Summary
- Tencent is down 70% from highs and trades at the same levels it did 5 years ago.
- There are $150 billion of equity investments on the balance sheet as compared to the $270 billion in market cap.
- Growth has disappeared, but that is likely due to a resurgence in COVID, with many of the businesses geared towards an economic upturn.
- The stock trades at 13x earnings even before accounting for the equity investments - making this a legitimate deep-value play in China tech.
Tencent ( TCEHY ), known frequently as "The Facebook of China," has had a rough ride as it suffered first from a crash in Chinese stocks and then a crash in tech stocks. This is a company which has around $150 billion of equity investments on its balance sheet (the market cap recently stood at around $270 billion). Growth has come to a standstill due to both increased COVID restrictions in China as well as a weak broader economy, but the current stock price is too cheap. If growth comes back, then the stock may re-value violently upwards as this is a company generating free cash flow and focused on utilizing it for share repurchases. While delisting risks remain present and may remain an overhang in the near term, at some point the underlying value should play out in the stock price.
TCEHY Stock Price
TCEHY peaked at $99 per share in early 2021 but has since crashed 70%. The stock now trades at the same levels it did in 2017.
I last covered TCEHY in September 2021, where I explained why I wanted to wait for a stronger share repurchase program before diving in. The stock has since fallen 49%, increasing the relevance of the hidden value in the balance sheet.
TCEHY Stock Key Metrics
TCEHY's latest financial results showed 3% year-over-year decline in revenue as the company's online advertising segment saw revenues decline by 18%.
The company has responded to the slowdown through cost reduction initiatives, with the most important being closing down loss-making businesses. That helped prevent profits from collapsing.
On the conference call , management stressed that the poor results were due to the business being adversely affected by the resurgence of COVID-19 (recall that China's government takes the pandemic more seriously than others) and the associated decelerating economic growth. Management noted that their businesses were "significantly geared toward a future economic upturn." They noted that commercial payment volume slowed to low single-digit growth in April amidst pandemic lockdowns, but recovered to high-teens growth in June. They also noted that the revenue decline rate in advertising stabilized greatly in the second quarter as well.
I suspect most investors buy TCEHY for its advertising business, but the gaming business remains a key driver. Gaming revenue declined 1% year over year, reflecting some impact from regulatory changes as well as there being fewer big game releases.
Management did note that they believe that they can grow earnings from the game business even without revenue growth, emphasizing that "game revenue growth is not a precondition for earnings growth."
Free cash flow made up 80% of non-GAAP profits in the quarter, though TCEHY still maintained its policy of modest share repurchases totaling around $440 million. The value of its listed equity investments totaled $90 billion, with the unlisted equity investments having a book value of $50 billion (and management believes that book value understates the true value).
TCEHY maintains a slight net debt balance sheet which can be viewed negatively as compared to the net cash balance sheet at Alibaba ( BABA ), but it reflects management's more aggressive capital allocation policies, aiming to stay fully invested in the market.
Is TCEHY Stock A Buy, Sell, Or Hold?
At the most bearish of circumstances, it is important to think longer term. TCEHY remains a technological giant in China, with a dominant gaming platform, a dominant social media presence through WeChat, as well as being a dominant operator in digital content, fintech, and cloud.
WeChat in particular is an important element of thesis. Anyone who has used the social media app knows that it is under-monetized relative to Facebook or Instagram. Like BABA, TCEHY has benefitted from the Chinese government's rule as the company built up monopolistic and wide-reaching businesses without too much regulatory intervention. TCEHY is expected to earn $2.19 in earnings per share this year, placing the stock at just 13x forward earnings. That is a curiously cheap multiple for a company that is expected to return to double-digit revenue growth next year.
Assuming that TCEHY can sustain around 20% earnings growth over the long term - outpacing revenue growth due to operating leverage - and that the stock trades at a discounted 1x price-to-earnings growth ratio ('PEG ratio'), the stock has 50% potential upside from multiple expansion to alongside annual returns from growth. This upside calculation does not factor in the roughly $150 billion of listed and unlisted equity investments, which make up 55% of the current market cap.
But what is the catalyst? Management has seemingly shown a greater willingness to undertake share repurchases - just examine the commentary below:
We are very focused on capital -- returning capital to shareholders given what we believe our share price is very undervalued and also undervalued in the context of our investment portfolio. So if you look at what we've done year-to-date, we've returned around $17 billion, $18 billion to Tencent shareholders. And we've been largely neutral in terms of our investments, divestments in other companies, excluding the substantial JD divestiture. So our focus from a sort of investments perspective has been buying back and dividending to our own stock, and that will likely remain the case going forward for some period of time.
In terms of your question as to how we can fund ongoing buybacks and dividends, then if you take our second quarter results, we generated annualized free cash flow of mid-teens billions of U.S. dollars and that's after investing in the CapEx and so forth to support Video Accounts and support international games and support enterprise software. In addition to that, we have disclosed that we have an investment portfolio whose market value was $90 billion at the end of the quarter. And we have demonstrated with JD and Sea that we're willing to work down that investment portfolio over time to more effectively return capital to Tencent shareholders. In addition to that, we have unlisted our private investment portfolio where the book value is over USD 50 billion. And we believe there's been substantial appreciation on that over $50 billion book value. And we also look for opportunities to return capital from that private investment portfolio in the form of dividends, distributions and buybacks.
I had previously been more critical of BABA for hoarding too much cash and failing to return cash to shareholders, but ironically it is now BABA that leads the way with share repurchases. TCEHY is paying a dividend, but the yield is not so significant. One could make the argument that TCEHY has been more active than BABA on the investment management front, but with the stock trading so cheaply, many investors (including yours truly) will place greater emphasis on share repurchases at this time.
This is a risky story. The most pressing risk is that of the potential for delisting, as the SEC aims to delist Chinese stocks which do not satisfy auditing requirements. One could theoretically bypass this risk by investing in Tencent through either its Hong Kong listing or through an ETF like KWEB ( KWEB ) which invests in Tencent through the Hong Kong listing (albeit with many other holdings). That said, a delisting event is likely to lead to further downside even for the Hong Kong shares, and many readers may be focused on the US listing regardless. It feels unlikely for Chinese stocks to be delisted, but the past has no bearing on the future. Another risk is that growth does not return. It is possible that TCEHY (and BABA for that matter) have become so large that they are now the incumbents that smaller operators are winning market share from. Investors should look for a robust recovery in growth rates over the coming quarters as the pandemic fades - the absence of that may suggest that there are deeper underlying issues at play. The main catalyst for upside remains management's ability to monetize its investments for share repurchases. The company has not proven so willing to do this thus far - it is possible that management never seeks to take advantage of the apparent discount.
I have discussed with subscribers of Best of Breed Growth Stocks that I am investing in a diversified basket of beaten-down tech stocks as my favored strategy in the current environment. TCEHY is one of the stocks in that bucket, fitting the bill as a high-risk, high-reward position. I rate the stock a buy as part of a diversified portfolio.
For further details see:
Tencent Is 'The Facebook Of China,' 13x Earnings, 55% Of Its Market Cap In Investments