This is an update of my prior article on China Literature published on June 22, 2020. China Literature’s share price has increased by +4% from HK$52.50 as of June 19, 2020 to HK$54.45 as of September 4, 2020, since my last update. China Literature trades at 31.8 times consensus forward FY 2021 P/E, and 4.2 times consensus forward FY 2021 enterprise value-to-revenue.
China Literature’s 1H 2020 financial performance was disappointing due to a impairment loss of -RMB4,406 million on goodwill and trademark rights for New Classics Media Holdings, higher platform distribution costs and selling & marketing expenses. More time is needed to assess if China Literature can maintain a good balance between its paid and free reading sub-segments, and monetize the value of its intellectual property more effectively in the future. As such, I retain a Neutral rating on the stock, while continuing to track the company’s developments closely.
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 $50 million, and market capitalization is above $7 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, Baron Capital Management, and MFS Capital Management, among others. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers or Fidelity, or international brokers with Asian coverage like Hong Kong’s Monex Boom Securities and Singapore’s OCBC Securities.
Impairment Loss In The Spotlight For 1H 2020 Results
On August 11, 2020, China Literature announced the company’s 1H 2020 financial results, and the company reported a net loss in the first half of the year as per its earlier profit warning issued on July 20, 2020.
China Literature suffered from a headline net loss attributable to equity holders of -RMB3,296 million in 1H 2020, as compared to a net profit of RMB393 million in 1H 2019. This was primarily attributable to a impairment loss of -RMB4,406 million on goodwill and trademark rights with respect to China Literature’s acquisition of New Classics Media Holdings Limited. New Classics Media Holdings is China Literature’s wholly-owned subsidiary, which produces and distribute television dramas and movies, that the company acquired in October 2018 for a consideration of RMB15.5 billion.
Notably, China Literature acknowledged at its 1H 2020 results briefing on August 11, 2020 that the acquisition of New Classics Media Holdings fell short of expectations “because we lacked a team with sufficient knowledge of both online literature and the drama production to drive progress.” The company also added that it “lacked a structure of top-down design to create an IP-centric content and operational strategy, which could maximize the lifetime value of IP (Intellectual Property) by promoting cross-media production.”
Excluding the impairment loss relating to New Classics Media Holdings, amortization of intangible assets (e.g. television drama and movie rights) and other non-cash items, China Literature’s adjusted net profit attributable to equity holders would have still fallen by -94% YoY from RMB390 million in 1H 2019 to RMB22 million in 1H 2020.
China Literature’s revenue increased by +10% YoY from RMB2,971 million in 1H 2019 to RMB3,260 million in 1H 2020. The 50.1% YoY growth in revenue for the company’s online business segment (online reading, online advertising, and game publishing) to RMB2,495 million in 1H 2020 was partially offset by a -41.5% drop in revenue for its intellectual property operations & others business segment to RMB764.8 million in the first half of the year.
In the company’s 1H 2020 results announcement, China Literature attributed the strong revenue growth for the online business segment to “the expansion of distribution channels and users’ growing willingness to pay for our reading content.” China Literature’s monthly ARPU (Average Revenue Per User) grew by +51.6% from RMB22.5 in 1H 2019 to RMB34.1 in 1H 2020. But the expansion of distribution channels for China Literature’s online business segment came at a hefty cost, as the company’s platform distribution costs increased by +314% YoY to RMB619 million in 1H 2020.
On the other hand, it was no surprise that revenue for China Literature’s intellectual property operations & others business segment fell -41.5% YoY in 1H 2020. As a result of lock-down and social distancing measures implemented in China in the early part of the year to contain Covid-19, China Literature’s television and movie production subsidiary, New Classics Media Holdings did not launch any new television dramas in the first half of the year.
It is noteworthy that China Literature’s adjusted net profit attributable to equity holders decreased by -94% YoY to RMB22 million in 1H 2020, despite a +10% YoY increase in the company’s top line over the same period. This was mainly due to higher platform distribution costs (discussed above) and selling & marketing expenses.
China Literature’s selling & marketing expenses increased by +30% YoY to RMB1,270 million in 1H 2020, and the company’s ratio of selling & marketing expenses-to-revenue expanded from 32.9% in 1H 2019 to 39.0% in 1H 2020. At the company’s 1H 2020 earnings call on August 11, 2020, China Literature explained that an increase in spending to “acquire users” for its online reading business and “promote our games” was the key factors that drove the increase in the company’s selling & marketing expenses in the first half of the year.
Maintaining A Delicate Balance Between Free And Paid Reading
As highlighted above, while China Literature’s online reading business has delivered strong revenue growth in 1H 2020, this has come at the expense of higher platform distribution costs and selling & marketing expenses.
Looking ahead, the success of the company’s online reading business will be dependent on how it maintains a delicate balance between its free and paid reading sub-segments. At its recent 1H 2020 earnings call, China Literature emphasized that the company “will continue to strengthen our advantages in the paying reading model market”, while “we will actively explore free reading business through combining China Literature’s advantages in high-quality content and Tencent’s (OTCPK:TCEHY) (OTCPK:TCTZF) [700:HK] advantage in user traffic” at the same time.
Earlier, China Literature has introduced its own free reading app Feidu Xiaoshuo to compete with other free reading applications in China. The company noted at its 1H 2020 results briefing that “Feidu’s overall performance failed to reflect the leading position the company enjoys in China’s online literature sector” and it acknowledged that the company’s growth in users for its online reading business “lagged behind major free-to-read service providers.”
Going forward, China Literature will adopt a two-pronged approach for its online reading business. For the paid reading sub-segment, China Literature wants to maintain and build on its reputation of being the leading provider of online reading content. As of end-1H 2020, the company has a library of 13.4 million literature works and a solid base of 8.9 million writers. For the free reading sub-segment, China Literature aims to leverage on its parent and major shareholder Tencent’s reach to expand market share and grow advertising revenues.
All Eyes On The Medium Term Growth Potential Of Intellectual Property Business
In the near-term, the outlook for China Literature’s intellectual property operations & others business segment is bleak. In 2H 2020, New Classics Media Holdings has disclosed that it is likely to only release 2-3 new television dramas due to a delay in production activities as a result of Covid-19, which could hurt its revenue. Earlier in March 2020, China Literature has guided for 8-10 new television drama releases this year.
Looking beyond short-term woes, China Literature’s intellectual property business has significant growth potential in the medium term. In April 2020, it was announced that Mr. Cheng Wu, Tencent Holdings’ Vice President and Tencent Pictures’ (movie production arm of Tencent) CEO, had been appointed as China Literature’s new CEO. This sent a strong signal that China Literature will be even more focused on monetizing its intellectual property by adapting online literature works into other formats in the future.
Notably, the monetization of intellectual property is not limited to just producing new television dramas or movies based on popular online novels. China Literature highlighted at the company’s recent 1H 2020 earnings call that it is working with Tencent Comics and Tencent Games on new visual comics & animation and games, respectively based on existing intellectual property. The company also stressed that its strategy for the intellectual property business “is to focus on incubating more valuable IP and also adapt these IPs into various entertainment formats.”
China Literature trades at consensus forward FY 2020 and FY 2021 P/E multiples (based on normalized earnings) of 97.2 times and 31.8 times, respectively based on its share price of HK$54.45 as of September 4, 2020. China Literature is also valued by the market at consensus forward FY 2020 and FY 2021 enterprise value-to-revenue multiples of 5.5 times and 4.2 times, respectively.
As per the peer valuation comparison table below, China Literature is trading at a premium to its Chinese online literature peers based on consensus forward P/E and enterprise value-to-revenue multiples.
Peer Valuation Comparison For China Literature
|Stock||Consensus Current Year P/E||Consensus Forward One-Year P/E||Consensus Current Year Enterprise Value-To-Revenue||Consensus Forward One-Year Enterprise Value-To-Revenue|
|iReader Technology [603533:CH]||38.7||27.8||4.5||3.7|
|Hangzhou Anysoft Information [300571:CH]||19.5||16.2||3.2||2.7|
The key risk factors for China Literature include a failure to manage both the paid reading and free reading sub-segments of the online reading business well, and fewer than expected new television and movie projects for its intellectual property business going forward.
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.