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Elevator Pitch

I maintain a Neutral rating on Hong Kong-listed Chinese online literature platform operator China Literature Limited (OTCPK:CHLLF) (OTC:CHLLY) [772 HK].

This is an update of my initiation article on China Literature published on April 6, 2020. China Literature’s share price has increased by +69% from HK$31.05 as of April 3, 2020 to HK$52.50 as of June 19, 2020 since my initiation. China Literature trades at 35.3 times consensus forward next twelve months’ P/E and 4.6 times consensus forward next twelve months’ enterprise value-to-revenue.

Mr. Cheng Wu, Tencent Holdings’ (OTCPK:TCEHY) (OTCPK:TCTZF) [700:HK] Vice President, was appointed as China Literature’s new CEO in late-April 2020, while founder and former CEO Mr. Wu Wenhui retired, as part of changes to China Literature’s management team. Also, a dispute between China Literature and writers regarding a new unified contract has recently been resolved, but its online reading business model and its relationship with writers are in the spotlight.

On the positive side of things, China Literature is likely to aggressively expand its intellectual property operations & others business and revamp its online reading business under the new management team. On the negative side of things, these changes could potentially have a negative impact on China Literature’s relationship with its writers, if they are not executed well.

With China Literature’s recent share price surge in the past few months and the stock trading at over 30 times forward P/E, positives associated with the change in the company’s management team have been priced in, which implies room for disappointment if China Literature fails to deliver on such high expectations. As such, I think that a Neutral rating for China Literature is justified.

Readers have the option of trading in China Literature shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the tickers CHLLF and CHLLY, or on the Hong Kong Stock Exchange with the ticker 772:HK. For those shares listed as ADRs on the OTCBB, note that liquidity is low and bid/ask spreads are wide.

For those shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Hong Kong Stock Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $40 million, and market capitalization is above $6.8 billion, which is comparable to the majority of stocks traded on the US stock exchanges. Institutional investors which own China Literature shares listed in Hong Kong include The Vanguard Group, BlackRock, Norges Bank Investment Management, and Invesco Capital Management, among others. Investors can invest in key Asian stock markets either using US brokers with international coverage, such as Interactive Brokers, Fidelity, or Charles Schwab, or local brokers operating in their respective domestic markets.

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Change In Management Team And A Greater Focus On Intellectual Property Operations Business

China Literature announced on April 27, 2020 that there have been changes to the company’s management team. The company’s former Co-Chief Executive Officers, Mr. Wu Wenhui and Mr. Liang Xiaodong, resigned, and Mr. Cheng Wu, Tencent Holdings’ Vice President and Tencent Pictures’ CEO, was appointed as China Literature’s new CEO. Mr. Cheng Wu is assisted by Mr. Hou Xiaonan, the Vice President of Tencent’s Platform and Content Group, who has also recently joined China Literature as President.

Tencent Holdings is China Literature’s parent and major shareholder with a 57% equity stake. Mr. Wu Wenhui is the founder of Qudian.com, the flagship Chinese online literature platform for China Literature, which was subsequently acquired by Tencent. Mr. Wu Wenhui has a 2.7% equity interest in China Literature, and he will become Vice Chairman and non-executive Director of the company following his retirement and resignation.

The company’s share price has surged by +69% from HK$31.05 as of April 3, 2020 (the date my initiation article was published) to HK$52.50 as of June 19, 2020, and investors are obviously excited by Tencent taking a more active role in managing China Literature, and the company’s future growth prospects. Notably, in China Literature’s press release issued on April 7, 2020, new CEO Mr. Cheng Wu emphasized that the company “will strengthen the core (online reading) business through enhancing IP (Intellectual Property) incubation capability” and “accelerate our IP development”, and also “establishing stronger connection between the products of China Literature and Tencent’s properties.”

China Literature has two key business segments, the online business (e.g. online paid reading, online advertising, and game publishing) and intellectual property operations & others (e.g. licensing & distribution of film & television properties) business. In FY2019, China Literature’s online business segment revenue declined -3.1% YoY to RMB3,710 million. Furthermore, China Literature’s monthly paying users for its online reading platforms decreased -9.3% YoY to 9.8 million over the same period, as it launched its own free reading app Feidu Xiaoshuo to fend off competition from other free reading applications in the Chinese market.

In contrast, the intellectual property operations & others business was a bright spot for China Literature last year, as segment revenue grew by +283.1% YoY to RMB4,637 million. China Literature’s intellectual property operations & others business derives the majority of its revenue from licensing intellectual property rights for television dramas and investing in such projects. China Literature’s television and movie production subsidiary, New Classics Media, which the company acquired in October 2018, has a pipeline of 8-10 new television dramas for 2020.

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Considering that China Literature’s new CEO is also Tencent Pictures’ CEO, it is reasonable to expect that China Literature will become more active in monetizing its intellectual property with new television and movie projects based on the adaption of popular online novels as going forward. Notably, as Tencent Pictures is Tencent’s movie production and distribution arm, China Literature could possibly increase its involvement in movie projects as opposed to being largely focused on television dramas. At the company’s FY2019 earnings call on March 17, 2020, China Literature acknowledged that movies were “a small part of the” intellectual property operations & others business segment revenue in FY2019, despite the fact that some of the company’s four to five movie projects last year did well at the box office.

Dispute Between China Literature And Writers Has Been Resolved Recently

In early May 2020, TechNode reported that there was a new proposed contract from China Literature that required China Literature to “unconditionally hand over the copyright for all content” to the company, and also involved “the removal of the (online reading) platform’s paywall for all content on the site in favor of a free content business model that relies on advertisements.” Subsequently, “the unified contract it (China Literature) previously asked all its millions of authors to sign” was replaced “with a three-tiered contract system in which authors can choose what kind of permissions they want to give the platform”, as reported by Caixin Global on June 5, 2020.

Nevertheless, this episode is significant for multiple reasons.

Firstly, this supports the market’s views that China Literature will be focusing a lot of attention on its intellectual property operations & others business going forward. This explains why China Literature has been eager to engage its writers on issues regarding copyright ownership and licensing.

Secondly, China Literature seems to be gradually pivoting from its core online paid reading business to advertisement-supported free reading, and this is probably an acknowledgment of the disruption threats that free reading applications pose. With former CEO and Qudian.com founder, Mr. Wu Wenhui retiring, it is clear that Tencent wants to have a new strategic direction for China Literature’s online reading business.

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Thirdly, the success of China Literature’s intellectual property operations & others business is dependent on the relationship between the company and the writers for its online reading platforms. If top writers choose to publish their new works on other online reading platforms that are not owned by China Literature, China Literature could be deprived of exclusive content that is available for adaption into television dramas and movies.

Valuation

China Literature is valued by the market at 43.4 times trailing twelve months’ P/E and 35.3 times consensus forward next twelve months’ P/E based on its share price of HK$52.50 as of June 19, 2020. China Literature also trades at trailing twelve months’ and consensus forward next twelve months’ enterprise value-to-revenue multiples of 5.1 times and 4.6 times, respectively.

Peer Comparison Of Chinese Online Literature Companies

Stock Trailing Twelve Months’ P/E Consensus Forward Next Twelve Months’ P/E Trailing Twelve Months’ Enterprise Value-To-Revenue Consensus Forward Next Twelve Months’ Enterprise Value-To-Revenue
iReader Technology [603533:CH] 83.6 55.5 7.4 6.3
Hangzhou Anysoft Information [300571:CH] 26.5 20.1 3.5 2.7
COL Digital Publishing Group [300364:CH] Company was loss-making No sell-side analyst coverage 6.2 No sell-side analyst coverage

Source: Author

Risk Factors

The key risk factors for China Literature are changes in the company’s strategy under the new management team that turn out to be negative for the company, and top writers for China Literature’s online reading business choosing to publish their works on competing platforms.

Note that readers who choose to trade in China Literature shares listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.