After nearly three challenging years of a stringent regulatory environment and impact from the pandemic, a new normal has been established for China’s Internet industry. The ebbs and flows in the industry will be changed, as a new regulatory regime with much stronger monitoring and focus on data security has been implemented.

Meanwhile, there has been a much higher penetration in online activities (imagine the daily life of a non-active Internet user during the pandemic when various kinds of social mobility restrictions were implemented).

From growth to cyclical stocks

We see mid-to-high single-digit percent as the long-term growth potential for the Internet sector on aggregate, compared to 20%–30% in the past. This is no longer a secular growth area, but a sector with increasing correlation with economic cycles.

We expect a lukewarm recovery in the Chinese economy this year, which should drive a recovery in Internet earnings growth. Nonetheless, high-frequency data in April suggest that the macro momentum has slowed, and we expect investors to raise their defensiveness in their allocation.

We prefer the less cyclical segments such as online games and online travel over advertising and e-commerce — the latter two have a stronger correlation with the economy. Between the two, e-commerce is facing renewed competition, so it may encounter margin pressure again.

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Here are our key arguments for the different Internet verticals.

Online games: Strong pipelines to drive growth

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We see online games as the least cyclical business among Internet verticals. Since this year, new title approval has returned to the normal pace seen in 2019–2021, suggesting that previous regulatory tightening has largely reversed.

Both online gaming majors in China have a strong pipeline of new titles, some of which have already received approval and others to be approved. We expect one or two blockbuster titles from each company, supporting strong revenue growth this year.

Travel: Buoyant pent-up demand

With the end of Covid-related restrictions, both China domestic and outbound tourism bookings should enjoy a robust recovery throughout 2023. Major online travel companies have indicated that domestic hotel and air ticket bookings have already surpassed pre-Covid levels and they also see very robust pent-up demand for outbound travel bookings.

During the five-day Labour Day holiday (29 April to 3 May), the China Ministry of Culture and Tourism reported that 274 million domestic tourists travelled, driving tourism-related sales of CNY148 billion ($28 billion). This is equivalent to 119% and 101% of the same period in 2019 (pre-Covid), respectively.

The government bureau also indicated that the recovery for outbound travel has picked up notably as flight capacity and ticket prices gradually normalises. Initially, short-haul travel seems more favourable compared to long-haul, with top destinations including Macau, Hong Kong, Bangkok and Singapore. The buoyant pent-up demand and improving capacity should drive travel companies’ domestic revenue recovery by up to 90% of pre-pandemic levels, in our view.

Advertising: Macro-driven recovery

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Advertising revenue is generally tied to the macro backdrop, with only a few exceptions (e.g. advertising on new games). Our economists assume a lukewarm recovery in the Chinese economy, which should drive a mild re-acceleration in advertising. In spite of this, each company still has a different leverage on the macro trend, e.g. live streaming e-commerce, chat functions, online marketing, AI chat boxes.

Tencent may gain wallet share of advertising with its strong traction of video accounts. The company plans to gradually raise the ad load and also explore live-streaming e-commerce. We also see room to dial up the monetisation of other WeChat functions, such as Moments and Mini-Programme.

We are watching if Baidu’s advertising vertical recovers on a better macro backdrop, as online marketing revenue still counts over half of total net revenue of the company. The key debate on the company, however, is whether its Ernie-bot (Baidu’s AI chat-box) will indeed boost traffic share and monetisation. Ernie-bot was initially launched as a standalone product, but the company aims to integrate it into the search function to improve user experience. This will be the focus of the upcoming 1Q2023 earnings release, as the market awaits to hear more details on the implementation plan.

E-commerce: Renowned but different headwinds

China’s domestic e-commerce players have delivered phenomenal performance during the first two years of pandemic (2020–2021). Nevertheless, the tide has changed in 2022. The industry has experienced a sharp growth deceleration since then.

In our view, this could be due to a combination of the following factors:

a. More severe/widespread impact from the pandemic in 2022 (heavy and persisting disruptions to supply chain and logistics);

b. Weakening consumption sentiment (possibly due to loss of job and reduced disposal income); and

c. Negative wealth effect (from the lacklustre property market performance).

Entering a period of new normal

With China’s reopening, the market has been expecting a strong recovery in domestic consumption. For e-commerce, the negative factor of (a) has disappeared. Nevertheless, we expect there could still be some lagging impact from (b) and (c) extending into 2023.

So far, based on government statistics, the recovery in January and February has been moderate, followed by a faster acceleration in March. Upcoming e-commerce companies’ quarterly earnings results should reveal more about where the growth is heading for the rest of 2023.

Our current assessment is that the industry e-commerce sales growth could return to mid-to-high single-digit figures in 2H2023. A double-digit growth level may be difficult to attain due to the lagging headwinds we have discussed. Moreover, e-commerce is already a deeply penetrated sector in China. The growth should gradually converge with that of the overall retail sales.

Richard Tang is China strategist and head of research, Hong Kong, and Eric Mak is Hong Kong and China equity analyst at Julius Baer

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