Tencent & Chinese Tech Stocks: There Is Hope After All

Summary

• Tencent reported a lackluster FQ4 earnings card. However, management offered cautiously optimistic guidance from H2'22.
• Notably, we think it represented a clear departure from the uncertainty in its previous earnings commentary.
• As such, we encourage Tencent investors to add exposure.
• I do much more than just articles at Ultimate Growth Investing: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Investment Thesis

Tencent Holdings Limited (OTCPK:TCEHY) is a highly successful Chinese Internet company. It's the largest mobile games developer in the world. In addition, it also owns a highly successful FinTech ecosystem. Furthermore, it's also a key player in the digital advertising market in China. Notably, it's the #2 cloud computing leader in China, and the #3 overall in Asia-Pacific, behind AWS (AMZN) and Alibaba (BABA).

It recently reported one of its worst showings on record in its FQ4 card. However, the company remains optimistic that it could be turning the corner from H2'22. Therefore, we think there's hope after all in Chinese tech stocks. We also discussed our optimism about Alibaba, given the recent Chinese tech stocks capitulation. The commentary from Alibaba's management was also consistent with Tencent's observation.

Therefore, we remain cautiously optimistic about Tencent's momentum moving forward. Furthermore, we also think its stock seems markedly undervalued at the current levels. We also believe the recent tech stocks massacre has corroborated the strength in the recent bottom.

As such, we discuss why Tencent investors should capitalize on its recent capitulation signal and add exposure.

The Optimism In Tencent's Lackluster Earnings Card

Tencent revenue YoY change % and operating margins % (TIKR)

Tencent reported a lackluster earnings card that saw its revenue increase by just 7.9% in FQ4, below consensus estimates of 9%. However, its operating margins remained pretty resilient at 20.8%. Moreover, while its FY21 FCF margin has declined markedly, it was still robust at 25.3%. Still, it significantly underperformed FY20's 33.2%.

However, we don't think investors were "disappointed" with Tencent's performance. Given the regulatory climate that has buffeted Chinese tech stocks over the past year, it was highly expected. Therefore, we think the company's prospects moving forward would be more critical. And that's why we believe investors should be optimistic.

Chinese Tech Stocks Capitulation and Regulatory Climate

The recent capitulation in Chinese tech stocks reflected the tremendous irrationality in investors' expectations in the near term. Institutional investors had been noted to have bailed out in droves, given several "uninvestable" ratings that we observed.

However, the retail base has remained "rational." As such, retail investors have capitalized on the massive firesale afforded by the market by loading into Chinese tech stocks. As a result, Hong Kong-listed ETFs of Chinese stocks saw a deluge of inflows from retail investors. CSOP Asset Management also highlighted (edited):

We have seen retail buying through ETFs when foreign institutional clients were selling in panic. It's a more transparent and efficient way of tactically trading the market. - Bloomberg

CSOP manages a series of China/Hong Kong equities. Its popular CSOP Hang Seng Tech Index ETF (SEHK: 3033) represents some of the largest listed Chinese tech companies. Its top five holdings include Alibaba, Xiaomi (OTCPK:XIACF), Meituan (OTCPK:MPNGF), Tencent, and Kuaishou (OTCPK:KUASF). Therefore, while the institutional managers went "risk-off," retail investors went "risk-on."

And H2'2022 Could Be The Turning Point

Tencent consensus estimates % (S&P Capital IQ)

Management was also cautiously optimistic that we could observe a better H2'22 than the mess Chinese tech investors saw over the past year. The commentary was also consistent with Alibaba's optimism. Therefore, we believe that management's guidance was credible. Still, the recent COVID-19 lockdowns could continue to impinge on China's economic recovery. Accordingly, investors are encouraged to monitor the progress in the resolution of the recent lockdowns.

Nonetheless, Tencent was confident about its business environment moving forward. Accordingly, it emphasized (edited):

For advertising, as we adapt to the new environment and further upgrade our ad solutions, we expect growth to resume in late 2022.

For Domestic Games, we expect to fully digest the impact of minor protection measures in the second half of 2022.

In addition, we'll continue to release new titles, which we expect to drive additional growth, particularly for 2023 and beyond. If you refer back to the 2018 period, there was a similar deceleration in game industry growth in China for comparable reasons.

And of course, over the next couple of years, as new games came to market, those fears and concerns moved into the background. And we think that's the situation we're in now. (Tencent's FQ4'21 earnings call)

Consensus estimates also largely concur, as seen above. The street expects Tencent's growth to decelerate further into Q1, reaching 5.4%. However, we should expect an inflection point from H2'22. The momentum should also be carried forward into FY23. Furthermore, the company's profitability remains highly robust. As a result, its adjusted EBIT margins are also expected to stay consistent.

Is TCEHY Stock A Buy, Sell, Or Hold?

TCEHY stock NTM FCF yield % (TIKR)

SEHK:700 stock consensus price targets Vs. stock performance (TIKR)

Tencent stock's NTM FCF yield reached 5.54% due to the recent capitulation. Moreover, its EBIT multiples are also at levels last reached in 2012. Therefore, investors have already significantly discounted the headwinds on Tencent stock.

Furthermore, we also observed significant ratings cut in Tencent stock, as some institutional analysts rated Chinese tech stocks "uninvestable." As a result, these analysts think that Tencent stock has a potential downside of 42% from the current levels.

Therefore, we think a significant level of pessimism has already been priced into Tencent and its Chinese tech peers.

As such, we reiterate our Buy rating on Tencent stock.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of NIO, TSM 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.