Articles

China Sector Analysis: Communication Services

Feb 5, 2019

The Communication Services sector was introduced in September 2018, following changes to the Global Industry Standard Classification System (GICS). The changes included renaming the ‘Telecommunications’(Telecoms) sector as ‘Communication Services’ and broadening its exposure to include firms from the media, entertainment, and interactive media & services industries. Upon implementation, these changes established a Communication Services sector in equity markets globally, including China. This sector is one of the largest by market cap in China, and is widely viewed as a long-term, high-growth play that seems well-positioned to benefit from China’s trends of rising consumption and technological prowess.

In this piece, we take an in-depth look at the key stats, notable companies, and thematic tailwinds affecting this sector.

Key Stats

Communication Services ranks as the third largest GICS sector in China by market cap, which is similar to its fourth-place ranking in the US. The largest industry group within the sector, making up over 37%, is Interactive Media & Service. This industry group consists of many of the country’s most innovative companies, including those running search engines and social media networks. Overall, analysts anticipate that China’s Communication Services will deliver higher revenue growth versus its US counterpart, owing to several thematic tailwinds, including deepening internet penetration, rising wages & consumption, changing consumer habits to favor new technologies, and government support – all of which is discussed in greater detail later in this piece. Despite higher growth expectations, valuations appear cheaper than its US counterpart, across price-to-earnings, price-to-sales, and price-to-book metrics.

Key Stats on China Communication Services Sector

While nearly half of the sector is listed in the United States via ADRs, the recent inclusion of onshore China-listed A shares into MSCI’s indexes greatly broadened foreign investor access to the Communication Services sector in China. Over half of the sector is comprised of A shares, H Shares, P Chips and Red Chips.

American Depositary Receipts (ADRs) are stocks of Chinese companies listed on American stock exchanges. A shares are listed on domestic stock exchanges in China and have been historically difficult to access. P Chips are stocks of companies operating in China, listed in Hong Kong, and incorporated in the Cayman or British Virgin Islands. Red Chips are stocks of companies based in China, incorporated abroad, and listed in Hong Kong. H shares are stocks of companies incorporated in China and listed in Hong Kong.

Notable Companies

China’s Communication Services sector includes a host of innovative internet, social media, streaming, gaming, and telecom companies that have been driving the country’s efforts to become a global technology powerhouse. Given the size of China’s middle class, many of these companies have built among the largest user bases in the world and are often compared to similar well-known firms in the US. The table below shows the top 5 companies by market cap in the Communication Services sector and provides a look at their core businesses and comparable firms in the US.

For Top 10 Holdings of the fund please click here. Holdings are subject to change. Current and future holdings are subject to risk.

Thematic Tailwinds Powering Growth

The Communication Services sector seems well-positioned to benefit from a confluence of powerful tailwinds, happening at the consumer, government, and international levels.

Consumers are Heading Online:

  • Much of China’s population has moved to cities in pursuit of higher wages and therefore greater disposable income. Since 2010, the percentage of the population living in cities has increased by nearly 3% annually and the disposable income of urban households has increased by nearly 10% per annum1
  • With greater urbanization and disposable income, China’s rising middle class has become increasingly connected online. Internet penetration has reached 55%, rising nearly 20% in a decade, but still has much further room to grow compared to the US, which stands at 87%2
  • Despite a lower percentage of internet penetration, China’s substantially larger population and avid adoption of new technologies has resulted in 3x as many internet users, 3.75x more mobile phone users, and 7.5x amount spent on mobile transactions compared to the US3

China Internet Penetration

Consumer Preferences Favor Tech: Chinese consumers have demonstrated quick adoption of new technologies. This is reflected in the rapid 4G adoption rates versus 3G, providing the backbone for data-intensive media consumption, mobile payments, and chat features. Part of this adoption speed is due to technology ‘leapfrogging’, which enables developing markets to quickly adopt the latest technology, rather than needing to replace well-entrenched habits or infrastructure. For example, Chinese consumers have leapfrogged credit cards, spending over $15 trillion in mobile payments during 2017, compared to $2 trillion spent in the US or $377 billion five years earlier.4 According to a recent study, China has the highest adoption rate of fintech globally, explaining the rapid growth of mobile payments and e-commerce in China.

China 4G vs. 3G Adoption Rate

Tencent’s one-stop social media application “WeChat” facilitates around 40% of these mobile payments as of 2017.6 The platform has redefined the entire concept of an app, not only serving as a messaging platform, but also acting as a one-stop substitute for Apple Pay, Venmo, Facebook, Amazon, Uber, and Grubhub, which are blocked by China’s “Great Firewall.” This comprehensive platform allows users to make payments, order food delivery, purchase entertainment tickets, and order rides through one of its million-plus “mini-apps.”7  The rising generation of 400+ million millennials in China, who are the power users of these apps, are also shattering China’s conservative saving mentality. Rather than save a majority of their income as previous generations have, Chinese millennials are earning more and saving less, causing many consumer firms to target their wallets through these apps.8

Government Support for Communication Services

A common theme among high-growth potential sectors in China is that the government helps accelerate expansion through a variety of supportive policies. For the Communication Services sector, the government has advanced a series of measures supporting its growth, from consumption stimulus to internet infrastructure, technological innovation, and deregulation.

  • Policy Support: Chinese fiscal stimulus, including the recent Individual Income Tax (IIT) cuts, is designed to increase overall spending on consumption, especially across areas that dovetail China’s broader national strategy. This includes the expansion of telecom infrastructure, enabling consumers to consume more through e-commerce and media & entertainment platforms. Key national strategies like the Made in China 2025 (MIC), Belt and Road (BRI), Broadband China, and Internet Plus initiatives, all buttress the sector’s growth by facilitating a greater buildout of internet infrastructure
  • Innovation: China’s government is heavily incentivizing research and development, putting China on track to outpace the US on R&D spending.9 Recognizing that technological advancements are critical to growth, China’s heavy R&D investments and incentives for start-ups and corporates alike has led these firms to assume global leadership roles in the development of disruptive technologies like AI & big data, autonomous vehicles, and 5G. These efforts accelerated China’s shift from producing labor-intensive manufacturing towards high value services in the Communication Services sector. As targeted beneficiaries, Chinese telecom and internet companies represented five of the world’s top 10 venture capital deals in 2018 and seven in 201610
  • Deregulation: Recent efforts to deregulate are expected to be key to unlocking the growth potential for Chinese companies in segments like gaming, where demand is strong across demographic segments. Nearly half of China’s country’s gamers are female versus only two-fifths in the US.11 With the December removal of an approval freeze on new games,12 game publishers are likely to further expand their userbases in what is already the world’s largest gaming market

International Expansion: Chinese communications firms often benefit from protections against foreign competition, which helps build their scale in China before competing internationally. Yet given that many have now built substantial scale, international expansion is inevitable. Over the last several years, Chinese game publishers have expanded abroad to fuel additional growth. Through partnerships and acquisitions, they have increased their international presence. Tencent has been especially aggressive, buying stakes in nearly 300 companies across developed and developing markets over the past 6 years, including Indonesia’s e-commerce giant, Shopee, and the US creator of ‘Fortnite’, Epic Games.13 Another firm expanding rapidly across markets is Baidu, which has partnered with Microsoft, Ford and Hyundai on its Apollo Project to develop autonomous driving and AI, as well as most recently with US retailer Walmart to test driverless delivery vans.

Conclusion

China’s Communication Services sector sits at the intersection of a variety of powerful trends, including rising consumption and the development and adoption of advanced technologies like search engines, social media, gaming, and mobile payments. As such, we believe this makes the sector one of the more attractive long-term segments of the Chinese equity markets.

 

Related ETF

CHIC: The Global X MSCI China Communication Services ETF seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI China Communication Services 10/50 Index.

Category: Articles

Topics: China, Emerging Markets

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