Plagued by an onslaught of negative news, from US-China trade war, tightening online games regulations to its lacklustre 2Q18 earnings result, Tencent Holdings (HKEX:700) has succumbed to investors’ pessimism, plunging by about -20% since our previous update on Tencent published on 7 May 2018 (Chart 1).
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Chart 1: Tencent Hammered Severely Over Last Six Months
What Led to Tencent’s Decline?
Since May 2018, Tencent’s online games business was confronted with a series of regulatory challenges. First, the Chinese government stopped Tencent’s launch of its highly popular PC game, Monster Hunter: World. Next, it was revealed that China has halted all video-game approvals since end-March without a fixed resumption date, a move that effectively stifled Tencent’s ability to monetise its much-hyped new games – PlayerUnknown’s Battleground (PUBG) and Fortnite.
More recently, regulators also announced that they will restrict the number of new games, crackdown on games with inappropriate content (violence and gambling) and limit playtime for minors (under 18 years old). The move came as regulators look to reduce myopia and video game addiction among children and teenagers.
Tencent is already feeling the heat from the tighter regulations. It delivered a disappointing 2Q18 financial performance, with both revenue and net profit falling short of consensus estimates, caused primarily by slower-than-expected online game growth The average revenue per user (ARPU) from online games deteriorated, exacerbated by the ‘cannibalisation effect’ as gamers shift their playtime from the well-monetised mature games towards the new non-monetised games. This reinforced investors’ fears that growth of Tencent Games has peaked and is struggling with regulatory troubles.
While a near-term slowdown in Tencent’s online gaming growth is inevitable given the regulatory woes, we believe that sentiment is overly bearish and investors should take advantage of the current price weakness to accumulate a quality stock.
1. Tighter Regulations Only A Short-Term Pain
While a near-term slowdown in Tencent’s online gaming growth is inevitable, we believe that the game approval suspension is merely a bureaucratic delay, amidst a restructuring of the relevant regulatory administrations. The consensus is that the gaming approval process should resume as soon as late-2018. Most importantly, the resumption of the approval process will kick-start a multi-year cycle of revenue growth, as Tencent starts monetising its massively popular games PUBG and Fortnite.
The government may have moved to limit playtime for minors, but it is worth noting that minors constitute a small portion of Tencent’s gaming revenue. We estimate that the group only accounts for about 10-15% of total online game spend from Tencent’s core player base. Minors may have a high inclination to spend on in-app purchases, but we believe they are hamstrung by their low spending capability.
Furthermore, previous time limits have had minimal impact on Tencent. In response to criticisms on the negative influence of its popular games on youngsters in July last year, Tencent pre-emptively released a protection system in mobile game Honor Of King, limiting playtime to 1-2 hours a day. Despite the restriction, the following quarter’s game revenue (3Q17) grew 12.5% on a quarterly basis, reaching a record high.
We think it will be no different this time as well. Shortly after August’s proposed regulations, Tencent has begun performing real-name checks and rolling out trials for facial recognition in Honor Of King to check gamers’ age. We are positive Tencent’s highly visible efforts in protecting the well-being of minors will help assuage widespread concerns over the societal damage of video-game addiction.
Tighter regulatory environment benefits larger players like Tencent, enabling them to consolidate market share and root out smaller firms. Small/mid-sized video-games studios, which typically rely on a few popular titles, would likely be most affected by the restriction in gaming time, as gamers become more selective. Tencent is also well-cushioned with ample resources to ride out the suspension in approval process, compared to smaller firms which may face greater financial strain.
Ultimately, we believe that Tencent Games’ revenue will be the least affected within Chinese video-gaming community. After all, Tencent’s popular games are still the top-grossing and most-played video-games in China (Tables 1 and 2).
Table 1: Top 5 Grossing Android Games in China (May 2018)
Table 2: Top 5 Most Popular Global PC Games (August 2018)
2. WeChat Remains Tencent’s Crown Jewel
While online gaming is currently the most prominent (and profitable) segment, Tencent’s super-app WeChat is ultimately its strongest moat. Despite concerns surrounding WeChat’s possible slowdown in growth, China’s largest social media network has continued to grow steadily. The combined monthly active users (MAU) of Weixin and Wechat reached 1.06 billion users in June 2018, an increase of 9.9% from one year ago (Chart 2).
Not only is the user base expanding, WeChat users are becoming more active on the social network, with DAU and per user message of WeChat increasing by double-digit percentages in 2Q18. Tencent has also noted that its users are spending more time on WeChat Mini Games and Moments across 2Q18, driving overall daily time spent per user.
Chart 2: WeChat/Wexin’s Large User Base Still Growing and Spending More Screen Time
Thanks to WeChat’s huge active user base, Tencent has transcended into a data-rich consumer-oriented digital ecosystem. As a digital ecosystem, Tencent’s network effect unlocks value for both users and advertisers. The network effect is self-reinforcing: as users engage in more digital services more frequently, advertisers are compelled to spend more marketing dollars to capitalise on the rising web traffic, while service providers are also enticed to onboard Tencent’s ecosystem, bolstering Tencent’s efforts in establishing an endless catalogue of on-demand internet services for its users.
Therefore, as long as users are kept engaged within Tencent’s digital ecosystem, it can continuously generate outsized revenues via advertising and commissions. To that end, Tencent has been highly active in building and acquiring a diverse range of internet services. As a result, much of China’s most exciting high-growth businesses and start-ups (Figure 1) have been drafted under the umbrella of massive duopoly Tencent and Alibaba Group (NYSE:BABA).
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Figure 1: Tencent’s Sprawling Network of Services and Associates Across China’s Business Community
3. Advertising and Digital Content to Boost Next Phase of Growtha
As standards of living improve greatly in China, demand for digital content (video, music, etc.) is growing at a rapid pace, driven primarily by tech-savvy Millennials. China’s video consumption has grown at CAGR of 65% in the last three years.
To capture this exciting growth, Tencent has been rapidly investing into the production of high quality media content. We think Tencent Video holds a slight edge over competitors, thanks to the large intellectual property (IP) bank from sister company China Literature (HKEX:772), which it can tap into to produce a huge variety of exclusive original productions like movies, drama series and reality TV shows.
As of 2Q18, Tencent Video has continued to gain user traffic, time spend and engagement, stimulated by the successes of its original content, which include blockbuster hits Ruyi’s Royal Love in the Palace (如懿传) and Legend of Fuyao (扶摇). As the most popular online video platform in China, Tencent Video currently has 604 million MAU, with 74 million of users converted to paid subscribers in 2Q18, an increase of 121% from one year ago (Chart 3).
Chart 3: Tencent Video Is The Most Popular Online Video Platform In China
Hooked to Tencent’s portfolio of high-quality content, its mushrooming base of active users are spending more time and visiting more frequently. This robust growth in user traffic through these services in turn spurred an accelerating online ad revenue stream, which grew about 40% from one year ago.
Moving forward, we expect strong growth momentum in Tencent’s online ad revenue (from both media and social ad), powered by the double-digit growth in China’s online advertising industry (Chart 4). The recent introduction of a 2nd daily feed ad per user in its Mini Program and WeChat Moment service will furnish Tencent with more ad inventory, propelling a swift social ad growth.
We are positive Tencent’s online ad and digital content segment are set to emerge strongly as the next long-term growth driver for the company, picking up the slack left by online gaming.
Chart 4: Online Advertising Industry To Quickly Outpace Online Games in China
Investment Risks
Fair Valuation
We have reduced our fair valuation of Tencent Holdings to HKD 464, down from the previous HKD 500, accounting for a slowdown in the growth of online gaming sales. In our Sum-of-the-Parts (SOTP) valuation, we cut our fair PE ratio for online games down to 30X from an initial 35X, while keeping the other price multiple constant (Table 3).
This implies an upside potential of 50%, based on closing price of HKD 305 (as of 5-Oct-18).
Tencent currently trades at a forward PE ratio 24.4X (based on 2019 estimated earnings), which is below peers’ average of 28X. It is also trading at the lowest PE ratio in the past 5 years. We think Tencent deserves a premium PE ratio at 35-40X, considering its higher growth rate and multi-dimensional growth potential
Given that Tencent’s share price has already been beaten down badly, we believe that the upside potential now overweighs the downside risks, presenting an attractive entry point for investors to accumulate on Tencent shares.
Our assumptions include:
Table 3: Sum-Of-The-Parts Valuation Based on FY2019 Estimates
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