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A week or two ago I took a long look at Naspers (NPSN), a company I like a lot but that is very dependent on its strong position in the South African pay TV business.

This business is just entering an era of open competition, which made me a little nervous, and I'd like to see that competition take a bite out of the share price before I buy in.

But the reason Naspers first came to my attention is that they were major backers of Tencent (TCEHF.PK), and still own about a third of the company. So if Tencent was what I found most intriguing, why not just look into investing in that company itself?

Well, for a wee fish like me investing in a Hong Kong listed company without a significant U.S. PR presence (or significant U.S. press coverage) is a bit of a pain, especially because its pink sheets volume is very slim. So that's the first hurdle... but it's not impossible, and it might be worthwhile.

Tencent's Business
What do we know about Tencent?

It's by far the leading provider of IM services in China, with its QQ product eclipsing 22 million simultaneous users, over 200 million active accounts, and nearly 600 million registered accounts in total. If you think "network effect" means money, QQ.com's online portal and community creates the strongest online community network in China and one of the most visited web pages in the world. Users use the portal not just for instant messenging but for casual games (both free and paid), buying accessories for their online avatars using the internal QQ Coins online currency, and other internet activities. The popularity of QQ coins even has the government a little anxious about the impact on the Yuan, though that's perhaps a stretch.

They've been in operation for about eight years, and public for just over two... and as far as I know, they have no plans for a U.S. listing of their stock.

The company is profitable, with earnings of about RMB 282 million for the last reported quarter (September of last year - PDF link) -- not cheap, but profitable. So far, most of their sales come from "internet value added services", which includes everything from avatar upgrades to downloads to paid messenging, including IM voting for Super Girls, the Chinese equivalent of American Idol.

Going down the list, their next biggest inflow is a near tie between "mobile value added" and games. The mobile value added is mostly SMS service, and messaging is a bit uncertain because it's undergoing a change with a new revenue agreement with China Mobile. The games had a bit of sales slump as they tried to take market share by cutting prices and offering free games, so both of these significant areas are hard for me to gauge moving forward, confident though I am in the size of their market in the long run.

And it's not until you get to the bottom of the list that you get to probably the greatest potential growth engine for Tencent; online advertising, which currently makes up about 10% of sales. If you are at all a believer that online advertising in China has significant potential, it's hard to overstate the impact this could have on Tencent , with (as of today), the ninth most visited site on the web, second in China only to Baidu (NASDAQ:BIDU) and with a much stickier user experience, any advertiser who wants young, wealthy Chinese eyeballs might be expected to be banging down the doors at Tencent's headquarters.

Financials
Earnings growth numbers look spectacular, but use very low year-ago comparisons when you look at annual numbers. Gross profit was up 4.4% sequentially and 116.5% year over year in the third quarter ending last September. Operating profit was up 5.6% sequentially and 179.3% YoY. Net profit grew 5.5% sequentially and 263.4% YoY.

They continue to have great margins, no surprise as a very scalable internet company. Net margins have lately been around 38%, with no significant erosion in recent quarters that I've noticed.

As I said, it ain't cheap - the company posts a P/E of 109 on its quote page. At a net profit of about RMB282 million in the last quarter, we could assume no growth and a steady income run rate of about a billion RMB to be conservative (their business is seasonal, so this is iffy, but it's also growing much faster than the seasonal impact, so I'll still call it conservative), that goes with a market cap of about 50 billlion rmb (they report most of this in Hong Kong dollars on their quote page, but the exchange rate with the yuan is pretty much even so I didn't bother messing with conversion).

So for a thumbnail that doesn't take into account growth or seasonal earnings changes, we get a PE of about 50. Which goes with income growth for the last year of well over 200%, so in some measures we've got what you might call an expensive bargain. This is not too far off from the valuation for Baidu, though I can't see how anyone can make a reasonably accurate growth projection for either one at this point.

Risks and Concerns

But of course, any investment in Tencent is based on an uncertain future, so what is there to worry about?

First, we're talking about monetization of something that isn't necessarily a guaranteed money pile. Remember, after all, that though everyone under 30 had an AOL Instant Messenger account for a while there, and many still do, AOL [Time Warner Inc. - (NYSE:TWX)] has never really made any money directly from that service. I think Tencent will do better at monetization due to their single-minded focus on the product and a very different audience, but I don't know that for sure.

Second, it's China; maybe it's an investment bubble, maybe it isn't, but shares have certainly climbed dramatically since they went public and any meltdown of the domestic or HK stock markets would be sure to take Tencent down as well.

Third, competition in some of their businesses is extraordinarily tight; games and wireless value added services have caused many Chinese companies to rise and fall on the whims of the marketplace and the fast-changing nature of popular games and services. I'm less worried about this because the huge audience of active QQ messenging users gives them a strong tailwind, but it's no guarantee of competitive performance in their other products.

And fourth, I'd be likely to buy on the pink sheets, and getting in and out of a position in these low volume shares, even a small position like I would have, isn't always easy.

Still, given all that, I'm tempted. I might convince myself to take a flier on a few Tencent shares one of these days. Today marks three months exactly since their last quarterly earnings release, so word from the company that moves the shares one way or another could come at any time. I don't believe they've announced an earnings date.

Disclosure: Though I never bought the Baidu shares I considered last fall, I do own Baidu options. I don't own any other company mentioned here, though Baidu, Tencent and Naspers are all possible purchases for my portfolio in the near future.

TCEHF.PK 1-yr chart:

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Source: A Close Look At Chinese IM Leader Tencent