2023-08-18 19:28:06 ET
Summary
- Tencent posted a solid performance in Q2 2023; although both topline and bottomline missed consensus estimates.
- Looking ahead, I argue that Tencent is slowly, but surely transitioning away from being a growth story, and becoming a value story instead.
- I see Tencent generating a well-moated, distributable annual income of RMB ~190-210 billion, suggesting 8-9% shareholder return going forward.
- I reiterate a Buy rating; but I lower my base case target price to $47.23/ share.
Tencent (TCEHY) reported a solid set of Q2 2023 results , although the Chinese Tech giant disappointed against Refinitiv consensus estimates. In sum: Tencent's revenue for the June quarter was up 11% YoY, accumulating to RMB 149.21 billion; Profit attributable to shareholders was reported at RMB 26.17 billion, up 41% YoY.
Looking beyond Q2 2023 reporting noise, I argue that Tencent equity continues to be valued attractively, trading at a EV/ EBIT of ~14x. On the backdrop of lower EPS projections through 2025, however, I cut my fair-value target price to $47.23/ share.
For reference, Tencent shares have underperformed YTD vs. the Hang Seng technology benchmark, as well as the U.S. stock market. Since January 2023, TCEHY shares are down about 6%, as compared to a loss of 5% for the KraneShares Hang Seng TECH Index ETF (KTEC) and a gain of 16% for the S&P 500 (SP500).
Overall Solid, But Disappointing Q2
Considering the challenging macro backdrop in China, Tencent's results for Q2 2023 were actually quite solid, in my opinion; however, the company still missed consensus estimates on both topline and earnings, according to data collected by Refinitv. During the period from April to end of June, China's largest technology conglomerate generated about RMB 149.2 billion of sales, which compares to RMB 134 billion for the same period one year earlier (up 11% YoY). Analysts, however, have projected Q2 sales in the range RMB 151 to 155 billion.
With regard to profitability: Tencent's gross profit jumped to RMB 70.8 billion, up 22% YoY vs. the RMB 57.9 billion recorded in the same period one year earlier; Tencent's operating income came in at RMB 50.1 billion, representing an increase of 37% YoY vs. Q2 2022, respectively.
On a segment basis, Tencent benefitted from a jump in advertising fee income, which was up 34% YoY, as healthcare, e-commerce, and travel saw a boost in demand following the COVID repopening tailwind. Tencent's core profit center, however, which includes Social Networks and Games, remained flat vs. Q2 2022 -- and actually decreased QoQ by about 6%. In my opinion, there are two major reasons for Tencent's weak performance in Games: First, investors should consider that the Q2 2022 benchmark was boosted by COVID lockdowns pushing people to indoors entertainment; Second, I would like to point out Tencent's weak pipeline of new game launches throughout 2022, as Chinese authorities froze the approval process for many Tencent titles. For reference, Tencent's International Games division was up 19% YoY.
Growth Out, Value In
Reflecting on Tencent's Q2 2023 results, I think it is fair to say that the tech giant's track record of materializing 20%+ CAGR has likely come to an end. However, what Tencent is losing on its growth appeal, the company is gaining on value.
Investors should consider that Tencent is attractively expanding margins on OPEX discipline and is now generating an estimated, annualized operating cash flow of approximately RMB ~200-220 billion. Modelling a reasonable RMB ~20-25 billion maintenance CAPEX on Tencent's asset-light business operations, investors may thus reasonably expect RMB ~190-210 billion of distributable cash flow.
Comparing Tencent's estimated distributable cash flow to the company's enterprise value of RMB ~3.2 trillion suggests a x16 multiple, or a ~6.2% yield. This yield, paired with a CAGR 2-3% terminal growth estimated, would reward Tencent equity holders with a 8-9% return.
Now, I would also like to point out that the above calculated cash flow should be highly sustainable over time, given Tencent's strongly-moated business operations protected by network effects: As of June 30th, Tencent owns China's #1 social media platform, #1 mobile payment platform, #1 gaming platform, and #1-2 position in Cloud.
Valuation Update: Lower Target Price
Reflecting on Tencent's Q2 report, I update my EPS projections for the Tech giant in line with analyst consensus revision, according to data collected by Bloomberg: Accordingly, I now anchor on EPS equal to $2.3 for FY 2023, vs $2.55 estimated previously. Moreover, I adjust my EPS input for 2024 and 2025, to $2.7 and $3.4, respectively.
I continue to base my valuation model on a reasonable 3.5% terminal growth rate (one percentage point higher than estimated nominal global GDP growth), as well as a 10.0%, cost of equity. Admittedly, the cost of equity might understate Tencent's risk premia, given the China-related investment risks. That said, investors who would like to test a higher cost of equity may reference the sensitivity table enclosed.
Given the updated EPS projections as highlighted below, I now calculate a fair implied share price for TCEHY equal to $47.23.
Company Financials:´; Author's EPS Estimates; Author's Calculation
Below is also the updated sensitivity table -- highlighting a favorable risk - reward even for higher cost of equity levels.
Company Financials:´; Author's EPS Estimates; Author's Calculation
China ADRs Remain Risky
Tencent is undoubtedly a great company, operating well-moated business models across operating segments (e.g., Social Media, Gaming, Cloud). Thus, I see little idiosyncratic downside risk for TCEHY.
On a more systemic-based risk assessment, however, my primary concern relates to investing in companies headquartered in China; specifically, to the regulatory pressure that China's tech and internet giants have faced in recent months/ years. Of course, if this ongoing regulatory scrutiny persists, Tencent's valuation might need to be adjusted with a considerable risk discount. That said, however, it is worth noting that the most intense phase of the regulatory clampdown in China has passed.
In addition to regulatory concerns, I would also like to highlight that the volatility of Tencent stock price is strongly swayed by the prevailing sentiment of investors towards Chinese ADRs. This implies that even if the underlying business fundamentals of the company remain stable, TCEHY stock may fluctuate based on how investors perceive the risks associated with Chinese investments.
Conclusion
Tencent posted a solid performance in Q2 2023; although both topline and bottomline missed consensus estimates. Looking ahead, I argue that investors should focus less on Tencent's growth story and appreciate that the Tech giant is slowly transitioning towards become a value investment opportunity instead. To render the value argument more concrete: I see Tencent generating a well-moated, distributable annual income of RMB ~190-210 billion, which would suggest a 8-9% shareholder return going forward, according to my calculations. On the backdrop of an attractive valuation, I continue to recommend a "Buy" for TCEHY.
For further details see:
Tencent: Growth Story Out, Value Story In