The Kuaishou $1024.HK advantage - Part 2.

Unlocking Growth in China's Lower-tier Cities.

This is the full analysis - the executive summary I published already last week.

Overview:

Kuaishou $1024.HK is a Chinese short video social media plattform - often regarded as the lesser-known counterpart of Bytedance’s Douyin—known as TikTok in the West. Despite barely being know in the West it is a household name in China with DAUs and MAUs on the Kuaishou App reached 382.5 million and 700.4 million. This positions them as one of the leading internet platforms, trailing behind giants like Tencent ($0700.HK), ByteDance, Alibaba ($BABA), Pinduoduo ($PDD), Meituan ($3690.HK), and Jingdong ($JD). Kuaishou is at the forefront among the smaller platforms, which include Xiaohongshu, Bilibili ($BILI), Zhihu ($ZH), VIPShop ($VIPS), and others.

Kuaishou operates across three primary segments: online marketing services, through targeted ads in short videos and external brand advertising; e-commerce (contained in the other services), from which it earns commissions on transactions; and live streaming, generating revenue by selling virtual gifts to fans of content creators. Within the live streaming segment, innovative business models such as Kwai Hire (快聘), a HR service, and Ideal Housing (理想家), which sells real estate, are experiencing rapid growth. Recently, their short dramas, 快手星芒短剧, have also seen rapid growth and are a significant driver of growth for the platform. In addition to these main areas, Kuaishou also maintains a small business presence overseas to which I come later.

Recent business development - financial metrics:

They have experienced rapid growth, with revenue increasing from RMB 8.3 billion in 2017 to RMB 94 billion in 2022, and reaching RMB 113.5 billion in 2023. GMV surged by 1973% to RMB 1,184 billion in 2023. While they are still smaller than some of their peers, their size is significant, and their GMV is outgrowing that of the established players. For comparison, Pinduoduo and Jingdong have a GMV of approximately RMB 3,500 billion, and Alibaba's GMV is around RMB 7,600 billion. Moreover, in China's internet advertising market, Kuaishou's share has exceeded 5% for the first time.

During this period, they incurred significant financial losses. Kuaishou went public in 2021 amid the peak of the COVID-related tech craze, with the stock trading at 400 HKD. This was a time when everyone was trying to expand revenue at all costs. Since then, the stock price has plummeted to below 50 HKD.

Like many Chinese internet companies (except Alibaba, which is gradually getting there, see my recent article on that), they have since shifted their priorities. Revenue growth has slowed to a more sustainable rate of about 20%, while they have also phased out unprofitable business areas, thereby increasing the gross profit margin from roughly 30% to nearly 50%. At the same time, they have succeeded in reducing operating expenses while continuing to grow revenue and earnings. This shift in focus among Chinese companies is well-discussed in Tencent's latest earnings call, where Tencent now views gross profit growth as their main KPI, moving away from revenue growth, which has become a less important metric.

2023 marks a turning point for Kuaishou, as it reported its first profitable year in the company's history. As operational leverage takes effect, a simple back-of-the-envelope calculation reveals that if they can achieve a 14% revenue growth with fixed gross margins and operational costs, it would result in a 150% growth in operating profit in 2024.

They boast a strong balance sheet, with approximately RMB 7 per share in net cash. In May 2023, they announced a HKD 4 billion share buyback program.

Technology advances:

On the technology front, Kuaishou's KwaiYii language model now outperforms GPT-3.5 by integrating extensive commercial knowledge, making it comparable to GPT-4 in reflecting the platform's core capabilities. The platform has seen advancements with the Niwa Digital Human platform, which supports over 2,200 digital humans for continuous broadcasting. Additionally, the Pangu Video AIGC technology has improved marketing conversion rates by 33%. These developments highlight Kuaishou's commitment to using AI to boost marketing effectiveness and return on investment.

Also, there was a notable quote in the Tencent earnings call regarding how large language models can enhance monetization.

In terms of the AI short-term benefits, I think financial benefits should be much more indexed towards the advertising side because if you think about the size of our advertising business as call it RMB 100 billion a year. And if you can just have a 10% increase, right, that's RMB 10 billion and mostly on profit, right? So that's the scale of the benefits on the advertising side and especially as we see continued growth of our advertising business and when we add in the Video Accounts e-commerce ecosystem, that just has a very long track of growth potential and also the low ad load right now within Video Accounts.

Why short videos are so important:

The significance of short videos in China has propelled ByteDance, the owner of Douyin and TikTok, to become one of the country's most valuable companies, even though it remains unlisted. Recently, it surpassed Tencent in terms of revenue. Around 80% of internet users in China utilize short videos, dedicating approximately 20% of their online time to these short video platforms.

Short videos and live streaming are particularly popular in China, with live streaming e-commerce enjoying far greater popularity than in the West. The reasons for this are not entirely clear to me, but what stands out is the cultural appreciation for the format and a preference for listening to live product pitches rather than searching or reading online. In my experience, this preference is deeply rooted in Chinese culture, where personal recommendations and interactions still play a crucial role in daily and business life. According to official data, in 2022, live streaming e-commerce buyers accounted for more than 40% of total internet users in China.

Whoever holds power and consumer mindshare can steer their users toward any product they wish in form of advertising. But there are more use cases, as demonstrated by Kuaishou’s HR service, Kwai Hire (快聘). They can rapidly attain user numbers that other platforms, such as Boss Zhipin ($BZ) and Tongdao Liepin ($6100.HK), took years to develop. (It's only fair to acknowledge that these platforms still do hold the advantage of specialized industry knowledge, yet I view Kwai Hire as a dangerous competitor to them - especially for blue collar jobs.)

No one knows about the power of consumer mindshare better than Tencent. Their WeChat app (微信) has the power to create substantial businesses like Pinduoduo, Jingdong, and Meituan, all leveraging WeChat's platform (referring specifically to the Chinese version of WeChat, not the limited version available outside of China). This platform's immense utility and consumer mindshare are unparalleled. Warren Buffett once posed a hypothetical question, asking if people would accept $10,000 in exchange for never using an Apple product again in their lives. Similarly, I would refuse even $100,000 to stop using WeChat (微信) again.

Recognizing the significance of this trend, Tencent, China’s largest company, has declared short videos a new strategic priority, viewing them as a key driver of growth. The opportunity and Total Addressable Market (TAM) are substantial, large enough even for major companies like Tencent. They have integrated their own short video platform, Video Accounts, into the WeChat app. Although this is not their first foray into the short video market—having previously discontinued the Now platform—Tencent has a history of investing in promising ventures when unable to build the business internally. After encountering challenges in e-commerce, they made successful investments in platforms like Jingdong ($JD), Meituan ($3690.HK), Pinduoduo ($PDD), and VIPShop ($VIPS), all benefiting from the traffic on the WeChat app. Due to their initial challenges in the short video space, Tencent acquired a 19% stake in Kuaishou. Despite this, Tencent is now making a determined effort to succeed with its own short video platform, and this time, they seem to be on the path to success.

Competitive landscape:

This might suggest an oversaturation of short video platforms, and indeed, the competition is intense. However, each platform in China has a specific user group, distinguishing itself in the crowded market. While major platforms like WeChat have virtually all Chinese internet users, others are strong in distinct subgroups. Kuaishou has a strong presence in lower-tier Chinese cities and among young users, whereas Douyin is more popular in Tier 1 and 2 cities. Xiaohongshu is favored among women, and Bilibili predominantly attracts younger users.

The UI and appearance of these apps have converged over the years. In the early days, Kuaishou maintained a split screen between short videos and live streaming, but now they have all converged and essentially look the same. Additionally, the business models have somewhat converged. While Kuaishou, a few years ago, generated 90% of its revenue from live streaming and only a small fraction from advertising, now it's more balanced, roughly at 35%.

Despite their superficial similarities, significant differences still exist among these short video platforms.

Douyin is known for numerous viral videos, including early lip-sync videos, and arguably possesses the strongest recommendation algorithm among the three. They care more about what gets likes and monetize that through advertisements and don’t try to be a social media platform. ByteDance, manages various media outlets, including Toutiao. This consolidation allows advertisers to reach a broad audience across various channels through a single company, significantly reducing the necessity for a sales team to interact with numerous platforms.

Kuaishou emphasizes interaction and engagement between users and content creators more strongly, which is particularly relevant in lower-tier cities. They were mainly working on building local communities by paying more attention to how people interact, like through comments and sharing, rather than just counting likes. They wanted to see what stuff people were sharing with their friends, trying to act more like a social media company, unlike Bytedance, which doesn't really try to do that. In lower-tier cities, Kuaishou is dominant and reaches users that are not accessed by any other platform.

Tencent has added Video Accounts to its WeChat app, aiming to create a unified platform. If successful, this could be a powerful combination, linking WeChat with short videos, payment services, and mini-programs. However, Tencent is currently trailing in development but catching rapidly up.

Kuaishou's Dominance in Lower-Tier Cities and Its Significance:

In China, young people are relocating from major cities such as Beijing and Shanghai to smaller ones, driven by the high cost of living in these larger cities, especially the cost of housing. Currently, houses in first-tier cities are trading often at 80 times the annual rent, rendering them essentially unaffordable for most young people. They question the rationale behind investing all their money into a cramped apartment when they could get a spacious house with a garden for a fraction of the price elsewhere. This shift leads to substantial savings, allowing individuals to allocate their funds towards other expenditures. Additionally, this trend is shaping consumer behavior; habits prevalent in large cities, including daily coffee consumption, are now taking root in smaller towns.

These smaller cities are not just helping people save money; they're emerging as new centers of economic growth in China. With more young people relocating to these areas, there's an increase in spending and new business opportunities, signaling a significant shift in where companies focus their growth efforts in China. This isn't just a temporary thing; it's a major shift that shows smaller cities are now key places for companies looking to grow in China.

For most online platforms, advertising is the primary way to earn money. However, since many of these platforms share similar users, advertisers typically choose to spend their money on the largest ones.

Kuaishou stands out in this context. A significant portion of its user base, nearly 61%, is in smaller, tier-3 cities and below, areas not heavily targeted by other major platforms. Previously, this unique aspect of Kuaishou was viewed negatively for advertising purposes, as advertisers considered these users to be less valuable.

However, today's changing consumer landscape has turned Kuaishou's previous disadvantages into strengths, setting it apart from other platforms. While most online products can reach users in larger, tier-1 and tier-2 cities without much difficulty, Kuaishou becomes essential for advertisers looking to connect with new users more affordably in smaller, tier-3 and tier-4 cities, as well as in county and township areas.

This is precisely what has recently made Kuaishou increasingly attractive to advertisers, as it reaches many users not covered by other social media platforms.

Overseas business:

Kuaishou initiated their international expansion in 2017, focusing on areas like Indonesia, and Brazil. Unlike their strategy in China, their international approach involved attempting to mimic Douyin by focusing on garnering likes instead of building communities.

However, unlike TikTok, they never pursued major acquisitions or spent significant money on advertising. As a result, their international efforts never truly gained momentum beyond the markets mentioned earlier, where they had a sort of first-mover advantage.

The issue they faced was an inability to monetize their international business, leading to significant losses. However, this situation has recently improved, with revenue growing by 265% year over year and losses decreasing by 58% year over year. Although the international business remains small compared to their domestic operations (a bit more than 2%), it is nearing the break-even point. At the moment, this segment of the business isn't highly significant, acting more like a potential opportunity for the future. The positive takeaway is that the huge losses are now essentially capped.

Risks:

Of course, there are inherent risks associated with the investment.

One major risk is the fierce competition among Chinese tech companies; Kuaishou is up against some of the best management teams in the country, including those from ByteDance and Tencent. So one has to monitor the situation closely.

Additionally, Tencent still holds a significant portion of Kuaishou's shares, and there's a possibility they might divest these shares at some point.

Regulatory challenges also pose a risk. Specifically, for their live streaming business, a 7% revenue decline is anticipated next year due to adjustments made in response to fraud and in proactive efforts to avoid governmental sanctions. In any case, live streaming is a no-moat business, heavily reliant on the presence of live streaming hosts. This vulnerability was highlighted recently when a renowned live streamer from New Oriental ($EDU) announced his departure from the platform, leading to an instant decline in share price by more than 10% (and then bouncing back after he announced that he would come back). Nevertheless, livestreaming is the weakest part of Kuaishou's operations. Other segments, such as advertising and e-commerce, are the true engines of growth for the company.

Why opportunity exists:

I believe several factors contribute.

A few years ago, Kuaishou was actually the leading short video platform in China. There was a debate about which company would emerge as the winner, and since then, Douyin has become the victor, gaining more users and securing a larger share of the advertising revenue. As a result, Kuaishou was perceived as the lesser platform. However, as I've attempted to explain, the situation is quickly evolving. Kuaishou is now profitable and attracting more attention due to its unique user base, which is becoming increasingly valuable. I believe this is still not recognized by too many people.

Another significant factor is that Kuaishou, with its limited international presence and being listed only on the Hong Kong stock market, often goes unnoticed by foreign investors. Similarly, other Hong Kong companies like Tencent, despite their extensive international presence through video games, attract less attention than Alibaba, and even less so for companies primarily operating within China, like Meituan and Kuaishou.

Summary:

In summary, Kuaishou, with its unique foothold in China's lower-tier cities, is ideally positioned to benefit from new growth opportunities in these regions. Its user base is becoming increasingly valuable. Currently, at an inflection point after just turning a profit, Kuaishou is poised for greater profitability thanks to operational leverage and various levers they can pull to further increase profitability. Together with their strong balance sheet, they appear to be undervalued at current prices.

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