Investors won\u2019t think twice about eye-watering valuations so long as Beijing keeps spending on the sector.<\/b>
\nChina is nothing if not ambitious. Facing a coronavirus-battered economy, Beijing is speeding up an infrastructure build-out to stimulate growth, vowing to spend an estimated $1.4 trillion over five years on areas such as 5G, industrial automation and cybersecurity.
This enthusiasm has propelled a fast and furious surge in stocks. The tech-heavy ChiNext Index is up 46% this year, and sports an eye-popping valuation of 35 times 2021 earnings. That\u2019s above the Nasdaq Composite Index\u2019s 27.5 times, which is already expensive and reason enough for the rally to fade.
Investors are smart to play in fields where the fiscal dollars are. But it\u2019s also a dangerous game. What\u2019s recurring income and what counts as extraordinary items? Once we remove government subsidies, the valuations of China\u2019s tech darlings become even airier.
Helicopter money can come in many forms. First and foremost, Beijing is a large client. Even before the coronavirus, the government was the biggest buyer of IT security, accounting for 27% of total spending last year, according to IDC. Meanwhile, the latest policies, which require stringent security reviews, clearly favor local providers. Investors have picked up on this theme: Shenzhen-based Sangfor Technologies Inc., with a 25% and 22% market share in China\u2019s VPN and content security segments, has soared 89% this year to $12.6 billion in market value.
There are also regular cash handouts that lubricate companies\u2019 daily operations, and money for new industrial parks. Injecting capital outright, as well as fast-tracking public-markets financing, are also on the table. Semiconductor Manufacturing International Corp., China\u2019s largest chip foundry and its best shot at catching up to Taiwan Semiconductor Manufacturing Co., checks all of the boxes. Its Hong Kong-listed shares have risen more than 200%, amassing a market cap of $29 billion.
Without the Beijing put, though, the income statements of many tech firms would look drastically different. At SMIC, government funding, which appears in \u201cother operating income,\u201d rose 87% to $293 million in 2019. A further $59 million in the first quarter exceeded the foundry\u2019s $51 million bottom-line profit; in other words, without subsidies, SMIC would be in the red \u2014 and it wouldn\u2019t even have a price-to-earnings ratio to look at.
This phenomenon is pervasive. Of the 37 listed companies classified as \u201cintegrated circuit\u201d industries, subsidies accounted for a whopping 15% of operating profit last year, on a market-cap weighted basis, Bloomberg Opinion analysis shows.
The stand-outs are memory-chip maker Gigadevice Semiconductor (Beijing) Inc. and Unigroup Guoxin Microelectronics Co., which designs chips used in smart cards. A similar picture emerges for software companies, such as Yonyou Network Technology Co., which aims to become China\u2019s Salesforce.com Inc., and Sangfor. All these stocks are big winners this year.
While it\u2019s great Beijing is tending its tech gardens right now, the question is whether and when it will pull the plug. Over the years, China\u2019s electric vehicle sector has had an on-again, off-again relationship with subsidies, creating turbulence in stocks, as my colleague Anjani Trivedi has written. Will the government get tired of paying for an expensive tech build-out, too?
Another aspect worth considering is that, unlike previous endeavors, this new infrastructure spree will rely more on local governments than national spending. Indeed, major areas including Beijing, Shanghai and Jiangsu province have been rolling out ambitious investment blueprints lately. But, pinched by the virus outbreak, they have no money. Their funding gap will reach as much as 11.5 trillion yuan ($1.64 trillion) this year, according to the Ministry of Finance. The southwestern city of Chongqing, for instance, saw its fiscal revenue tumble by 16.8% in the first four months this year. Still, it vowed to become a strategic investor in Tsinghua Unigroup Co., which has the very expensive goal of becoming China\u2019s Samsung Electronics Co. Will Chongqing be able to deliver?
Of course, extraordinary times call for extraordinary ways to look at stocks. Right now, investors have big grins on their faces when they do a word search for mentions of \u201cgovernment\u201d in company filings. China\u2019s tech carnival can\u2019t go on forever, though. At some point, wary of the trillion-dollar bills, Beijing will want to slow down the money flow. By then, investors will be left holding stocks with lofty ambitions and peanut-sized earnings.
To contact the author of this story:Shuli Ren at sren38@bloomberg.net
To contact the editor responsible for this story:Rachel Rosenthal at rrosenthal21@bloomberg.net<\/p>\n