Trouble for Weibo as China Tightens Censorship Rules

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Shares of Weibo (NASDAQ: WB) rallied nearly 140% this year, but the company now faces major headwinds as Chinese regulators tighten their control over the country's top social networking platforms. The latest crackdowns started in June, with regulators ordering Weibo and two other platforms to halt their live video and audio broadcasts until they obtained new government-backed licenses.

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It accelerated in September as regulators fined Weibo's parent company SINA (NASDAQ: SINA), Baidu, and Tencent (NASDAQOTH: TCEHY) for allegedly allowing its users to "spread information of violence and terror, false rumors, pornography, and other information that jeopardizes national security, public safety, and social order."

That same month, Weibo required all its users within China to register their real names, although it's unclear if those rules were actually enforced. Earlier this month, ahead of the Communist Party's National Congress, Weibo and Tencent blocked their social media users from editing their personal profiles until November. Weibo also suspended all overseas account registrations until Oct. 30.

Weibo then announced that it had hired 1,000 new Weibo supervisors to filter out "pornographic, illegal, and harmful content." It also introduced "social credit" scores which would be reduced with each violation and limit a user's ability to use the platform. These measures were clearly aimed at appeasing regulators, but many users quickly complained that the rules were too strict, with photos being flagged as "pornographic" if a woman's leg, abdomen, or cleavage was shown.

Weibo is at the top of a slippery slope

On the surface, Weibo's growth figures look impressive. Its monthly active users (MAUs) rose 28% annually to 361 million last quarter, with 92% of that total accessing the platform from mobile devices.

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Its revenue surged 72% to $253.4 million, fueled by a 72% jump in ad revenues, and its non-GAAP net income soared 144% to $86.7 million. Its GAAP-adjusted earnings rose 184% to $73.5 million. Wall Street expects its revenue and earnings to respectively rise 66% and 100% this year. But Weibo's stock is also priced to perfection at 110 times earnings, and the bears are starving for a reason to short this high-flying stock.

Is history repeating itself?

Many investors likely forgot that Weibo used to be bigger, with over 600 million registered accounts a few years ago. But Weibo started losing ground to Tencent's WeChat, which became China's top messaging app with 963 million MAUs worldwide.

In 2014, The Telegraph reported that overall activity declined on Weibo every time Chinese regulators cracked down on its users. In 2011, regulators demanded Weibo users register their real names, as the company is doing again now. In 2012, regulators implemented a "five-strike" rule against Weibo users who posted about politically sensitive subjects, which mirrors the fines it levied in September.

In 2013, regulators launched a new crackdown on online "rumors" and arrested several top account holders, including angel investor Charles Xue. Weibo repeatedly pledged to tighten its censorship measures, and hired even more staff to filter offending posts.

Therefore, when SINA spun off Weibo in an IPO in 2014, it seemed like the company was merely trying to divest a struggling business which faced an uncertain future amid tough competition from Tencent and unpredictable regulatory headwinds. Yet Weibo mounted a stunning comeback by signing partnerships for pre-installed apps with smartphone makers, expanding its reach into rural areas, and streamlining its business to showcase top celebrity accounts.

The fundamental problem with Weibo is tough to ignore

Weibo has been a great growth stock, but its long-term challenges are troubling. Most of its users are in China, and the Chinese government seems determined to tighten its control over the country's top social media networks.

Weibo already had a rough time with regulators between 2011 and 2013, and history could repeat itself and send users flocking to other apps. If Weibo's user growth slows down and its platform becomes associated with controversies instead of celebrities, its ad revenues could dip and the bears could torpedo its richly valued stock.

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Leo Sun owns shares of Baidu, Tencent, and Sina. The Motley Fool owns shares of and recommends Baidu. The Motley Fool recommends Sina and Weibo. The Motley Fool has a disclosure policy.