY drop since December 2022 when Tesla cut output and prices in response to rising inventories.

Vehicle sales did increase approximately 14.3% MoM from October, a positive sign of improvement from the stagnation seen since the peak in June at 93,680 vehicles. Despite the 14.3% MoM growth, Tesla is still tracking at less than half the BEVs as BYD and will need much more than one month to maintain its lead globally.

China EV Sales, BYD vs Tesla

Source: TESLA, BYD, GASGOO

November and December are typically the strongest seasonal months for China’s EV market, a common theme seen in other auto manufacturers’ deliveries for last month. December has also tended to be the strongest month for Tesla — aside from in 2022 — so the true test for Tesla will be exceeding June’s total as December has traditionally done in the past. That would represent MoM growth of ~13.6% and YoY growth of ~67.9%, a reversal back to double-digit growth after a 4-month string of weakness.

In 2021, Tesla saw similar weakness in October and November that then set up for a strong December. 2023 could follow that pattern with a strong December boosted by the refreshed Model Y and Model 3 Highland – Tesla will need to show at least 95,000 units in volume in December (or a minimum of 50% of BYD’s BEV volume) for the bullish thesis but if it misses under 90,000 then China continues to be too big to ignore, and we will look for an opportunity to buy lower. We are on the sidelines until then.

China Sales YoY Growth, BYD vs Tesla

Source: TESLA, BYD, GASGOO

I/O Fund Equity Analyst Damien Robbins previously reported last month that Gigafactory Shanghai “is essentially maxed out in terms of the volume of vehicles that it can churn out, so October’s stagnation raises more questions about how Tesla will regain market share in China. With BYD’s strong growth in Q3 and Tesla’s slide in September, the American EV maker saw its NEV market share fall more than 300 bp QoQ from 12.98% in Q2 to 9.89% in Q3.”

October’s stagnation saw Tesla’s market share deteriorate further: Reuters reports that Tesla’s “share of the country's EV market dropped to 5.78% in October from 8.7% in September.” That marks a swift decline in market share – down 1220 bp from Q2’s 12.98% in just over a quarter.

Tesla’s market share is sliding as Tesla’s deliveries are lagging and rival deliveries are growing; Tesla’s October sales grew 1% YoY compared to 30.1% YoY for the passenger EV market. For November, EV sales are estimated to increase 29% YoY to approximately 940,000, per the China Passenger Car Association. A CPCA official said that “every carmaker is making a dash to the year-end as they try to meet their sales targets.” In November, Tesla’s below-market growth rate of (-17.8%) YoY compared to 29%, is looking to set the carmaker up for further market share losses as Chinese domestic rivals’ deliveries continued to witness strong growth:

  • BYD’s NEV sales reached a record and second straight month above 300,000, with BEV sales rising 49% YoY to 170,150.
  • Great Wall’s NEV sales rose for an eighth consecutive month, rising 143% YoY to 31,824 vehicles.
  • Changan’s NEV sales increased nearly 53% YoY to 50,598.
  • GAC’s NEV sales grew 49% YoY to 50,231 for the month and 80% YoY to 490,925 YTD.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

BYD Matches Tesla’s BEV Market Share

Due to China’s large population and the importance of this country in terms of demand, BYD is set to surpass Tesla on global sales next quarter.

BYD’s EV growth flatlined in November on a MoM basis, with growth just below 1% from October’s levels. However, November’s tally of 301,378 vehicles (BEV+PHEV) marked a second straight month with more than 300,000 deliveries. For a direct comparison to Tesla, BEV sales increased 49% YoY and nearly 3% MoM to 170,150 units, taking Q4’s to-date total up to 335,655 vehicles. As a result, BYD is poised to overtake Tesla’s BEV sales in Q4 – BYD is on track to surpass 500,000 BEVs delivered, whereas Tesla is forecasting a volume of at least 449,000 vehicles in Q4 to reach its 1.8 million target for 2023.

BEV Market Shares, Q3

Source: TRENDFORCE

With BYD’s strong growth through Q2 and Q3, combined with a strong start to Q4, it’s also on track to soon become the top brand globally in terms of BEV market share, taking the throne away from Tesla. On a YTD basis up to Q3, Tesla held approximately 20.1% share of the BEV market, compared to BYD’s 15.9% share; however, in Q3, BYD matched Tesla’s market share at ~18%, per TrendForce data.

The team at the I/O Fund strives to be early and objective, highlighting last month for our readers that Tesla was set to lose market share to BYD as China growth stagnates. Read that analysis here.I/O Fund strives to be early and objective, highlighting last month for our readers that Tesla was set to lose market share to BYD as China growth stagnates. Read that analysis here.

For Q4, BYD is set to surpass Tesla’s delivery tally by 10% or more, based on current growth rates and seasonal strength. Some of China’s major EV brands, including BYD and Li Auto among others, “have either cut prices or increased the royalties for customers since late November to boost year-end sales,” which could help BYD further extend such a lead.

Conclusion

The main story for Tesla investors remains the margin picture, and when margins will bottom as automotive and gross margin continues to deteriorate. We outlined this in detail here: “Tesla’s Margins: How Low will They Go?”

Tesla is heading towards a weaker position in China than what mainstream media is currently reporting as vehicle deliveries in the back half of the year have been relatively weak, allowing main rival BYD to catch up rather quickly, to the point where it may overtake the top spot in terms of market share. If not in Q4, then it looks to be inevitable come 2024.

China is a core market for Tesla for production, deliveries and exports, with Gigafactory Shanghai accounting for ~52.1% of Tesla’s 1.32 million total deliveries through Q3. Though Tesla has been raising Model Y prices over the past month, this slippage in market share raises concerns that margins will continue to suffer through Q4 and into 2024.

I/O Fund Equity Analyst Damien Robbins contributed to this analysis

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

Tesla Sells 33% Of Vehicles Below Average Cost, BYD Pulls Ahead

Posted on by io-fund

This article was originally published on Forbes on Nov 9, 2023,09:23pm ESTForbes Forbes on Nov 9, 2023,09:23pm EST

BYD more than doubled Tesla’s China sales in October as Tesla’s sales slipped on a month-over-month basis, while NEV startups showed strong sales numbers across the board. China’s new energy vehicle (NEV) industry continues to exhibit solid momentum, with September seeing NEV sales rise about +22% YoY and October estimated to see around +34% YoY growth. As a whole, China is expected to once again be the primary driver of global EV sales this year, with volumes forecast to reach or exceed 8.5 million units, or more than 60% of the projected 14 million global volume.

Tesla has been in the spotlight recently — its margins have contracted significantly over the past few quarterscontracted significantly over the past few quarters as it prioritizes price cuts. China is Tesla’s most important market as it currently represents the highest remaining total addressable market (TAM), therefore the recent weakness is not something to ignore, especially as domestic rivals pick up their pace of growth.

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BYD Trumps Tesla in China as Sales Stagnate

BYD’s delivery numbers have shown tremendous growth in Q3 and the start of Q4, as opposed to Tesla’s stagnation as consumer demand looks to be shifting in favor of local OEMs. XPeng and Li Auto both posted record October numbers with ~300% YoY growth, while NIO saw +60% YoY growth. BYD’s increased dominance in China is more visible with sales data by model: 5 of the top 6 highest selling models in October were BYD, combining for nearly 214,000-unit volume, compared to the Model Y’s 53,249 volume for the month.

China Sales, BYD vs Tesla

Source: I/O Fund

BYD has seen steady growth in NEV and purely BEV sales since May, and since June, BYD has posted five straight record months for NEV deliveries, rising from 253,046 in June to close out Q2 to more than301,000 in October June to close out Q2 to more than301,000 in October to kick off Q4. Deliveries grew +39% YoY in October, the slowest growth rate so far this year, where monthly sales have averaged +77% YoY growth. In terms of BEV sales, for a more apples-to-apples comparison to Tesla, BYD recorded +60% YoY growth to 165,505 deliveries and exports of China-made vehicles in October – more than double Tesla’s total . At that rate, BYD is set to overtake Tesla in terms of quarterly BEV deliveries, being on track to surpass 500,000 BEVs in Q4, whereas Tesla is forecasting a volume of at least 449,000 vehicles in Q4 to reach its1.8 million target for 2023.

China Sales YoY Growth, BYD vs Tesla

Source: I/O Fund

On the other hand, Tesla’s China sales peaked in June at 93,680 vehicles, with September seeing a nearly (12%) MoM and (11%) YoY decline to 74,073 vehicles, including exportspeaked in June at 93,680 vehicles, with September seeing a nearly (12%) MoM and (11%) YoY decline to 74,073 vehicles, including exports. October saw a fractional YoY increase of just +0.6% while registering a consecutive MoM decline of (2.6%), as the OEM continues to lag the growth of the broader NEV industry.

The Profitability Picture

NIO and XPeng are struggling to find a shift to profitability with elevated levels of R&D and losses piling up, whereas Tesla is facing margin troubles, exacerbated by its reliance on China. The reason here is simple: Tesla continues to sell vehicles in China below its average cost, from Q4 2022 through Q3 2023. Currently, the base Model Y is priced around $36,200, and the revamped Model 3 saw a 12% increase in its base price to $35,800 – both still below Tesla’s average cost of ~$37,487 per vehicle in Q3.

The recently announced Model Y price hikes may help alleviate the issue, given the Model Y is accounting for just over 70% of monthly sales in China, but the past four quarters have seen China’s ASP trail average cost per vehicle by (3%) or more.

Tesla's China ASP Below Average COGS Since Q4 2022

Source: I/O Fund

  • Q1 saw Tesla deliver 137,429 vehicles in China (excluding exports) for an average ASP of $35,589.
  • Q2 saw China’s ASP rise ~$1,000 to $36,578 on a +14% QoQ rise in deliveries to 156,676 vehicles. ASP was aided by a price increase in May and a higher mix of Model Y sales.
  • Q3 saw ASP decline once more to $35,953, as deliveries slipped (12.2%) QoQ to 139,624

Although Tesla has made progress in bringing its cost per vehicle lower over the past four quarters, ASP has declined at a quicker rate due to extensive price cuts. However, the sheer volume that China contributes – just under 33% of YTD deliveries at 433,729 vehicles – combined with ASP trailing average COGS means that Tesla’s margins will likely not recover above 20% until China’s ASP shifts back above average COGS. It is important for cost of goods sold (COGS) to be below average selling price (ASP), as the difference between the two is the gross profit. In Tesla’s case, China’s ASPs being below average COGS are weighing negatively on gross profit.

We previously discussed how Tesla will likely continue to lower prices to increase its leading EV market share to stave off competition which will intensify over the next few years. In a competitive analysis framework, we projected Tesla’s Q3 operating margins to decline to a level between Honda and VW, or to 7.8% compared to most recent 9.6%. Operating margin for Q3 was 7.6%, just below our base case and above our bearish case model. For a deeper dive into Tesla’s margin story is evolving, read more here and here.to 7.8% compared to most recent 9.6%. Operating margin for Q3 was 7.6%, just below our base case and above our bearish case model. For a deeper dive into Tesla’s margin story is evolving, read more here and herehere and here.

Automotive Gross Margins

Source: I/O Fund

This is increasingly evident when looking at Tesla’s automotive gross margins. Automotive margin saw a pinch in Q2 2022 as COGS rose, before falling below 20% in Q4 2022 as China ASPs shifted below the COGS curve. Margins have fallen each quarter this year as China ASPs remains below the curve, dragging on global ASP which continues to slide as a result of price cuts.

However, BYD is showing strength in margins this year – BYD’s automotive gross margins surpassed 25% in Q3, rising from 20.7% in Q1 and from 22.8% in the year ago quarter. Automotive gross margin has also markedly improved from 15.6% in Q1 2022, an expansion of 1010 bp, while Tesla’s margins have contracted 1390 bp since peaking that same quarter at 29.65%. BYD has cut prices of some of its popular models, but not to the degree that it has become detrimental to margins.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

China’s Importance to Tesla

Tesla’s weaker sales numbers in China in September and October do raise some demand concerns, as these two months typically are the start of seasonal strength lasting through December. It also raises broader concerns within its margins and revenue growth, due to the outsized influence China has on Tesla’s production and deliveries.

Gigafactory Shanghai accounts for slightly more than half of Tesla’s current installed production capacity of ~1.85 million vehicles, with the plant capable of operating at a ~0.95 million annual run rate. Tesla noted in Q3 that the “Shanghai factory has been successfully running near full capacity for several quarters, and we do not expect a meaningful increase in weekly production run rate.” In Q3, Tesla sold 222,517 China-made vehicles, with 82,893 exported. On a YTD basis, Tesla sold 699,056 China-made vehicles, with 265,327 exported. That means China accounted for ~51.1% of Q3’s total deliveries and ~52.1% of the 1.32 million total deliveries YTD.

Shanghai is essentially maxed out in terms of the volume of vehicles that it can churn out, so October’s stagnation raises more questions about how Tesla will regain market share in China. With BYD’s strong growth in Q3 and Tesla’s slide in September, the American EV maker saw its market share fall more than 300 bp QoQ from 12.98% in Q2 to 9.89% in Q3.

While September’s MoM weakness could be chalked up to a production line upgrade in anticipation of the revamped Model 3, October’s MoM stagnation either points to a slowdown in production off full capacity at Giga Shanghai (annualized rate of ~0.86M vs ~0.95M max), or a build-up in China-made inventory. Neither scenario would be much of a positive for Tesla heading into China’s seasonally strong Q4, as both could suggest more demand weakness through the end of the year.

Conclusion

The main story for Tesla investors at the moment is when margins will bottom, as automotive and gross margin continues to deteriorate. China offers a major clue for when and where margins will bottom, given that Tesla relies on the country for about one-third of its deliveries and just over 20% of its revenues.

BYD is excelling at executing during this price-competitive time, with deliveries reaching a new monthly record while margins expand. On the other hand, Tesla has seen monthly sales in China stagnate, with ASP in the country sliding again in Q3. With China’s ASP currently going on five quarters below Tesla’s average COGS, the bottom for margins is still not in sight.

I/O Fund Equity Analyst Damien Robbins contributed to this report.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

I/O Fund Discusses Bitcoin Miners and Tech Stocks on Fox Business News

Posted on by io-fund

In November, Beth Kindig shared her views on bitcoin miners, Microsoft and other tech stocks on the Fox Business show “Making Money with Charles Payne.” Below are video previews of her discussion and an overview of what the two of them discussed.

Beth Kindig is known for her stock-picking skills, focusing primarily on the tech sector. Roku, for example, has given four-digit returns to its readers. Other prominent winners include Nvidia, Zoom, and Bitcoin, which have all provided triple-digit returns from Beth’s free newsletter.

New sizzling stocks

One of the I/O Fund’s top holdings is Bitcoin. As we continue to see rapid adoption and more accessibility on a global scale, we currently like the risk/reward with Bitcoin miners. We have discussed this trend and our picks in the sector with our premium members.

In the interview above, Beth discusses that China’s losses will be gains for the United States.

Furthermore, investing in miners is, we believe, a leveraged way to play the crypto space. It’s closely correlated to the Bitcoin’s movements, so as the larger trend in Bitcoin continues up, we expect the miners to follow, yet at a higher rate of change. These plays come with levels of realized volatility that relegate these positions to small satellite plays, with an expiration date as well as stop underneath, just in case we are too early.

We think that this space will eventually attract a lot of institutional interest as the migration of miners to the US continues.  As investing in crypto becomes more desirable, and regulations continue to make it difficult for portfolios to trade, mining infrastructure allows institutions to exposure to Bitcoin through the public markets. We like that China is giving away a profitable business that the United States, primarily Texas, can host. We have traded Bitcoin miners in the past year and were able to booked a 44% gain in less than a month. We continue to closely watch this sector for any companies that are outperforming. We are holding another miner with a minimal loss of 6%, at time of writing.

A brief snapshot of the bitcoin miner’s recent earnings

Marathon Digital Holdings released its Q3 results on November 10th. The company’s revenue accelerated an impressive 6,091% YoY and 76% QoQ to $51.7M. Despite this, it missed consensus revenue estimates by $15.67M. The adjusted earnings per share (EPS) came in at $0.85 and beat analysts' estimates by $0.42. The company produced 1,252 bitcoins in the recent quarter, up 91% QoQ. For the next quarter, the analysts estimate revenue to grow 3,530% to $96.05M and adjusted EPS is expected to come at $0.65. For the most part, the four digit growth is priced in and we will need to see what MARA provides for forward guidance.

Another bitcoin miner, Riot Blockchain, released its Q3 results on November 15th. The company’s revenue jumped 2532% YoY to $64.8M. It missed the consensus revenue estimates by $2.35M. The GAAP net loss per share came at ($0.16) and missed estimates by 50 cents. The company produced 1,292 bitcoins in the recent quarter, up 482% YoY and up 91% QoQ. The analysts estimate revenue to grow 1,710% YoY to $95.57M for the next quarter and GAAP EPS is expected to come at $0.50. The company recently raised its hash rate to 9.0 EH/s from 8.6 EH/s.

Hut 8 Mining Corp released its Q3 results on November 11th. The company’s revenue grew by 768% YoY to C$50.3M (beat estimates by C$9.24M). The GAAP EPS came at C$0.15, which beats the estimates by C$0.04. The company mined 905 bitcoins in the recent quarter.

Bitfarms Ltd released its Q3 results on November 15th. The company’s revenue grew by 559% YoY and 22% QoQ to $44.8M. It missed the analysts’ consensus estimates by $1.83M. The company mined 1,051 bitcoins, up 38% QoQ. For the next quarter, the analysts expect revenue to grow 453% YoY to $62.6M.

Cloud Stocks

We have been tracking Cloud stocks in this earnings season to see which companies beat analysts’ estimates. We also track the key performance indicators like net retention rates and recurring revenues, which give us a better understanding of the forward growth estimates of the companies.

We have several winners in the Cloud industry. For example, Beth strongly believed that Microsoft’s focus on the hybrid cloud would help win the competition from other cloud companies.

We have published various articles on Microsoft, which can be found below:

Focus on Enterprise Pays off For Microsoft

Why Microsoft (Not Amazon) Will Win the Pentagon Contract

Here’s Why Microsoft Stock Could Overtake Amazon on Cloud Infrastructure

I/O Fund is comprised of a team of analysts who share their research publicly as they build a portfolio of 30 stocks. Our team has record results for a retail Fund and we also have four-digit gains on some of our free newsletter coverage. You can learn more about our premium service by clicking here or sign up for our free newsletter here. clicking here or sign up for our free newsletter here. 

Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.

Kingsoft Cloud Update

Posted on by io-fund

The growth of cloud IaaS in China is why we are invested in Kingsoft Cloud. Below, we review this company in light of a missed earnings report and weaker price action than some of our other positions.

Background on KC:

Kingsoft Cloud specializes in internet streaming, yet has incredibly strong parent companies for an opportunity this size. The two parent companies are Xiaomi, the number three mobile device globally second to Apple and Samsung, and Kingsoft Corporation, which is a software company from the 1990s that is the equivalent of Microsoft Office in China.

Xiaomi gives its traffic to Kingsoft Cloud, and therefore, mobile streaming and internet traffic is a specialty. This is seen in the client list of ByteDance (Tiktok), iQIYI, Bilibili and NetEase. Notably, Xiaomi is on the blacklist but this isn’t too surprising as a mobile company.

What is interesting to me is the internet-of-thing (IoT) footprint that Xiaomi has, which is the largest in China. According to Harvard Business Review, Xiaomi has surpassed $37 billion in IoT revenue from more than 210 IoT devices excluding smartphones and laptops. The article is a good read as HBR did a “multi-year” review on how Xiaomi grew its market by targeting price conscious and tech savvy consumers. The company then strategically set up retail locations to attract IoT purchases.

Kingsoft Cloud is also moving quickly into the enterprise cloud, which should help the company diversify from public cloud (i.e. the mobile/internet streaming). You’ll see below in the Financials section that this is where the majority of the growth is coming from. The company noted verticals such as Finance and Health Care as their major focus. This entry shouldn’t be terribly difficult given the parent company Kingsoft Corporation holds a spot similar to Microsoft Office in China with enterprise customers using the WPS Office software.

The reason Kingsoft Cloud can be considered a bit safer than other Chinese stocks, in my opinion, is that the company is on a $1 billion annual run rate. In addition, China has made it clear that becoming a leader in 5G and AI is a primary focus and this is impossible without a larger cloud IaaS footprint. There is a serious gap here in the country’s ambitions compared to the country’s capabilities. We first covered this with our Alibaba premium research report where we said the following:

“China’s enterprise IT market is five to seven years behind the United States and Western European markets. Once fully mature, China’s need for cloud infrastructure will rival the United States with 3x the population and a bottomless appetite for smart cities, artificial intelligence and machine learning plus manufacturing IoT automation.

The reversal of where China is today with cloud IaaS, and where China will be in five years, could be a bigger story than the B2B marketplace as the growth is closely tied to China’s position as a global leader.

In 2017, China published a roadmap on how it seeks to become a global powerhouse in AI. According to the report entitled “Next Generation Artificial Intelligence Development Plan,” the domestic AI market will be worth a total of $150 billion. Today, China’s AI market is worth $6.2 billion.

Artificial intelligence and machine learning require private cloud and public cloud infrastructure-as-a-service (or a hybrid mix with on-premise servers) as storing data in separate silos weakens AI and ML capabilities, reduces training performance and lowers accuracy. Artificial intelligence and machine learning require speed with most AI solutions split between 40/60 with private/public cloud or 60/40 if you’re a regulated industry.”

Although we closed our position in Alibaba, a similar thesis applies to Kingsoft Cloud.

Overview of Cloud IaaS

In the Top 10 LTBH webinar when I covered Datadog, I had stated that if the tech giants all believe cloud IaaS is the most critical layer into the foreseeable future, who am I to argue with this?

The chess game has been set with AWS’s Andy Jassy now CEO of Amazon and Azure’s Satya Nadella as CEO of Microsoft. I’ve also made the case that Google better hurry up and find its focus because these two heavyweights have chosen their primary focus and direction for the next decade.

Basically, I want exposure to this strong positioning. Although SaaS shows the most revenue overall globally, it’s being clearly communicated from Big Tech that IaaS is the most important layer. I could write a whole report on why that is (and will when I cover Datadog soon). Primarily it’s not only the infrastructure for software but is also the infrastructure for AI, ML and 5G.

Regarding Kingsoft Cloud, it’s centered in this trend and in the region where the most growth will occur. In fact, China is unique from the United States because cloud IaaS is China’s largest category in terms of revenue whereas software is the largest globally.

 Here are estimates from Statista:

Source: Statista

The interesting part is that China grew much, much faster than these estimates predicted. In fact, due to Covid, Alibaba reported 60.1 billion Yuan in fiscal year 2021, or about $10 billion USD.

According to IDC, the Q4 cloud IaaS market in China was at $3.49 billion, or annual run rate of $14 billion. If we look at the size of the global IaaS market, which Gartner states was $82 billion in 2021, then we see China is equal to about 17% of the market if we calculate with the 2021 average of $14 billion.

The market in China is expected to grow at 28.3% CAGR compared to United States growth of 20.3% CAGR from 2019 to 2024. Notably, these estimates were given prior to Covid.

If we take only the public cloud market, Frost & Sullivan predicts the market will grow from 81 billion RMB to 368 billion RMB in 2024 – or nearly 5X. Right now, China has about 6.5% of the global public cloud market and this is forecast to grow to 10.5% by 2024.

As outlined in the S-1 filing, the same firm predicts that China’s internet cloud market will grow 4X from roughly $50 billion RMB to $215 billion RMB and the enterprise market will grow 3X from $108 billion RMB to $345 billion RMB.

Of the 17% that China has, Kingsoft Cloud stated in the S-1 filing from 2019 that they have 5.4% in terms of revenue from IaaS and PaaS.

The estimates indicate that China will take increasing market share in cloud IaaS as the country catches up to other developed regions. With many segments expected to double in percentages, we can comfortably assume China will own 20% of the cloud IaaS market.

If Kingsoft Cloud grows to own 10% of the market, and we figure $23 billion for the Chinese market in two years ($14 billion at 28% CAGR), then the company should hit around $2.3 billion in annual revenue.

$2.3 billion happens to be what the analyst estimates are, as well, for FY 2022

This implies growth of about 50% this year from annual revenue of $947 million to $1.5 billion and also 49% growth the following year.

Financials

This quarter, Kingsoft Cloud reported growth of 30% for $1.81 billion RMB in total revenues, equal to $277 million USD. This means Kingsoft is a $1 billion USD annual run rate, which is rare for China. Public cloud makes 77% of revenue with enterprise cloud 23% of revenue. The enterprise cloud grew 131.3% in the most recent quarter.

The revenue missed consensus of $1.88 billion RMB.

Despite tougher comps following Covid, Kingsoft is guiding for second quarter revenue growth of 39% to 45%, which represents a reacceleration from Q1. However, the company’s guidance of 2.13 billion RMB to 2.23 billion RMB is also under Q2 analyst consensus for 2.41 billion RMB.

Last year, the company reported 58% growth in Q2 2020. As with all Covid beneficiaries, analysts are timid as to KC’s growth in the back-half of the year as the company reported 75% and 72% in revenue, respectively. This means the hurdle is higher for KC in Q3 and Q4. Perhaps the stronger guide for Q2 is a good sign. The company repeated many times that the backlog is healthy with RMB 2.8 billion, or $432 million (a little over a quarter’s worth of revenue). This does not include new bids from Q1, which management alluded to included “some big internet companies.”

The adjusted gross margin increased from 4.9% last quarter to 6.7% this quarter. In the earnings call, management noted the improvement was attributed to the financial and health care verticals, and the contribution of public cloud’s revenue and margin.

The company has a cash position of RMB 5.46 billion, or about $840 million USD. The company’s loss per share improved from RMB 0.39 to RMB 0.11 or ($0.02) per share.

Valuation:

It takes about two seconds to see the massive discount Chinese that stocks are trading at compared to stocks in the United States. Kingsoft is not immune to the China discount as it has more revenue than cloud stocks Okta and Datadog yet trades at 1/6 the forward P/S.

When the chart below is adjusted for a 3-5 year time frame, we see it has been since March of 2018 that Chinese stocks and United States stocks traded in the same range of 15 P/S. There was a strong decoupling after early 2018.

Kingsoft held the 15 P/S range in February of 2021 so it’s not out of the question the company could return to this valuation. It would need to meet/exceed guidance on Q2 and to guide strong for Q3-Q4 to resume these levels. Cloud IaaS is fully capable of this because it tends to be a steady performer.

Management:

Jun Lei, the CEO of of Xiaomi, serves as the Chairman of the Board of Directors. He has been with Kingsoft since 1992 and was also previously the chairman of Cheetah Mobile. The CEO of Kingsoft comes from Phoenix New Media, an internet, mobile and television company in China. The Board also has members who previously held roles at Google/IBM and IDG Capital/McKinsey. Management has members with experience from Goldman Sachs Asia (CFO), enterprise cloud company Qiniu, gaming company Zynga and Baidu.

The most critical member is Jun Lei as he accomplished the unusual feat of rising to the top of China’s most treasured industry – mobile. He overcame Apple for the number one spot in China in 2014 and is now in the number three spot. To be frank, he did this by ripping off Apple, but nonetheless it was an accomplishment as United States companies dominated China prior to this breakthrough.

In 2013, he was appointed a delegate of the National People’s Congress.

Risks:

The risk to Kingsoft Cloud is not the addressable market, the growth/demand and timing, or even number of competitors. The risk is the size of its competitors. Cloud SaaS in the United States is a great example of a category where competitors tend to be similar sized, and therefore, the playing field is level. This isn’t the case with cloud IaaS where BAT (Baidu, Alibaba, Tencent) rules China like MAG (Microsoft, AWS and GCP) rules the United States. Now we have to add H to the acronym for China as Huawei is growing rapidly.  

Kingsoft Cloud is the largest independent cloud provider, which means there is no conflict of interest for internet companies to work with KC as they don’t directly compete. Tencent and Baidu, for example, compete with smaller internet companies.

Another prominent risk is the costs associated with building out infrastructure. The adjusted gross margins are drastically lower than the SaaS category in the 70%+ range. You can also see the costs associated with IaaS reflected in the IDC costs, which cover bandwidth and racks. These costs range between 68% of revenue in 2020 to 77% of revenue in 2017.

 We’ve covered the fact that Kingsoft Cloud is not audited in this write-up here.

Conclusion:

We try to have a diversified portfolio across tech and China is a region we want exposure to. With that said, China is not for everyone. For the I/O Fund, it’s easier to invest in a stock in China long-term that has solid parent companies and is participating in a predictable trend.

We will need to see one of two things happen for Kingsoft Cloud to resume its previous valuation of 15 P/S. The company needs to come in strong in the second half of the year or we need to see China come back in favor. The first one is where we have focused our efforts in this analysis.

We think a cloud IaaS company with $1 billion in revenue and 50% growth is investable. It has a rock bottom valuation coupled with the recent history of trading at a much higher valuation.

Additional Reading:

Alibaba Premium Analysis 2019
August 14th: Alibaba Quick Glance
Alibaba and Ant Group Premium Research Report
Kingsoft Cloud (KC)

Market Update – March 19th, 2021

Posted on by io-fund

Since the market topped on February 16th, the current correction is a very different experience depending on if one’s style of investing (value or growth). While the S&P500 only dipped 5.6% and is currently at new highs, the tech-heavy NASDAQ100 dipped 12% from peak to trough, and is still 7% from new highs. After value has underperformed for years, we are finally seeing a meaningful rotation out of tech and into beaten down value names.

The story on the rotation has to do with the quick rise in the US 10-year treasury yield. There are many reasons why bonds are being sold off, which inversely pushes up yields – inflation pressure has the bond market believing the FED will have to raise rates, which would likely stop this economic expansion. Also, the amount of fiscal debt written since the pandemic is creating a glut of supply, which the FED will likely not be able to fully absorb and this will put pressure on rates

Regardless, since many high growth stocks are projecting positive cash flow into the future, higher yields on longer duration bonds will affect future cash flows, causing a reset of current valuations. While the speed of the rise is unusual and unnerving to some investors, it is important to zoom out to gain some perspective on the recent move in yields.

As we can see above, the US 10-year treasury yield is still at historically low levels.  In the chart above, bear markets are highlighted in gray.  Going back to 1970, we have never seen a bear market begin with a US 10-year treasury yield below 3%.  Our current rate is around 1.75%. 

Further assurance comes directly from the Fed Chair, Jerome Powell, when he recently said the Fed expects to observe a momentary bump in inflation in March and April as the $1,400 stimulus checks shows up in economic data, but that they are not concerned about inflation rising above their 2.5% tolerance threshold.  If inflation start to rise more than expected, Fed officials believe they have the tools to control it. 

The Fed further claimed that they will be able to control inflation and has stated they will want to see maximum employment before changing their policy.  This suggests it could be at least 2023 before we see major policy changes from the Fed, which is in line with the timeline they have outwardly discussed.       

What’s Next?

With numerous microtrends in play, and recent earrings reports confirming or even raising future guidance, we view this correction in tech stocks as normal and temporary. We believe central banks are and will continue with an accommodative monetary policy for the foreseeable future.  Corrections in growth stocks are not uncommon or unusual, no matter how painful they may be.  A short-term price correction does not ultimately affect the underlying businesses of the stocks that we own.

In 2019, we saw a similar correction in tech growth. That year, the focus was on cloud pure plays, where the popular narrative at the time was stressing the overvalued cloud stocks as the neo-bubble stocks. While the S&P500 dipped 6.6%, and quickly recovered, many names like Twilio, Zoom, Fastly, Shopify, Okta, etc. saw corrections between 30-50%.

Our portfolio is geared towards taking advantage of powerful, long-lasting industry microtrends that will shape future generations.  It is therefore illogical to stress over daily price movements in these innovative companies.

Growth Vs. Value and the NASDAQ100

Since the current secular bull market began in March of 2009, there is not an extended period of time where value has outperformed growth. This has been a growth driven bull market, with tech leading the way.

 

Even since the March low in 2020, tech has continued this trend. After the pandemic shutdown, many tech names saw outsized growth due to ongoing microtrends, while others saw a bump due to a stay-at-home economy leaning heavier on tech for support. Many of the value names were hit exceptionally hard, further widening this gap. With valuations stretched in the tech sector, rates on the rise and the economy opening up, we are starting to see a real value rotation.

 

 As the chart above shows, the 14% Gap between Tech Growth and Value has nearly closed. In fact, while many growth names are down, much like the cloud names in 2019, value stock in the same timeframe are actually up.

We view this rotation as a positive sign for the overall market. We need all sectors participating in a bull market for it to remain healthy. Furthermore, we do not believe this market will continue with value leading the charge. There are simply to many exciting and profitable microtrends unfolding in tech, which we do not see ending anytime soon. Instead, we view this moment as an opportunity.

We have been focusing on the NASDAQ100 for several reasons. For one, it is predominantly tech focused. Also, it has been leading this bull market, and for the market to continue higher, we don’t see that being possible without the NASDAQ100. We really need it to join the other major indexes to new highs before we can count this correction as being over.

In short, if the NASDAQ100 can break above last Wednesday’s high at 13300, the probability increases that the low is in for this growth selloff. However, if we fail to break above this level, we could see another leg lower before we can write this correction off.

With the NASDAQ100 showing a negative RSI reversal signal, coupled with many charts we track whose current corrections appear to be incomplete, we may add hedges going into next week. We are 3% from the 13300 breakout, and about 10% from our downside target, if the NASDAQ100 cannot breakout above the 13300 region. This is the type of risk/reward we are willing to take for a hedge, if this final leg lower does unfold.

Relative Strength

Regardless, if we breakout and continue up, or need one final leg lower, we do not believe this bull market is over yet, and that this drawdown has provided some fantastic opportunities. In periods of market weakness, it is important to look at areas of strength. The future leaders tend to be stocks that go down less than their peers, bottom first, and lead out of a correction. That being said, the bounce off the March 5th low has provided some clues on where who might lead the next leg higher.

As the above chart shows, to lump all of tech into one category would be a mistake. Even though the S&P500 Tech Sector is showing poor relative strength in the chart above this year, as well as from the March 5th bottom, it’s important to identify what dominates that sector. Being a market cap weighted index, Apple and Microsoft makes up over 40% of the index, so it is heavily influenced by big tech.

If we dive into other microtrends within tech, there are a handful of sectors that are showing strong relative strength, even in light of the tech sell-off. What interests us are the sectors that are showing the most strength since the March 5th bottom.

Bitcoin/Crypto Currencies

The number one performer since March 5th is bitcoin/cryptos, and the businesses around this microtrend. Bitcoin is up over 58% YTD, and more notable is that it has continued its strength since the March 5th bottom. Bitcoin is our largest position, and though we are forecasting a bout of weakness in the near future, we do believe the uptrend will ultimately continue into 2022.

However, there are several businesses that benefit from the crypto market, such as Square, Silvergate Capital, eToro, Coinbase, Voyager Digital, just to name a few. We currently own Voyager Digital (VYGVF), which is a crypto exchange as well as a fintech company.

After being up over 500% YTD, we believe Voyager’s best days are ahead of it. It’s also the leader of the group just mentioned in terms of projected forward growth. If Voyager Digital continues with the revenue it already posted in February at $20 million per month, the valuation below will be cut in half.

China Tech and Green Energy

Another trend we have seen since the March 5th bounce is green tech and Chinese tech. In fact, they rank as the #2 and #3 micro sectors within tech since the March 5th bottom.

This falls in line with one of our favorite tends in 2021 – Chinese EVs. XPeng has been in a large downtrend, which we have thoroughly tracked and bought into along the way. Since the March 5th bottom, XPEV has bounced as much as 48%, showing outstanding relative strength. Nio has also bounced as much as 38% from the bottom. We used this bout of weakness in Nio to begin our position. Even if we do see another leg lower in the market, the reaction from March 5th further confirms the opportunity we see in the Chinese EV market in 2021, which we will continue to target. 

You can read Beth’s analysis on XPEV and NIO here and here.

OTT/CTV Ads

Finally, OTT/CTV Ads has also shown considerable relative strength since the March 5th bottom. Going into 2021, it was one of our biggest convictions and we allocated our portfolio accordingly. This micro sector has been considerably strong YTD, outperforming all major sectors in the broad market, short of beaten down energy stocks. It currently ranks #4 in terms of strength since the March 5th bottom, suggesting that this trend still has more room to run.  

We currently own Roku, Magnite, Fubo within this trend. Even after a considerable drawdown in these names, they are still showing outperformance against the NASDAQ100.

Stocks on our Radar that are Showing Solid Relative Strength

Two more stocks that made news from a relative strength perspective include UPST and VUZI.  UPST recently raised 2021 revenue guidance by over 50% and the stock roared higher, while VUZI stock also reacted very positively to its earnings beat. 

Conclusion

We do not believe that this is the end for tech leadership in the bull market. There simply too many important microtrends at play, and more about to go online. This rotation is healthy. We want as many stocks and sectors participating in the bull market, which is typically what we see going into the strongest leg of a bull market.

We believe this correction has provided a fantastic opportunity to buy shares of out-of-favor tech names, which we do not believe will stay out of favor for long. The relative strength in certain micro sectors is telling us what areas will likely lead into the next leg up, and we are pleased to see that they are lining up with Beth’s 2021 thesis so far.

 

Kingsoft Cloud (KC)

Posted on by io-fund

On Friday, we initiated in Kingsoft Cloud. Please keep in mind, KC carries risk as the company has disclosed its earnings statements are not audited. As stated on the forum by our readers, the United States House is set to consider a measure this week to force U.S. listed Chinese companies to comply with audit terms. We cover additional risks below and Knox goes into the levels he is watching and how he plans to manage risk for this particular position.

We want to give a few bullet points here as to why we initiated despite the fact KC.

Overview:

We like Cloud IaaS in China and this is the basis for our Alibaba position. I mentioned this on the forum here. The United States cloud IaaS market is about $45 to $50 billion while China recently surpassed $5 billion – which reveals an important gap for this massive population.

According to some numbers, Kingsoft Cloud is the #3 cloud provider second to Alibaba and Tencent. According to others, Kingsoft Cloud is a close tie with Baidu in the #4 spot. Here is the quote from the S-1 filing: “We are the third largest internet cloud service provider in China with a market share of 5.4% in terms of revenue from Infrastructure as a Service, or IaaS, and Platform as a Service, or PaaS, public cloud services in 2019, according to Frost & Sullivan.”

Kingsoft could see multi-cloud as a tailwind due to being the largest independent cloud provider. Also, companies like Bytedance and iQIYI use KC to avoid using Tencent (direct competitor). The concentration of Bytedance and others is a risk.

Although market is undecided about Xiaomi’s involvement due to large customer concentration, we see this particular customer/backer as a positive. We like the Xiaomi has done well in China and we also like the focus on 5G, video content and health care/medical IoT to help KC find an edge against Alibaba, Tencent and Baidu. Xiaomi is the number two smartphone in China ahead of Apple and we think this resilience is a positive. In fact, we would not have invested without a strong backer in either AI or 5G so Xiaomi as an early investor, co-chairman and 14% of revenue is primary to our interest.

Kingsoft is focused on verticals, such as video streaming, gaming and health care. We like this approach as it shows an understanding of competitive positioning and clear differentiation from the larger competitors.

Kingsoft Cloud is scheduled be added to the MSCI China All Shares Index on November 30th at market close.

Net dollar retention rate is 155% in FY 2019

Revenue increased 72.6% year-over-year. This represents 48.1% growth from public cloud services and 257.3% growth from enterprise cloud services. Some of this was a rebound in enterprise from a covid deceleration. The company is expected to grow revenue 62% next year to $1.62 billion. To compare, Tencent Cloud is in the $3 billion range.

Adjusted gross profit was $16.9 million and adjusted EBITDA of -$3.9 million.

 

Risks

There are currently over 200 Chinese companies that are listed on U.S. exchanges. However, unlike U.S. companies that must comply with strict regulatory requirements, China-based audit firms are not in compliance with the U.S. Public Company Accounting Oversight Board (PCAOB) inspections required under the Sarbanes-Oxley Act of 2002 (SOX Act), which is supposed to apply to all U.S. listed publicly traded companies.  

The NASDAQ is requiring additional listing requirements for Chinese firms, while the U.S. Senate passed S. 945, the Holding Foreign Companies Accountable Act. This Act requires foreign companies to prove that they are not owned by governments, as well as requiring them to disclose to the SEC information that allows the PCAOB to perform inspections.

This change in U.S. regulations was soon followed by the Luckin Coffee fraud. The Chinese competitor to Starbucks admitted to falsifying their sales by roughly $2.2 billion yuan. This not only led to a sharp selloff in the stock, but also caused the NASDAQ to delist the stock.

The above reasons led to valuations in Chinese tech companies that are hard to come by in today’s markets. Because of the above risks, we will still invest in ideas we like, but with risk controls in place. Our two Chinese positions are Alibaba (BABA) and Kingsoft (KC), both of which now have stops in place. This will allow us to participate in the growth stories, while at the same time minimize our exposure to the macro and regulatory risks going on within China today.

The national debt to GDP ratio of the U.S. economy is estimated to be around 98% of GDP by the end of 2020, with the largest increase in government debt. In a similar response to the GFC, the Chinese government also attempted to stimulate their economy through debt, and is currently looking an unsustainable debt to GDP ratio of 317%, with the largest focus in corporate debt.

Basic Technical Analysis

From a basic Technical Analysis perspective, we have a nice base that has formed, which provides a clear breakout zone.

Note the large volume spike accompanied by a long green candle. This suggests that the sellers have dried up, leading to a rush of buyers. Seeing Friday close above $39.25 is promising. The next level of resistance will be $43.

Elliott Wave Analysis

If we dived deeper into the price structure, we can get further support of a potential breakout on the horizon.

The above chart outlines my structural analysis of the current price action in KC. First off, from its all-time low, we have a clear 5 wave move to the ended just below the $43 level. Each wave within this structure (in green on the left), moved along standard extensions, further supporting a wave 1 within a larger uptrend (in blue).

We then saw a symmetrical retrace to the 50% retrace level of the first wave. Once again, we typically see 2nd waves terminate around the 50% retrace level. The structure of this retrace also was symmetrical.  In other words, the length of the c wave in red was around the same length of the a wave in red.

This retrace was then followed by another 5 wave move up, and smaller retrace, suggesting that we are in the early stages of the larger degree 3rd wave in blue. The move on Friday further supported this thesis when we saw a high volume breakout above the $39.25 resistance. If we see a further breakout above the $43 level the above targets will be in effect.

We will use a wider stop than normal in this starter position. We always start small, and if we analyze a trend accurately, which is confirmed by an increase in price, we tend to build on that position along the uptrend. We will have a stop at $31.90 based on the closing price.