Technology: The tug of war - innovation vs. regulation

By Sundeep Gantori, Analyst, Carl Berrisford, Analyst, Hyde Chen, Analyst

The regulatory backlash in 2018 is unlikely to derail the long-term growth prospects of Asia’s innovative industries, and we continue to expect them to disrupt traditional industries in the years ahead. While uncertainty may persist in the near term, we see opportunities in public markets following the 2018 sell-off and in private equity for longer-term investors.

Asian innovation boom continues

The 2018 Bloomberg Innovation Index hasexperienced two significant milestones in2018. First, the US dropped out of top 10 for the first time in six years with a new rankingof 11. Second, China jumped two places to 19, entering the top 20 for the first time.While other Asian countries like South Korea (firmly in first) and Singapore (moved up three spots to third) continue to top the index, our key takeaway from this ranking shift is that the innovation gap between China and the US is narrowing. China continues to impress on patent activity with a global ranking of 6. Its ascent is perhaps best epitomized by the jump in the number of unicorns, or unlisted start-ups valued at more than USD 1bn, to 83 currently from 55 at this time in 2017.

Notably, the list of Chinese unicorns is dominated by what we call the “secular seven” industries: advertising, biotech, e-commerce, fintech, gaming, online education and onlinetravel. These sub-sectors account for almost 38 unicorns, with a combined valuation of around USD 84bn, and create significant disruption in China, driving annual sales close to USD 1.4trn and registering 25% revenues growth over the past few years. (The longterm growth potential for these industries is addressed in our past Shifting Asia publications “The road to cashless societies,” “China’s biotech revolution,” and Ahead of the game.”

China’s innovation gap with US is narrowing

Innovation score

Source: Bloomberg Intelligence, UBS, as of November 2018

Impact of regulations: shaken but not stirred

However, public markets have told us a different story in 2018 – the share prices of companies in the “secular seven” industries have been hit hard by new regulations in China. Tech stocks corrected by 30–40% as consensus revised down earnings estimates, flagging short-term growth concerns. The question remains whether the cloud of uncertainty will eventually lift as regulators clarify the rules of the game, or if regulations will permanently derail the long-term growth potential of China’s innovative industries.

The brief history of such innovative industries in China makes it hard to predict when regulatory pressures might cool down. However, lessons from the regulations of innovative companies in other countries lead us to believe that growth rates may reset only slightly as these companies adjust to the “new normal” of greater scrutiny – but they should still deliver growth rates well in excess of nominal GDP growth thanks to strong secular opportunities. For most innovative industries in China, we now expect 15–20% revenues growth rates over the next few years (versus 20–25% previously). Such growth rates – still impressive considering Asian market revenues are growingby 5–10% annually – should be achievableas these industries gain market share from and disrupt traditional industries.

Key to our view is our belief that the intention of the Chinese government is not to deter, let alone to damage, innovative or online business models. Instead, regulations are intended to prevent excesses, improve user protection, and drive healthier and more sustainable growth. For instance, the new nationwide drug tendering system in China’s biotech space is a positive long-term development, in our view, given the government’s ambition to shift drug costreimbursements away from cheaper genericsand toward higher-priced innovative and bio logic drugs, for which demand is high but affordability is low. Similarly, regulations in gaming, online travel and e-commerce aremeant to maintain high-quality content, reduce addiction and offer user protection.

Summary of key regulations affecting innovative industries in China

By industry and regulation in China

Industry

Industry

Regulation

Regulation

Industry

Biotech

Regulation

Nationwide drug tender system triggered concerns over generic drug prices.

Industry

E-commerce

Regulation

New e-commerce law effective 1 +an 2019. Increased tax burden and user protection.

Industry

Fintech

Regulation

New online lending rules and reserve requirements for payment companies.

Industry

Gaming

Regulation

Suspension of new game approvals and comments on near-sightedness effect of games.

Industry

Online advertising

Regulation

Network security regulations to protect data privacy.

Industry

Online education

Regulation

New education-related regulations including tax obligations.

Industry

Online travel

Regulation

No default cross-selling and increased user protection

Where are the pockets of opportunities?

For longer-term investors, we believe most of these innovative industries now offer appealing entry points given attractive valuations. Tactical investors could reference our matrix below comparing the seven industries’ growth rates to their regulatory environment (on a scale of 1–5 with 5 being the most regulated). We believe companies in the fast growth, low regulation part of the matrix provides relatively less nearterm risks – i.e. online advertising. We also believe the worst risks to online travel are behind us, although growth rates for the industry are lower than peers’. The other industries like biotech and gaming have more near-term regulatory risks but, as highlighted earlier, have robust structural growth prospects. In addition to public markets, investors could seek opportunities in the private equity space to gain exposure to Asian innovations – in areas like artificial intelligence and healthtech, where regulatory risks are limited at this stage.

Regulation and growth matrix for innovative industries in China

Regulation score (scale: 1–5, y-axis) and
Industry’s growth opportunities (%, x-axis)

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