PROSF - Is China Investable Again? Another Look At Prosus And Tencent

Summary

• After years of zero-Covid, China is finally reopening.
• Tencent is allowed to license new games again, and the Tech crackdown is mostly over.
• Tencent is distributing its stake in Meituan as a special dividend.
• Prosus will continue to use its discount to NAV to create value for shareholders.

Many people have called China uninvestable for the last year and a half, yet this sentiment has changed in recent weeks. In October, I wrote my previous article about Prosus ( PROSF ) and Tencent ( TCEHY ); since then, Prosus shares have gained more than 70% from the lows. Let's see what changed this sentiment and if it still provides an attractive opportunity.

China is reopening

Since the pandemic's start, China has held onto its Zero Covid policy. This worked fine for a while, but eventually, this policy evolved into a subhuman treatment of civilians, with people starting to starve under the strict lockdown policy. Finally, Zero Covid stopped to work and in April, the first spike happened, with 36,000 new cases in one day at the peak. The second and so far the last peak was at the end of November with 71000 cases in one day. Over 2 million people have gotten Covid in China so far. Around the same time, China started to open up again and now even the borders are reopened by air, land, and sea.

China's Central bank ends the tech crackdown

Another, maybe even more important, piece of news for Tencent is that a central bank official declared the two-year crackdown on technology companies to be over. This is taking the stress away from the companies that have been in the crosshairs of regulators for two years and have seen share prices cut in half and worse in some cases.

In September, Tencent and NetEase ( NTES ) were allowed to publish new games after a 14-month break. This should enable Tencent to return to being a growing company, unlike in the recent past: In the last two quarters, Tencent saw its first decline in revenue on a trailing twelve-month basis. Since the peak at $88.36 billion, revenues declined to $77.84 billion in the most recent quarter.

Tencent's Q3 2022 earnings

Let's look at the last earnings report for Tencent. Results have been pretty steady year over year but up across the board sequentially. The operating margin stabilized at 29% after dropping to 23% in Q4 21. A lot of this has been achieved by efficiency initiatives ( Slide 7 ):

• Marketing programs -> reduced S&M expenses by 32%
• Business services -> strategic focus on high-quality revenue
• Video accounts -> operating costs per view reduced significantly
• Workforce optimization -> reduced headcount

Tencent continues to return capital, benefitting Prosus

In my last article, I mentioned that there were rumors about Tencent looking to sell down more of its investments to return capital to owners. This ended up happening in Q3, when Tencent announced the divestiture of its entire stake in Chinese Food delivery and super app company Meituan ( MPNGF ), valued at $13.3 billion at the time of the announcement. Additionally, the company accelerated its buybacks to $3 billion in the last 12 months. Previously, Tencent used to dilute shareholders with Stock-based compensation (SBC), adding $18.56 billion in SBC over the last decade. The $3 billion buyback still is insignificant compared to its market cap, which bottomed at $240 billion and is now back at $447 billion, but it is a good allocation of Tencent's capital.

What does this mean for Prosus?

Prosus is a big beneficiary of the new capital return strategy of Tencent. I already talked about this in my first article last February , where I concluded that the company will have to change its capital allocation strategy and will return more to shareholders. This does not interest me as much as a company that can invest its money efficiently, but Prosus can benefit from this due to its discount to net asset value ((NAV)). Prosus will receive around 262 million shares in Meituan, which are currently worth about $5.7 billion. They already stated that they intend to sell them as soon as they receive the special dividend. This frees up more cash for Prosus to use in its buyback strategy to exploit its discount to NAV. I explained how this strategy works in this previous article , but in short: Prosus is selling shares of Tencent to repurchase its own shares. Because Prosus trades at a discount to its NAV, every repurchased share increases the NAV per share, thus unlocking value for shareholders.

How large is the discount to NAV now?

In my opinion, the investment thesis for Prosus revolves around its discount to NAV and its ability to repurchase shares. According to Prosus NAV calculation, updated daily, the company currently has a NAV of 160.9 € billion for the whole company and 1307 million shares, equating to 113.3 € NAV per share. When the mass buybacks were announced, the company had 1420 million shares outstanding, so we have already seen a sizable 8% decline in the share count with around $3.3 billion spent on buybacks. Shares currently trade at 75 € and offer a 33% discount to NAV.

Is Tencent still cheap?

If we look at historical multiples, we can see that Tencent, after its rally, is now trading at a 23 PE, 17 EV/EBITDA, and a 4.2% FCF yield. These multiples are still below historical averages, but analysts expect a more modest growth rate than the last decade. I believe Tencent is around fair value but not a big bargain anymore.

Conclusion

I sold out of Prosus last August at a 33% gain. In hindsight, not my best decision; shares have run up another 22% since then. I sold out at a gain to lock in profits in a still uncertain environment. I still am not a fan of investments in China due to the regulatory uncertainties and at these prices, which are closer to fair value than before, I am personally not looking to invest. I'll leave Prosus at a buy, though, because the discount to NAV is still attractive at 33% and Tencent is not overvalued right now. We must also remember that Prosus can buy back around 4% of its shares from the special dividend (Meituan). Overall, I am not excited about China, but I see Prosus as a decent way to get exposure to the market.

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