Tencent: Game-Changing Moves

Summary

• Chinese equities succumbed to some correction following weeks of defying harsh rhetoric from the U.S. and a warning by state-run media of pullbacks.
• Tencent Holdings launched an e-commerce mini-program within its WeChat messaging app as it sought to more directly benefit from the strong shift towards online shopping.
• Besides getting itself directly involved in e-commerce, Tencent is also endeavoring to develop and publish games outside of China on its own.
• Tencent's potential acquisition of iQIYI could stem losses on its video unit and leverage on the latter's push into overseas markets.
• Judging by the small upward revisions to the revenue estimates despite the potentially game-changing moves recently, subsequent adjustments by analysts could be a catalyst for further share price gains.

By ALT Perspective

In my previous weekly update, I remarked on the disconnect between the headwinds faced by Chinese businesses, and the bullish moves their share prices were making. Despite the challenging backdrop, the relevant benchmarks performed exceedingly well. For instance, the Invesco China Technology ETF (NYSEARCA:CQQQ) gained a whopping 11.24 percent for the week ending July 10. Even the broader market iShares MSCI China ETF (NASDAQ:MCHI) rose a hefty 8.98 percent.

Fast forward a week later and we are finally seeing some reversal. Nevertheless, the market wasn't simply pricing in a delayed response to past issues. Rather, it took a raft of fresh negative developments to spook investors.

The Chinese markets reacted to President Donald Trump's Friday comments that he wasn't considering a phase two trade deal with China, blaming it on the "severely damaged" relationship between U.S. and China caused by the coronavirus pandemic. The acrimony came even though data from the U.S. Department of Agriculture (USDA) showed China made its largest purchase ever of American corn and increased its bookings of American soybeans, demonstrating its commitment towards the phase one trade agreement.

Tensions heightened further Monday when U.S. Secretary of State Mike Pompeo released a detailed statement denouncing "most" of China's maritime claims in the South China Sea. The U.S. military had conducted several Freedom of Navigation operations which yielded little results in challenging China's occupation of the contested region.

Following the toughened stance, the U.S. could undertake measures that are likely to provoke China. Investor sentiment could then suffer from a round of tit-for-tat rhetoric even in the absence of concrete policy enactments.

President Trump took back the limelight Tuesday from Pompeo, signing an executive order revoking the different and preferential treatment for Hong Kong which the city enjoyed even after its return to Chinese rule in 1997. With the current punitive tariffs the U.S. imposed on mainland China now also applicable to Hong Kong exports, market players were concerned about the impact of the loss of this important trade war tariff loophole. Like clockwork, the Chinese government condemned the move and vowed retaliatory actions.

On Thursday, a state-run media outlet poured cold water on a domestic liquor maker which had momentarily become China's most valuable publicly listed company in the past weeks. Analysts took to mean the government was concerned about the exuberance in the local stock markets and highlighted the prominent stock to warn of the broader market.

Some pundits welcomed the "healthy correction", suggesting that occasional pullbacks were normal in an uptrend. Bargain hunters seemed to agree, helping equities to post modest gains on Friday. However, the late-week rebound was inadequate, with the relevant ETFs of Chinese companies (NYSEARCA:FXI) still in steep losses even as their U.S. counterparts (SPY)(DIA)(QTEC) managed to be flat or show slight appreciation.

Data by YCharts

The Chinese Internet sector representative ETF, the KraneShares CSI China Internet ETF (NYSEARCA:KWEB), fell in line with the broader Chinese ETFs, closing down 6.3 percent for the week. Among the key holdings of the KWEB ETF, the share price of e-commerce player Bilibili (BILI) was particularly hard hit, sinking 11.9 percent.

The second consecutive week of decline reduced Bilibili's one-month gain to a mere 1.9 percent, nearly erasing the optimism spurred by its potential secondary listing. Perhaps investors had come to grips that a listing in Hong Kong could only take place next year, as listing rules required at least two financial years of good regulatory compliance on another qualifying exchange.

Meituan-Dianping (OTCPK:MPNGY)(OTCPK:MPNGF), the leading food delivery and lifestyle services provider in China, was another big loser. Its share price dropped 8.1 percent. Being part of the "ATM" moniker together with Alibaba Group (BABA) and Tencent Holdings (OTCPK:TCEHY)(OTCPK:TCTZF), shareholders were happy to "withdraw" their profits from the trio last week.

As Meituan-Dianping appreciated the most in the past months (up 97.4 percent since the beginning of May versus 27.1-32.3 percent for the latter two), it should not be surprising profit-taking from the counter was the most aggressive. Alibaba and Tencent shed 5.3 percent and 4.0 percent respectively.

Data by YCharts

TAL Education (TAL) was an anomaly, eking out a small positive gain in the sea of red. There were some speculations that the largest education companies like TAL Education could accelerate their growth via acquisitions even as they are benefiting from rising online penetration amid the digital learning wave. There could also be a rotation to the bigger names following the jump in sub-$5 per share China education stocks in June.

As explained in a past issue of the Chinese Internet Weekly, I found the KWEB ETF holding the most representative stocks in the sector. As such, an overview of the week's share price movements of the top few holdings of KWEB as compared with the ETF itself is provided as follows for convenient reference especially for the stocks mentioned in this article.

Data by YCharts

In the subsequent sections, I will discuss some significant updates from Tencent Holdings.

Tencent is getting directly involved in e-commerce

E-commerce has been clearly expanding its share of total retail spending even before the COVID-19 pandemic. From just 5 percent of China's total retail gross merchandise value ('GMV') in 2011 (see the following chart), the GMV from e-commerce has soared to one-quarter of the total retail sales in China in 2019.

Source: iFAST

At the same time, China was also increasing its share of the world's retail e-commerce sales. From representing less than one-fifth of the worldwide retail e-commerce sales prior to 2011, China's share has risen to more than 60 percent.

Source: FDI China

In U.S. dollars, China's online retail transaction value in 2019 was estimated at a staggering $1.5 trillion, more than double that of the U.S. The amount puts China's online retail market larger than the next 10 markets combined.

Source: McKinsey

China's online retail transaction value grew at a 24 percent CAGR in 2017-2019. In a May 2019 publication, industry consultant eMarketer forecasted that the growth in the Chinese retail e-commerce sales would dip from 27.3 percent in 2019 to 24.3 percent in 2020.

Source: eMarketer

With the nation-wide lockdown earlier this year as well as fears of infection when shopping in person, it is likely that instead of a slowdown, we could see an acceleration in e-commerce sales this year. This is supported anecdotally and indicated by statistics released for recent shopping events like the 618 shopping extravaganza.

This view is affirmed by rating agency Fitch Ratings which believed that even after the relaxation of movement restrictions, the ratio of e-tailing sales to total retail sales (goods only) would still "climb in the rest of 2020." Besides the behavioral changes spurring the robust growth, Fitch Ratings surmised that "sophisticated information and communication technologies" deployed by China's e-commerce leaders would also be instrumental.

On the back of this favorable industry trend, relatively new player Pinduoduo (PDD) has leapfrogged stalwarts Alibaba and JD.com (JD) in valuation gains in the past months, although the latter two have also advanced substantially.

Data by YCharts

Tencent's investment acumen is validated by virtue of it being the largest shareholder in both Pinduoduo and JD.com. Nevertheless, the obvious proposition to directly participate in e-commerce is apparently not lost on Tencent which has recently rolled out a new 'mini shop' named WeStore as a mini-program within its ubiquitous WeChat messaging app boasting 1.2 billion monthly active users in the first quarter of this year.

While its Chinese name 'mini shop' connotes a limited functionality, WeStore offers the essential e-commerce features including marketing, logistics, customer service, and after-sales support. Currently a free service, WeStore looks set to triumph over its predecessor which was launched more than two years ago as a public beta but did not enjoy a good take-up rate ostensibly due to the processing fees imposed on vendors.

WeStore is understood to pose a greater threat to Weimob (OTCPK:WEMXF) and Youzan, the largest provider of WeChat stores, due to their nature as third-party software-as-a-service ('SAAS') solution providers. The two are, ironically, also Tencent-backed companies but Tencent has been known to encroach into its investee territories as it deems fit. In April, Tencent launched mini-program Xiaoepinpin (小鹅拼拼) that facilitates buying in groups aimed at lowering the purchase price of items (see the snapshot as follows), a retail format dominated by Pinduoduo.

Source: TMTPOST

As we have seen in the earlier projection that the share of retail e-commerce sales could more than double in five years from 30.9 percent of the total retail sales in 2018 to 63.9 percent by 2023. The cake is also enlarging at the same time, meaning that all the players could have a bigger piece assuming the status quo.

For Tencent, perhaps the thinking among the executives is that it's better to enter the fray itself at the expense of its investments, rather than let others have more of the cake. After all, social e-commerce is catching on like wildfire, growing at a rapid clip, and who else better equipped to capture this phenomenon other than the social media giant itself which incidentally is also the leading digital payment operator?

Source: China Internet Watch

It would take a few months to see if Tencent's efforts bear fruit. Meanwhile, shareholders wouldn't complain the company is riding the trend and creating a potentially significant revenue growth driver in the coming years.

Tencent is developing games overseas on its own

Besides getting itself directly involved in e-commerce, Tencent is also endeavoring to develop and publish games outside of China on its own. Tencent has ownership stakes in major games developers Riot Games, Epic Games, PUBG Corporation, and Clash of Clans maker Supercell. Nonetheless, it is not resting on its laurels.

Reuters reported early June that the gaming titan opened a new California-based studio called LightSpeed LA. Former Rockstar Games veteran Steve Martin will head the studio and "will focus on the development and publishing of AAA titles, Tencent Games’ LightSpeed and Quantum Studios."

In May, TiMi Studios, a wholly-owned subsidiary of Tencent Games, announced it has hired veteran game designer Scott Warner to serve as the new director to help expand and grow its new North American studio. Warner was the lead designer of "Halo 4" while TiMi Studios is the maker of "Arena of Valor" and "Call of Duty: Mobile", both highly popular games globally.

A renewed push on overseas gaming opportunities would help address investor concerns regarding an over-reliance on its domestic games market which is subjected to a heightened regulatory environment. The Chinese government is expected to continue its stringent games approval regime and demands for game developers to incorporate measures preventing the addiction suffered by young gamers.

Tencent's potential acquisition of iQIYI

It also bears mentioning that Tencent had reportedly held talks with search engine giant Baidu (BIDU) on acquiring all or a portion of its 56.2 percent stake in iQIYI (IQ). The idea is to combine the video unit of Tencent with iQIYI to lower expenses and competitive pressure, amid escalating content production and acquisition costs.

The embattled Chinese video-streaming platform operator was a target of a short-seller outfit in April. The share price jump following the Reuters news could have been partly contributed by a short squeeze. I wrote an article rebutting some of the arguments put forth by the short-seller. Nevertheless, I concede nothing refutes the fraud accusations on iQIYI better than a display of confidence by a fellow Chinese internet company.

Data by YCharts

The backing from a larger parent could also bolster iQIYI's overseas ambitions. It had, in June, poached an executive from its U.S. peer Netflix (NFLX) for the post of vice president of international business to oversee strategic planning, marketing, business development, and public affairs functions for overseas businesses according to its press release.

"Kuek's innovative vision and extensive experience in the international entertainment and tech industries will benefit iQIYI. We want to send a strong signal to potential partners that we are looking to collaborate and contribute to the global streaming ecosystem. I look forward to seeing Kuek's leadership, across markets and cultures, accelerate the company's global expansion." - Yang Xianghua, President of Membership and Oversea Business Group of iQIYI

More revenue revisions to the upside are possible at Tencent

It is not known if the above developments have been considered by analysts in their revenue projections. Judging by the small upward revisions (0.25 percent to 0.77 percent) to the revenue estimates for 2020-2022 in the past month, based on the data compiled by Seeking Alpha (Premium service), perhaps analysts have yet to factor in the recent bullish moves.

Fiscal Period Ending	Revenue Estimate	YoY Growth	1M Trend	3M Trend	6M Trend
Dec 2020	68.04B	27.08%	0.25%	3.58%	1.96%
Dec 2021	82.95B	21.90%	0.72%	3.50%	2.69%
Dec 2022	99.76B	20.27%	0.77%	4.12%	-1.63%
Dec 2023	118.00B	18.28%	3.57%	5.57%	3.94%

Source: Seeking Alpha Premium

According to the consensus, Tencent would see its price-to-sales ratio on a forward basis shrink from 9.4 times for 2020 to 5.4 times by 2023. This is supported by the 18.3 percent to 27.1 percent year-on-year growth in its revenue. When more analysts come around to appreciate the positive contributions from the latest developments, we could see the ratio reduce further as the revenue projections get adjusted upwards.

Fiscal Period Ending	Revenue Estimate	YoY Growth	FWD Price/Sales	Low	High	# of Analysts
Dec 2020	68.04B	27.08%	9.40	65.69B	71.79B	41
Dec 2021	82.95B	21.90%	7.71	77.04B	90.68B	42
Dec 2022	99.76B	20.27%	6.41	88.35B	109.85B	30
Dec 2023	118.00B	18.28%	5.42	114.51B	121.49B	2

Source: Seeking Alpha Premium

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.

Disclosure: I am/we are long BABA, BIDU, JD, TCEHY, NTES. 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.