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Credit FAQ: The Competitive And Regulatory Risks For China's Internet Giants

China's internet consumer companies have caught the attention of debt investors. They are cash-rich, growing fast, and pouring resources into new consumer businesses. One such area is community group buying--a relatively new retail model. Some internet companies have already drawn fire from regulators. The crackdown on car-hailing giant Didi Global Inc. is but one example.

S&P Global Ratings believes most of our rated issuers have the financial headroom to offset the investment and regulatory risks that will likely persist. In our view, these companies have strong market positions, potential for growth in their niche segments, and an ability to monetize their user bases and data. This will be crucial to maintaining credit quality.

So far, the investment and regulatory risks appear to be mostly credit neutral to slightly negative for rated issuers. Investors have asked us about the potential impact on ratings should these risks materialize. We address these questions here.

Frequently Asked Questions

Emerging internet companies have made rapid gains in their user bases. How do such gains influence S&P Global Ratings ' view on the competitive landscape?

User base growth is just one of several key analytical factors for internet companies. Others include engagement and monetization. These add to the business considerations common to most companies such as market landscape, competitive positions, and cash flow generation (see "Different Routes To Riches For China's Niche Internet Players," published on RatingsDirect on Feb. 7, 2021).

A growing user base is an indicator of a company's growth potential and whether its service resonates with its users, and provides incremental value to existing apps, etc. The ability to grow a user base is important for internet companies in maintaining their competitiveness and credit quality over the long term. But improving user "stickiness" and monetizing traffic is equally important. A service may draw tremendous traffic but if that fails to generate revenue the business model is unsustainable.

How does S&P Global Ratings view the financial risks of cash-rich companies that have strong liquidity backed by capital markets but are currently loss-making?

Having ample cash on hand does not automatically translate to low financial risk. Strong investment appetite can quickly erode a company's cash pile. And capital market funding may not always be there should investor sentiment sour. A key fundamental measure remains a company's ability to generate free operating cash flow. A crucial question is whether the company is on track to generate cash flow within the expected time frame. Only when a company is able to generate free operating cash flow, can it organically support its operations.

On the other hand, if we don't expect a company to generate free operating cash flow for some time, then cash burn analysis becomes central to our rating analysis (i.e., based on the current cash burn rate or in a less rosy business environment, how long the cash will last before the company runs into liquidity issues). In this case, capital market access takes on greater importance as well.

As part of assessing financial risks, we also examine debt leverage. We look at certain financial ratios such as debt-to-EBITDA on a forward-looking basis. This considers management's risk appetite and tolerance for financial risks in making business decisions, seeking funding, and how the company constructs its balance sheet. Aggressive debt-funded acquisitions, large capital expenditure plans, or shareholder-friendly measures are some examples that may increase financial risks and erode a rating buffer.

How does S&P Global Ratings assess social implications, given many large platform operators contribute to society by providing jobs and paying taxes?

Our rating considers social factors that can materially influence the creditworthiness of a rated entity or issue. But this may only include factors that have sufficient visibility and materiality in our analysis. Depending on their size, large platform operators may receive different forms of support from the government, such as subsidies, research funds and tax benefits. These benefits may be included in our numbers when they can be reasonably forecast, or backed by a track record and government policies. However, these are usually small and have no material effect on companies' credit qualities.

There are examples of governments stepping in to support large and heavily indebted private companies. For example, Jiangsu provincial government recently provided liquidity support to one of China's largest retailers by revenue (not rated). But such support is not something we consider in assessing the credit qualities of private internet companies. Such kinds of support are unpredictable and in many instances are not timely enough to meet maturities. And it is more likely for internet companies to get into distress when they lose significant traffic to new platforms. This represents a change in consumer preference, in which case it's less likely a government would provide support.

Chart 1

How does S&P Global Ratings assess a founder's control and influence?

We assess a founder's control and influence in two areas. First, according to the effectiveness of the board; and second, whether controlling ownership negatively influences corporate decision-making by promoting the interests of the controlling owners above those of other stakeholders. If a board can effectively safeguard the interests of all stakeholders, it may be difficult for the founder to exert undue control or influence.

Excessive founder control may negatively influence performance or create risks. For example, we lowered the rating on shared-workspace provider, WeWork Inc., in September 2019 because of corporate governance risks. Questions arose about leadership accountability, oversight and conflicts of interest from a series of related party transactions, and senior executive positions held by family members or friends.

Table 1

Summary Of Scoring Rules For Governance Subfactors
Neutral Negative
Board effectiveness The board maintains sufficient independence from management to provide effective oversight of it. The board retains control as the final decision-making authority with respect to key enterprise risks, compensation, and/or conflicts of interest. The board manifests a lack of independence from management and provides insufficient oversight and scrutiny of key enterprise risks, compensation, and/or tolerates unmanaged conflicts of interest.
Entrepreneurial or controlling ownership Management and the board of directors have professional, independent members who are capably engaged in risk oversight on behalf of all stakeholders, including minority interests. The influence of controlling shareholders is offset by risk-aware professional management and a board that effectively serves the interests of all stakeholders. Controlling ownership negatively influences corporate decision-making to promote the interests of the controlling owners above those of other stakeholders.
How does S&P Global Ratings account for regulatory risk in credit analysis, and how has regulation affected credit ratings so far?

Threats from tightening regulations for large internet companies in China are rising, particularly around antitrust, data security, and variable interest entity (VIE). Penalties and fines are potentially big since they could be assessed according to companies' revenue. But most rated companies have healthy financial headroom in terms of cash and other key credit measures.

Non-financial implications are potentially the bigger risks and could change the companies' profitability and growth prospects. Forced break-up at this point isn't likely in China, in our opinion.

Chart 2


Antitrust actions have changed the way large internet companies operate. For instance, they can no longer force merchants to sell exclusively on their platforms; and the hurdles for large M&As are now higher. This will likely intensify competition, particularly in new growth areas, such as community group buying.

Tightening data and cybersecurity laws could result in business prohibition and financial penalties. The example of Didi shows that apps can be pulled from app stores--a material risk for most companies. This could affect the rated issuers as it potentially will test the consistency and predictability of future cash flow generation.

Among rated issuers, we are yet to see data privacy and security risks severely hit business growth. But the risks are growing in China. On the other hand, stricter regulations could benefit larger players since they have more resources and technical expertise than their smaller peers to cope with the regulatory requirements.

We believe the risk for VIE structures has increased in the past six months, especially for companies in sensitive sectors that have direct implications for national security and social stability. Education services (especially kindergarten-high school) certainly belong in that bucket. For companies operating in other areas, we believe the structure will endure but changes are possible.

VIE structures have been extensively used by some of the highest-profile companies to fund their operations and growth. Dismantling or disallowing VIE would cause significant disruption to these companies, capital markets, and dissuade foreign investors from investing in China, which conflicts with the government's stated objectives.

How does S&P Global Ratings determine peer selection for the so called "new economy" companies?

Our peer analysis usually includes companies with similar industry characteristics, business models, and financials. While China's internet landscape is diverse and issuers could be leaders in different niche markets, their success still hinges on four key considerations:

  • Market landscape, which has important implications for issuers' revenue size, growth, and profitability;
  • Competitive positions within that landscape;
  • User base and data, which is key to monetizing digital traffic and increasing barriers; and
  • Cash generation.

Focusing on these dimensions, we compare Chinese internet companies to both domestic and global peers, even if they don't operate in the same market. For example, we compare China's Tencent Holdings Ltd. to U.S.-based Alphabet Inc., Activision Blizzard Inc., and Netflix Inc. since these companies provide one or more online entertainment, media, or consumer service globally.

Related Research

Related Criteria

  • Corporate Methodology, Nov. 19, 2013
  • General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012

This report does not constitute a rating action.

Primary Credit Analyst:Aras Poon, Hong Kong (852) 2532-8069;
Secondary Contacts:Sandy Lim, CFA, Hong Kong + 852 2533 3578;
Clifford Kurz, Hong Kong + 852 2533 3534;

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