Tencent: Opportunity Behind The Smoke
Summary
- Tencent, with its WeChat ecosystem, gaming leadership, and growing FinTech and ad business, is an interesting candidate for long-term investors.
- A quick look at past business performance, financial metrics, and future prospects reveals a clear undervaluation.
- However, fundamentals do not matter. Fear and uncertainty drive the price of the stock.
- It may be a good idea to be a contrarian and buy some shares at the current price.
Tencent (OTCPK:TCEHY) is currently the biggest Chinese company in terms of market capitalization and one of the biggest worldwide. WeChat serves over 1.2 billion people and millions of businesses every day. Besides its regular operation, the company invests its excess capital in private and publicly traded companies, which has already created one of the world's biggest and most successful investment funds.
The company has a bright future. Long-term-oriented investors should consider adding it to their diversified investment portfolios. Fear and bad sentiment around China have caused a recent selloff of all Chinese equities and Tencent has not been spared. We know the reasons - the CCP, tech crackdown, antitrust regulations, delisting from the NYSE, etc. However, judging from the behavior of some market participants, it may be the right time to buy some shares of Tencent at current levels.
Tencent money machine
For people who do not know the company (most regular people outside of China), it is overwhelming to learn how broad the spectrum of Tencent's operation is. Even for investors, it is very hard to learn everything about the company as it comprises hundreds of subsidiaries. Tencent itself does a good job simplifying this task for us. In the picture below, they state clearly what their primary objectives are.
Source: Tencent Corporate Overview, May 2021
Let's discuss briefly core business segments.
Communication & Social with Weixin & WeChat enables over 1.2 billion people to communicate every day with friends and with businesses in China. WeChat is a so-called super app. It is like an operating system for mobile devices in China. Millions of mini programs enrich WeChat and let people shop, pay, order a taxi, entertain, and many more. An average user spends over 80 minutes a day using WeChat. The ecosystem developed by Tencent enables many businesses in China to flourish. Examples? Chinese platforms JD.com (JD) or Pinduoduo (PDD) established a massive competition for Alibaba (BABA) thanks to the access to WeChat's platform.
Tencent is also the biggest player worldwide in the gaming industry. Games contribute over 30% to the company's revenue. The company owns Riot Games, Supercell, it has significant ownership in Activision Blizzard, Ubisoft, Epic Games (Fortnite), etc. It has a huge portfolio of popular IPs and is the preferred publisher for many other top titles (see below).
Source: Tencent Corporate Overview, May 2021
Streaming of movies and music is the biggest contributor to the fast-growing digital content area. This segment provides services similar to those offered by Netflix or Spotify. It is not yet as big, but it grows rapidly every year. In 2020, the platform had around 220 million subscribers to video, music, and game streaming services. There is still a lot of potential to win more customers as the whole of Chinese society is getting wealthier and eagerly uses new technologies for entertainment.
Source: Tencent Corporate Overview, May 2021
FinTech and Business Services (like cloud services) are the fastest growing business branches in the last five years. From a negligible amount in 2015 to over 25% of total revenues currently. The growth is simply spectacular as the Chinese quickly switched almost completely to mobile payments and Chinese businesses realize that the cloud is their chance to reduce costs and improve quality. In their presentation, the company says that WeChat Pay (naturally integrated into the WeChat platform) has currently over 1 billion daily commercial payments.
Source: Tencent Corporate Overview, May 2021
During the last Investor Day, Alibaba stated that China is well behind the USA in the cloud services and has to catch up quickly to remain competitive (see more in my BABA analysis). Currently, Tencent Cloud is No. 2 in China, just behind Alibaba, but the battle is far from over yet.
Source: Alibaba 2020 Investor Day
Last but not least, there is an advertising segment. It adds around 17% to total revenue. It is pretty natural that having such a successful ecosystem, the demand for advertising will be strong. Millions of businesses are using social channels and media platforms from Tencent to reach over 1.2 billion Chinese customers.
Source: Tencent Corporate Overview, May 2021
Business performance
Digitalization is a non-stoppable worldwide phenomenon and Tencent is a key digital services player in one of the most populous countries in the world. Just look at the number of WeChat users:
Source: Tencent financial reports
The same applies to the VAS segment, which comprises game + music + video subscription services. Look at the dynamic in the trend below and the huge potential to add a significant number of new customers in the coming years:
Source: Tencent financial reports
This huge and increasing user base allows Tencent to grow its top-line nicely:
Source: Tencent financial reports
Below are three charts offering more insight into the most important components of revenue:
Value-added Services - gaming, video, music subscriptions
Revenues from online ads
FinTech and Business Services (read WeChat Pay)
Source: Tencent financial reports
Source: Tencent financial reports
Source: Tencent financial reports
Especially interesting is the development of the FinTech branch. It was initiated only 8 years ago and currently contributes over 25% to the revenue. WeChat Pay is today the major rival for the Alipay ecosystem from Alibaba.
As shown below, revenue streams are nicely diversified, so that even the last regulatory issues (e.g. gaming restrictions) in China should not harm the company much.
Source: Tencent financial reports
The next positive information: profit margins. Tencent's high margins over a prolonged time indicate a strong economic moat (see below).
Source: Tencent financial reports
For potential investors, it is also important to know how effectively the company can invest its money to grow the business. A good representation of management effectiveness is Return on Invested Capital (ROIC). Below is my calculation of ROIC as a ratio between cash flow for owners and the sum of shareholders' equity and long-term debt.
Source: Author's own calculation
Even though I would prefer to see a rising or at least stable ROIC trend, I like the results anyway because at the same time there is very high growth in the shareholders' equity (see below), which shows a value creation for shareholders and is a sign of healthy, profitable business.
Source: Tencent financial reports
Investments in other companies
The company management correctly recognized that the income generated by the traffic on Tencent properties can be used to invest in other companies. It creates a kind of flywheel where Tencent's high traffic attracts different companies, giving them access to a broad customer base. Tencent can quickly analyze which company has the potential to be successful and invest in it at an early stage of business development.
In the last years, Tencent has bought stakes in many well-known companies like Meituan Dianping, Sea Ltd., JD, Pinduoduo, Tesla (TSLA), Epic Games, WeBank, etc. The total list of investments is around 700-800, with over 80 companies being valued today at more than $1 billion. More information can be found here.
Tencent reports the value of its investments in its financial reports. Below, there is an overview of the development of their portfolio. Last year was, of course, rather an anomaly, as Covid-related perception of the world has pushed the valuation of many investments to the sky, but the general investment return is pretty impressive - yet another sign of skillful management.
Source: Tencent financial reports
Valuation
To value Tencent, we need to summarize two components - operating business and the investment portfolio.
Let's start with investments. According to the latest company reports, the fair value of stakes held in listed investee companies (excluding subsidiaries) amounted to RMB 1,445,978 million (around $225 billion). If we subtract it from the current market cap of $565 billion, we get a price of Tencent's operating business at $340 billion. The investment portfolio contributes currently ~40% to total market capitalization or ~$23/ADR share.
To calculate the value of core business, I took the FCF and calculated three outcomes depending on growth rate in the coming years (see the table below). Even if I assume a very depressed growth rate in my worst-case scenario, I end up with the price of $41/ADR share for a 10% expected rate of return. Adding the value of the investment portfolio, we get a $64/ADR share. Repeating the same calculation for a more realistic case results in a $74/ADR share.
Source: Author's calculation
I could add here more valuation models which will only prove the point that the company is fundamentally undervalued. But in the current market, the price of Chinese companies has nothing to do with fundamentals. Currently, it is all about the CCP, regulations, the US-China relationship, sentiment, and so on. But let's have a look at a few arguments showing that it may be not a bad idea to have at least some exposure to Tencent at the current price.
What is happening behind the smoke?
There has been a lot of bad press around China lately (the smoke). However, it does not change the fact that the economies of the USA and China have never been more connected. This is a relationship that was built over the last decades and cannot be easily reversed. Below there is a graph showing the value of goods exchanged between both countries. Despite the ongoing tensions, last year set a record in this statistic.
Source: FRED database
Why is it important? Because both parties profit from it - no matter what political leaders say and how bad current sentiment is. It also means that regular businesses in both countries need each other. Trade creates jobs, wealth, and thrust. There is simply no benefit for any side to destroy it, so they will likely rather look for ways to coexist and cooperate.
Taking this conclusion to the stock market, I think that any radical moves like e.g. invalidating VIE structures by the Chinese government seem to be in this case highly improbable as it would hurt all and benefit nobody (lose-lose situation).
The next thing I wanted to point out is the activity of smart money. They seem to believe that:
- VIE structure is going to stay here. There are simply too many investment funds adding to their positions or opening new positions in Chinese stocks.
- Chinese tech stocks have attractive valuations and the selloff is exaggerated.
- Delisting risk can be mitigated by switching to Hong Kong listings.
Looking at funds' holdings, we can see that despite some funds deciding to sell off the stock, the total number of Tencent shares held is at an all-time high. Looking at the latest 13-F summary, we can also see that there were more ADRs bought than sold, which suggests that smart money is convinced about future positive outcomes of all the current issues.
Source: WhaleWisdom.com - Tencent TCEHY ADR
Another example suggesting the change in the perception of Chinese stocks is the recent behavior of big banks buying, e.g. Alibaba, Goldman Sachs, Morgan Stanley, JP Morgan - all are increasing their exposure to Alibaba significantly (see 13-F filings for 30th of June 2021).
Last but not least is the way the smart money mitigates the delisting risk. Many switched their ADRs to Hong Kong shares in last months. To most prominent example belongs BlackRock. The biggest wealth management company in the world switched its holdings in May this year. The results can be seen in all their well-known products like MSCI Emerging Markets ETF (EEM).
Conclusion
There is a lot of fear and bad sentiment around China and Chinese companies. Many claim that China is "uninvestable". I suggest staying rational and observing what market participants are doing. Their actions reveal often a different picture than what media serve us. I do not claim that it is time to go all-in on China, but looking at the latest moves of investment funds and big banks, as a long-term oriented investor I would consider some exposure to China through Tencent. The company has an outstanding track record of successful business development, a proven management team, and an attractive valuation. I am looking forward to your feedback and constructive discussion in the comment section.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BABA either through stock ownership, options, or other derivatives. 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.
I am long Alibaba (9988 in Hong Kong).
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