Tencent: Recent Correction Presents Good Entry Opportunity

Tencent Holdings is well-positioned to benefit from the growing Internet population in China.

Tencent is essentially China’s Internet Experience – a complete digital ecosystem providing a variety of online services like social messaging, online games and mobile payment services.

Riding on the tailwind of secular growth trends, Tencent’s businesses are expanding at a steady pace. Tencent is also investing strategically to expand its future growth opportunities.

We think that the recent sell-off is an entry opportunity for investors, and Tencent is worth the investment considering its growth potential in the years ahead.

We estimate the fair valuation of Tencent at HKD 503, giving it an upside potential of about 31.4%.

Tencent Holdings (HKEX:700) is China’s largest technology company, most prominently known for its WeChat app, a popular social messaging service in China. It is also the world’s largest online gaming company. Over the years, Tencent has essentially become China’s Internet experience – an entire digital ecosystem providing a variety of online services such as social networks, online games, media entertainment and payment services.

Despite a 75% jump in its FY17 net profit, Tencent’s stock price plunged after its latest earnings release, losing more than 20% from its 52-weeks high, as the company missed revenue estimates, with operating margins also showing signs of degradation. However, we feel that the sell down was too heavy-handed, considering Tencent’s business fronts are still expanding steadily and its long-term growth potential remains intact. We believe that the current weakness presents itself as an investment opportunity into China’s biggest tech company.

1. WeChat, More Than Just Messaging

The iconic poster child of Tencent, WeChat (or Weixin) is China’s largest social network service. Followed closely behind by QQ and QQZone (Tencent’s other services), it is the Chinese’s primary medium for messaging. More than just a social communication platform, WeChat seeks to be the gateway into an entire universe of digital products and services, such as daily news, taxi bookings, food delivery and banking transactions. In fact, WeChat has become so integral to the daily lives of many Chinese consumers that it is now common for users to be able to complete their daily online tasks without having to leave the app.

WeChat has recently achieved a new major milestone: one billion monthly active users (MAUs) – up from just 355 million back in 2013. It has an 80% penetration rate of all smartphone users in China. Alongside the growth of its user population, users are also spending more time on the app: WeChat alone took up 29% of all mobile usage time spent in China across 2017 (Chart 1).

Chart 1: China Mobile Internet Daily Hours by App (Nov-2014 to Apr-2017)

This gives WeChat its distinctive edge over its competitors: a sticky user base. Once users start relying on WeChat for digital services, they inadvertently get locked into Tencent’s online ecosystem and it becomes difficult to switch out to alternatives. At the same time, it enables Tencent to actively cross-sell its many digital services to WeChat’s growing network of users, drawing user traffic further into the ecosystem and monetising them in the process. Over the quarter, Tencent saw a 51.8% year-on-year increase in social network revenue through a combination of virtual item sales, online advertisements and subscriptions fees.

Moving forward, the growing affluence of Chinese Internet users will underpin future consumption and demand for digital content (video, music and news), and should lend further support to Tencent’s revenue growth in the years ahead. Quick to capitalise on this trend, Tencent is rapidly expanding its catalogue of domestic and overseas digital content to its users through partnerships and content acquisitions. It also has a large content bank from its subsidiary China Literature (HKEX:772), which it can tap into to produce a huge variety of original programs like movies, drama series and reality TV shows.

2. Leading the Growing Online Games Industry

China is the world’s largest online games market. Despite its size, China is set to expand into a USD 42 billion market by 2020 (Chart 2), outpacing its global peers by a significant margin. Tencent’s dominance in the market and expertise in digital gaming allow it to capitalise on China’s fast-growing gaming industry. Its online games segment grew by 38.2% year-on-year in 2017, contributing to 41% of Tencent’s total revenue.

Chart 2: 2013-2020 Chinese Games Market, by Revenue (USD Billion)

As China’s leading gamemaker, Tencent has an impressive portfolio of online games, including titles like League of Legends and Clash of Clan. These games are not only popular, but they are also among the top grossing (Table 1). Having acquired significant stakes in game developers and studios (Supercell, Riot Games, Epic Games, etc.), Tencent has also enhanced its capability to publish a continuous pipeline of high quality online games across 2018, ensuring that gamers constantly have new games to look forward to, keeping Tencent’s target market and their spending within its gaming platform. The booming global scene of competitive gaming (‘eSports’) is also a trend that is likely to bode well for Tencent’s gaming business.

Table 1: Industry Peers Comparison

Interestingly, Tencent’s mobile games revenue grew 64% year-on-year in 2017 and is now the primary driver of Tencent’s online games business. With the explosive growth in popularity of mobile games, Tencent is also looking to target non-gamers by expanding its catalogue of casual mobile games. It recently launched a series of casual games such as QQ Dance and QQ Speed, both of which were well-received amongst mobile users. At one point, QQ Speed has 20 million daily active users and is the second highest grossing iOS game. If Tencent is able to make further inroads into the casual mobile games space, it will enable Tencent to further monetise its growing gamer base.

3. Paving The Expansionary Path Forward

In its attempt to dominate every inch of China’s Internet space, Tencent has started looking beyond its current digital services, with a series of strategic investments that may become its future growth drivers and provide greater diversification of its revenue streams. Tencent’s online payment services and Tencent Cloud are two of its most promising projects.

Online Payment & Wealth Management Services

As China moves towards a cashless society, Tencent’s blossoming payment platforms – including the popular WeChat Pay, which is now the second largest in China – are likely to gain further momentum. Incorporated within the WeChat app, WeChat Pay makes paying for things simple. Users can pay for almost anything in China using WeChat Pay – be it transportation, restaurants to roadside stalls – all within the users’ fingertips. It is not surprising that offline transaction volumes have grown rapidly, doubling year-on-year across 2017. As WeChat Pay gets more widely adopted, Tencent is set to be a major player in the USD 12 trillion China mobile payment market.

Not only is Tencent making it easy to pay for things, it is also extending traditional financial services to the masses. With this move, Tencent is potentially not just an Internet service company, but also a financial services company. From within the existing mobile payment platform, users can obtain financial products and services in just a few taps, without the hassle of paperwork tied to traditional banking. As the Chinese get wealthier, demand for wealth management services is expected to pick up pace.

LiCaiTong, a wealth management platform of Tencent, has accumulated over RMB 300 billion in assets under management as of January 2018. Meanwhile, its consumer loan business,Weilidai, managed loans of over RMB 100 billion and will benefit from China’s burgeoning online consumer finance market.

Tencent Cloud Services

Tencent’s cloud computing service is also fast gaining momentum in China, as it enables companies to tap on digital resources (like computing power and software) from Tencent’s data centres as an on-demand service. This will relieve the companies from the need to construct and maintain their own data centres. Such cloud services are also essential for small and medium enterprises to meet their online infrastructures requirements without huge capital outlay, empowering these companies to focus on their core businesses.

Across 2017, Tencent Cloud expanded its client base for its cloud services to the financial and government sectors. While its cloud revenue is relatively small now, it could grow rapidly in the future should the business take flight.

These projects, if proved successfully, are likely to drive an expansion to a larger total addressable market for Tencent and thus even bigger revenue opportunities in the long run.

4. Investment Risks

A. Increased Government Regulations and Interventions

China’s media regulator has been tightening its grip on digital content and clamping down on content deemed inappropriate. News sites and apps like Toutiao were recently ordered to shut down and step up their efforts to clean up ‘vulgar’ content. This could hinder Tencent’s plans to expand its digital media offering, especially those popular foreign content. We think Tencent might incur greater expenses in the short-term to internally audit its digital content to ensure compliance and stay in good books with the authority. However, we believe that any margin compressions would likely be short-term, given the strong growth of digital content consumption by Chinese Internet users. The likelihood of increased regulatory measures to be imposed on the industry would also raise the barriers to entry for new competitors.

B. Uncertainty in Higher Investment into The New Initiatives

As Tencent engages in higher investment in new initiatives like the cloud and Internet payment and financial service, Alibaba (NYSE:BABA) is also aggressively ramping up its investment into these areas. Such intensified competitions to grab market shares may lead to short-term margin compressions, which could negatively impact its earnings in the next few quarters. Furthermore, many of Tencent’s high-risk high-rewards projects, such as Artificial Intelligence (AI) capabilities and Smart Retail initiative may not bear fruits in the long-term.

However, we think that any margin pressures will likely be short-term and Tencent’s strategic investments is likely to drive a further acceleration in consumers’ and enterprise adoptions’ of digital solutions. This will serve as a catalyst to expand Tencent’s total addressable market and creating greater revenue opportunities in the long run.

5. Fair Valuations

Using a Sum-Of-The-Parts valuation, we value Tencent Holdings at HKD 4,783 billion with an intrinsic value of HKD 503.34 per share. Our 2018E estimated earnings per share (EPS) is HKD 10.63 and our estimated three-year earnings CAGR is 22.8% (2017-2020). We think that this is conservative, considering the historical three-year earnings CAGR was 35.9% (2014-2017). The implied 2018 PE is 47.3X. Based on Tencent’s closing price of HKD 382.80 (as of 4 May 2018), the upside potential is about 31.4%.

Our assumptions include:

Online Games: The price-earnings (P/E) ratio of 35X is in line with peers in the Digital Games sector, which includes NetEase Inc, Electronic Arts Inc, Take Two Interactive Inc and Activision Blizzard Inc.

Social Network: Earnings derived from WeChat, Tencent Video, News and Music. The P/E ratio of 28X is in-line with peers in the Internet Services sector, which includes Netflix Inc, Spotify Inc, Alphabet Inc, Facebook Inc, Twitter Inc, Weibo ADR and Baidu ADR.

Online Advertising: Earnings derived from Social and Media Ads. The P/E ratio of 28X is in line with the peers in Digital Advertising sector, which includes Alphabet Inc, Facebook Inc, Twitter Inc, Snap Inc, Weibo Inc and Baidu Inc.

Payment and Internet Financing: The Price-Sales (P/S) ratio of 10X is in-line with peers in the Payment Processing sector, which includes Mastercard Inc, Visa Inc and Paypal Inc.

Investment: Minority Interest in variety of listed and unlisted entities. The prominent listed entities include JD.com, Snap Inc, Tesla Inc and Activision Blizzard Inc. The book value is based on Tencent Holdings’ FY17 book value of its investments in associates.

Table 2: Sum-Of-The-Parts Valuation for Tencent

Conclusion

Overall, we believe that Tencent is an exciting company to invest into. Its value proposition as the China’s online ecosystem of digital services will remain rock solid in the years ahead. Tencent’s strategic investments in cloud and financial services will serve to expand its headroom for further growth. While Tencent focus mainly on the China market, we noticed that it has begun to make its move into Southeast Asia, pushing for the adoption of its WeChat app. Moving forward, if Tencent can replicate its success in the China market to other parts of the world, its growth potential ahead will be astronomical.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.