Tencent Misses On Profits, But Who Cares?

| About: Tencent Holding (TCEHY)

Summary

Tencent posted a strong revenue beat in 3Q16 while earnings missed expectations.

Driven by outperformance in social network revenue, performance-based ad revenue and 348% growth in other revenue.

Shift to growing video subscription revs and performance-based news feed ads should help offset reliance on video ads.

Perhaps not the best time to buy with valuations moving toward the upper range of the PE band.

Tencent Holdings Ltd (OTCPK:TCEHY), China's biggest social network and online entertainment firm, posted a strong revenue beat in 3Q16 while earnings missed expectations. Revenue grew 13% QoQ and 52% YoY to RMB40.4bn, 3-5% above consensus, on 87% YoY mobile game revenue growth and 58% YoY social networking revenue growth. Gross profit margin declined from 57.3% in 2Q16 to 54% in 3Q16 as payment/cloud of a lower margin accounted for a higher proportion of revenue, i.e. 12% in 3Q16 vs 10% in 2Q16 and video content investment increased. Resulting adjusted profit grew 4%
QoQ and
42% YoY to RMb11.7bn, missing consensus expectations.

Here's what drove Tencent's top line numbers: outperformance in social network revs, performance-based ad revs and 348% growth in other revs (mainly from payment revs). Performance ads were up 83% y/y thanks to the rev contribution from Weixin Moments and re-allocating of some news feed inventory from brand to performance-based ads. WeChat-based advertisers doubled quarter over quarter in number in 3Q16.

On the video side, seasonality and competition has driven up content spending in 2H16 as more top-tier content is likely to be released.

The big growth boost came from payment with 348%yoy growth in the "Other" revenue line on rapid merchant adoption. In terms of transaction volume contribution, a majority comes from social payments like red package and transfers, followed by B2C transactions through Didi, Meituan, JD and online game in-game purchases, and lastly offline merchants like restaurants, supermarkets, convenient stores and other local SMEs.

Cloud services numbers were no slouch either. Revenue tripled yoy on larger enterprise accounts and higher usages by key accounts, particularly in online games, online video and O2O services within its ecosystem.

What all this indicates is this - while some investors are concerned about the slowdown of brand ad and macro headwinds into 2017, the shift to growing video subscription revs and performance-based news feed ads should help offset the higher risks of relying solely on video ad revs and help to navigate through a declining brand ad budget amid challenging macro and advertisers' demand shift.

Tencent seems to be going gun-ho in the Chinese mobile games market toward the end of the year. It performed very strongly in July and August although for September it captured only 2 out of the top 10 (vs 4 in August) with Hero Moba remaining as # 2 while JX Online dropped from #4 to # 7. In the latter half of October and early November however, Tencent has been pushing its top games more aggressively and Tencent saw 5 out of the top 10 rankings and 9 out of the top 20 as of Nov 13 (see table below).

Overall, Tencent remains a bellwether name with strong fundamentals and growth prospects. Is it looking a little pricey? Maybe. The stock trades at 29x 12m forward P/E, a 26% premium to the China Internet median of 23x. It outperformed the benchmark HSCEI by 4% in the past three months.

A very good company to invest in but perhaps not the best timing with valuations moving toward the upper range of the PE band.

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