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Summary

• The growth in eSports will reward online gaming companies.
• Tencent holdings has become a distribution behemoth with a large catalyst that has not yet seen its full potential - Honor of Kings.
• Tencent continues to generate significant cash flow which will reward the patient investor.

Tencent Holdings Ltd ADR (OTCPK:TCEHY) will continue to dominate the global gaming market in the future and take advantage of the rise in eSports. Per Wikipedia, eSports "are a form of competition that is facilitated by electronic systems, particularly video games; the input of players and teams as well as the output of the eSports system are mediated by human-computer interfaces. Most commonly, eSports take the form of organized, multiplayer video game competitions, particularly between professional players."

The growth in eSports is something that some investors have picked up on but overall many have investors have undervalued the true growth potential here. Amazon (AMZN) has recognized this trend early and has made great acquisitions in this space. For example, the leading eSports streaming service Twitch was bought by Amazon in 2014 for just shy of one billion (US dollars). Football (soccer) clubs have even began signing Fifa stars in the virtual game knowing that this trend will be lasting. Sports arenas and even theme parks dedicated to specific games have been built. Regardless of your opinion on whether this is good or bad for society at large - the evidence is clear - eSports is here and it is growing rapidly.

The heart of gaming is in South Korea, the world leader in Internet connectivity with the fastest average Internet speeds. In this culture, young people gather at "PC bangs" which is a type of cafe to go and play video games at through the night. Companies like Tencent will continue to grow and monetize their user base through selling in-game items, virtual items, subscriptions, advertising, and through various other sources.

Revenues for TCEHY grew 48% in 2016 versus 2015. Over this same period, free cash flow grew 50%! Operating margin came in at 37%, down 2% over the prior year due to the mix in revenue streams.

source: 2016 10-K

The revenue increase in value-added services (VAS) was driven by growth in smart phone games such as Honor of Kings. According to The Wall Street Journal, Honor of Kings, a massive hit in China that brings in $435 million every month with over 50 million active users, is coming to the United States.

Online gaming revenues increased 25% in the year. This Chinese firm has stakes in Activision (ATVI), has bought Supercell (which owns Clash of Clans), and purchased a majority stake in Riot Games which owns the most popular PC game in the world, League of Legends.

Photograph: Tom Jenkins for the Guardian

To expand further on just how successful League of Legends has been, it drew 40,000 live spectators to the 2014 World Championship Finals in Seoul, the top player (Faker) makes a salary of roughly $2.5M USD per year, and according Riot executives the game has over 100 million monthly players. To put this number in perspective, if you took all of the games under Activision including Overwatch, Call of Duty, Destiny, and others, you would arrive at 55 million monthly players. Keep in mind that League of Legends is free to play (with monetization strategies for skins and bundles in game which cost money) while Activision games cost close to $60. While gaming is a huge growth driver for Tencent, it is not the only growing segment.

The revenue from social networks grew 54%. Tencent is the largest Internet service provider via two key social networking platforms, Weixin/WeChat and QQ. The time spent on WeChat is around 66 minutes per day (according to Quest Mobile) which is above prior year and also above Facebook's (FB) 50 minutes per day (Morningstar analyst report). WeChat has close to one billion users but is behind Facebook in terms of revenue generation. For example, Facebook makes $4 in advertising per user compared to just $1.30 with WeChat according to Arete Research analyst Muzhi Li. The app continues to develop user experiences such as news feeds and search functions without having to navigate elsewhere. In our view, the fact that all of the advertising per user has not been optimized is future upside for the firm. In their social networks going forward management plans to add more services for greater user convenience and crease more business opportunities for ecosystem partners.

Revenues in advertising increased 54%. Performance based advertising revenue grew 81% - mostly derived from Weixin Moments, mobile news apps, Weixin Official Accounts. Display advertising grew 28% due to higher revenues from mobile media platforms such as Tencent News and Tencent Video.

Revenues from the Others segment increased 263% mostly driven by growth in payment related and cloud services. The reason this company is an awesome growth story is because you have a global leader in gaming paired with a massive social media platform which makes a distribution behemoth.

If you look at the trend in year-over-year (YoY) growth you will notice that in the latest fiscal year the growth has surpassed the five-year average growth rate which signals that growth is not stagnant and has in fact accelerated as of recently.

To continue to grow management is focusing on expanding popularity of their major smart phone games and adding new genre-driven PC games. They are expanding advertising market share, continuing to grow their digital content subscriber bases, and aiming to boost usage frequency of payment related services. Additionally, they intend to use machine learning to personalize recommendations within digital content services, sharpen advertising targeted capability, enrich social interactions via features such as animated face masks, and save costs by optimizing customer service needs.

What many growth companies of this size often give up in order to achieve such stellar revenue is profitability. This is not the case with Tencent holdings. Free cash flow generation has remained at a very impressive level.

The current P/E multiple Tencent is 48 with a PEG of 1.5. Based on our discounted cash flow model, we arrived at a fair value price of $38 per share implying an 8% upside at current levels. Thanks for reading.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TCEHY over 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.