2023-03-08 02:42:16 ET
Summary
- Tencent owns the most popular Chinese social media, video and live-streaming platforms and has control over the Chinese gaming and fintech industries.
- Tencent's biggest threat is represented by the Chinese government and the series of crackdowns implemented on the tech industries.
- Despite having a current stock price higher than its intrinsic value, Tencent should be added to the investors’ watchlist waiting for a price correction.
Investment Thesis
Tech giant is a reductive adjective for Tencent ( TCEHY ), this colossus owns the most popular Chinese social media, video and live-streaming platforms and has control over the Chinese gaming and fintech industries.
While competition from other companies doesn’t represent a big threat to Tencent given its scale of operations, the natural enemy of Tencent is the Chinese government and the series of crackdowns implemented on the tech industries.
Despite the Chinese government getting in the way, Tencent delivered great results in the past and is expected to keep succeeding in the future.
In today’s analysis, we will assess why Tencent, despite having a current stock price higher than its intrinsic value of $39 per share, should be added to the investors’ watchlist waiting for its price to decline making it a good investment opportunity.
Business Model
Tencent’s business model is divided into four main segments: Games, Social Networks, Online Advertising, and FinTech services.
Games and FinTech services account for the majority of revenues, respectively at 32% and 33% of total revenues, while Social Networks and Online Advertising revenues account for 20% and 15%.
Being a tech conglomerate permits Tencent to have a well-diversified portfolio of operations that helped the company to perform relatively well even when one or more segments were tackled by government actions or macroeconomic issues in the past years.
Regulation Risks
Back in 2020, the Chinese government started introducing tighter regulations on tech companies, especially on the biggest ones like Tencent and Alibaba, to realign their interests with the ones of the Communist party.
Many are the antitrust regulations imposed on Tencent, like being forced to terminate the upcoming merger of the two main Chinese streaming platforms, Huya and Douyu, in which Tencent had a majority stake, and being forced to give up on exclusive music rights on behalf of its subsidiary Tencent Music Entertainment ( TME ).
Other than antitrust policies, Tencent had to face new regulations for the gaming industry that imposed restrictions on gamers under 18 years old to play online video games only during weekends and national holidays, and for a total of only three hours during that period. Beyond time constraints, also spending capabilities have been reduced for underage gamers, harming even further the gaming industry.
Other than imposing restrictions, new video game approvals stopped for 9 months from July 2021 to April 2022 in China not permitting Tencent to introduce new titles to the market.
Operating Performance
Looking at Tencent’s past operating performance, despite the actions of the Chinese government, Tencent’s revenues managed to grow at a compound annual growth rate or CAGR of 27.5% since 2012, expected to be around $80 billion in 2022.
High growth rates have been accompanied by great efficiency and profitability having a 5-year median operating margin of 25.8% and a median return on invested capital or ROIC of 13.6%.
Combining high growth and high efficiency resulting in a solid and consistent cash flow generation, with FCFF that went from $2.1 billion in 2012 to $14.4 billion expected in 2022.
Financially Tencent has a negative net cash position of -$13 billion but can still be considered a healthy company having a current ratio of 1.45, a debt-to-equity ratio of 0.45, and an interest coverage ratio of 20.5.
Growth Drivers
As a tech conglomerate, Tencent has different growth drivers. Other than R&D expenses, which are needed to keep developing cutting-edge technologies that will enrich Tencent’s ecosystem, Tencent heavily relies on the purchase of intangible assets like music and game licensing needed to support the music and video game platforms. Last but not least, Tencent future growth is derived from the investments made in acquisitions to acquire new and already underway proprietary technologies.
Future growth can be determined by looking at how much and how well a company has invested in its growth drivers. The Reinvestment Margin shows what percentage of revenues has been reinvested into the company, while the Sales to Invested Capital ratio, shows how much revenues have been generated for each dollar invested by the company. If we multiply these two values and take the median value over the years, we obtain the expected growth rate in revenues based on how much and how well a company has invested in its growth drivers.
In our case, Tencent’s expected growth rate is 16.17%.
DCF Model
I use the discounted cash flow ("DCF") analysis method to value companies. The aim of a DCF analysis is to determine the present value of expected cash flows generated by the company in the future. The first step is to project the growth rate at which revenues will grow in the future. Secondly, we will need to assume the degree of efficiency and profitability at which the company will turn revenues into cash flows.
Efficiency is represented by the operating margin, and profitability by the ROIC. Having the revenue projections and future operating margins, we obtain the EBIT and, after subtracting taxes, we get the net operating profit after taxes. The ROIC is used to determine the reinvestments needed to support future growth, determining how much profit the company generates from every dollar reinvested into the company.
Future cash flows are calculated by subtracting the reinvestments from the net operating profit after taxes. The higher the growth rate, the higher the reinvestments needed to support it, hence the lower future cash flows will be.
The last step of a DCF analysis is to apply the discount rate to future cash flows, usually calculated using the weighted average cost of capital ('WACC').
Projections
Projecting Tencent’s performance into the future, we can start by forecasting future revenues by applying the expected growth rate of 16.17% and letting it slowly decline as the company enters its steady state. With these assumptions revenues are expected to reach $185 billion by 2032, growing at a CAGR of 8.76%.
Moving on to future efficiency and profitability, being Tencent a well-diversified and established company with significant leadership in the markets in with it operates, we can expect the operating margin to remain around its historical values of 25%, while the ROIC can be expected to improve to 18% by 2032 as the company entering its maturity phase stops to invest heavily for future growth.
With that said, FCFF are expected to remain solid and consistent reaching $27.3 billion by 2032.
Valuation
Applying a discount rate of 8.2%, calculated using the WACC, the present value of these cash flows is equal to an equity value of $368 billion or $39.2 per share.
Conclusion
Given my analysis and assumptions, Tencent’s stocks result to be slightly overvalued at today’s prices.
Thanks to its scale of operations, Tencent has proved to have a resilient business model able to survive the numerous attacks from the Chinese government, and despite the many regulations imposed, can be expected to keep thriving in the future. However, at the moment, Tencent should be carefully kept on our watchlists waiting for a significant price correction that will make the company a great investment opportunity.
For further details see:
Tencent Holdings: Delivering Value Amid Government Crackdowns