2023-08-02 03:56:00 ET
Summary
- Tencent is reporting double-digit revenue growth again and gross margin as well as operating margin are improving.
- The stock is still trading for rather low valuation multiples - especially for a high quality business growing in the double digits.
- Despite all optimism, we should not ignore the high debt levels China is facing right now.
In the last few years, Tencent Holdings Limited ( OTCPK:TCEHY ) – as well as many other Chinese stocks – saw a huge discrepancy between the stock price and the fundamental picture. Of course, we should not ignore that Tencent has been struggling in the last few years: Since early 2021, the company has had trouble growing revenue and earnings per share.
When looking at the performance of the stock, Tencent is more or less at the same price level as five years ago. But the fundamental picture is telling a different story: Revenue increased 85% in the last five years, earnings per share grew 106% in the last five years and free cash flow increased 141% in these five years.
And while Tencent might have been overvalued at the beginning of 2021, it seems like the stock is still undervalued and one of the better investments in this market.
Low Valuation Multiples
This perspective of a discrepancy between the fundamental performance and the stock price can also be backed up by looking at the price-earnings ratio as well as the price-free-cash-flow ratio.
In the fall of 2022, the stock was trading only for 9 times earnings – an extreme for a company like Tencent. Although the stock has moved away from these extreme valuation multiples, Tencent is trading for 16 times earnings and 17 times free cash flow right now. And this is still not only one of the lowest valuation multiples ever for the stock, it also seems extremely cheap for a business with a wide economic moat and a business that can report double-digit growth rates again.
Picture Improving Again
In the last few quarters, Tencent’s picture improved again – of course, we are far away from 30% to 50% reported growth, but growth rates are improving again. And we also see margins – gross and operating margin – improving again since early 2022. Additionally, Tencent is still reporting double-digit numbers for return on invested capital.
We can also look at the different segments – especially Fintech and Business Services improved its gross margin further.
Tencent Q1/23 Results Presentation
Quarterly Results
When looking at the top line, revenue increased from RMB 135,471 million in Q1/22 to RMB 149,986 million – resulting in 10.7% year-over-year growth. Operating profit also increased 8.6% YoY from RMB 37,217 million in the same quarter last year to RMG 40,429 million this quarter. And diluted earnings per share increased 9.8% year-over-year from RMB 2.404 to RMB 2.639. Especially free cash flow increased with an impressive pace – 240% year-over-year growth to RMB 51.8 billion.
Tencent Q1/23 Results Presentation
When looking at further metrics, fee-based VAS registered subscriptions declined from 229 million one year earlier to 226 million on March 31, 2023. But the combined MAU of Weixin and WeChat increased from 1,288 million on March 31, 2022, to 1,319 million on March 31, 2023 – 2.4% year-over-year growth.
Tencent Q1/23 Results Presentation
FinTech and Business Services
One of the segments mostly responsible for growth is FinTech and Business Services . In 2018, the segment was responsible for 23% of total revenue and when looking at the trailing twelve months numbers it is now responsible for almost one third of total revenue (32%). In the first quarter of fiscal 2023, revenue for the segment increased 14% year-over-year and 3% quarter-over-quarter.
And not only is Tencent number one in mobile payment in China, it seems like the recovery in consumer spending and maybe a recovery of the economy is gaining steam. During the last earnings call, Chief Strategy Officer James Mitchell commented:
Looking at FinTech and Business Services, segment revenue was RMB49 billion, up 14% year-on-year. For FinTech services revenue resumed double-digit year-on-year growth benefiting from the recovery of payment activities. Off-line payment transactions rebounded more sharply than online as categories such as retail, travel and dining services benefited from people going out and about more frequently.
Additionally, Tencent is trying to expand its wealth management services and is also trying to explore new opportunities in consumer loans or online insurance services.
Tencent Corporate Overview May 2023 Presentation
And when looking at Business Services, revenue growth turned positive in the first quarter as it is benefiting from a stabilization in its cloud services.
Value Added Services
Revenue for value added services increased 9% year-over-year and 13% quarter-over-quarter to RMB 79,337 million. While long-form video subscription revenue decreased 6% year-over-year due to delayed content releases, music subscription revenue increased 30% year-over-year.
Tencent Corporate Overview May 2023 Presentation
Aside from the social networks sub-segment, especially games could return on its path of growth. Domestic games were struggling in previous quarters as the government often didn’t allow the release of new games, but in Q1/23 revenue from domestic games increased 6% year-over-year. And International Games – one of the growth drivers in the last few years – could grow 25% year-over-year. While International Games were only responsible for 3% of total revenue in 2018, they account now for 9% of total revenue (trailing twelve-month numbers).
Online Advertising
And finally, online advertising could also improve again. While revenue declined 15% quarter-over-quarter, revenue increased 17% year-over-year to RMB 20,964 million. And we should not ignore that the same period last year included a several percentage point contributions from the Beijing Winter Olympics. During the last earnings call, Mitchell commented:
The rapid year-on-year revenue growth was supported by the new revenue stream from video accounts ads, solid demand for mini program ads and the continued recovery of our mobile ad network.
Additionally, Tencent is also upgrading its machine learning advertising platforms to deliver higher conversion for advertisers.
Growth
I already talked in my last article about the growth potential Tencent has. The company can grow especially by expanding its eco-system of subscriptions, cloud services, introducing new games or new mini-programs which are embedded in WeChat – just to name a few. The major drivers of growth will probably be the Cloud business (although Tencent is not the market leader here) and its FinTech business.
Tencent Corporate Overview May 2023 Presentation
And of course – like many other technology companies – Tencent is also focusing on artificial intelligence and is investing in its AI capabilities. Tencent will also focus on attracting new creators:
As a result, our creator community is increasingly vibrant. In the first quarter, daily active creators and daily video uploads more than doubled year-on-year, while the number of creators with over 10,000 followers more than tripled year-on-year. On QQ, We deployed a new architecture to optimize development efficiency across operating systems on a unified code base.
In the last ten years, Tencent grew its revenue with a CAGR of 28.87%, operating income increased with a CAGR of 22.42% and earnings per share grew with a CAGR of 30.34%. And when looking at earnings per share estimates for the next few years, Tencent is still expected to grow in the double digits.
Tencent EPS Estimates (Seeking Alpha)
We should always be careful not to be overly optimistic, but Tencent has so many growth opportunities in the years to come by using its “everything-app” WeChat. Tencent’s digital ecosystem is fulfilling almost every need – from watching videos, playing games, communicating, paying, working, and collaborating to seeking medical help.
Tencent Corporate Overview May 2023 Presentation
Intrinsic Value Calculation
I already mentioned above that Tencent seems to be rather cheap based on simple valuation metrics – the P/E ratio and P/FCF ratio. Additionally, Tencent also seems cheap by using a discount cash flow calculation. Free cash flow in the last four quarters was RMB 153.8 billion and when using that amount as basis in our calculation and assuming a moderate growth rate of 6% for the years to come (and till perpetuity) we get an intrinsic value of RMB 405 for Tencent. For our calculation we used 9,483 million outstanding shares and a 10% discount rate.
Tencent Corporate Overview May 2023 Presentation
And as Tencent is trading in Hong Kong Dollar, the intrinsic value for the stock is HKD 442 right now, implying that the stock is trading for a 20% discount.
When looking at past growth rates, we can be even more optimistic. Of course, we should not ignore that Tencent was struggling in the last few quarters, but in my opinion, we can also make the case for 10% growth in the next ten years followed by 6% growth till perpetuity leading to an intrinsic value of RMB 538 and resulting in HKD 587. In the last three years, earnings per share could still grow with a CAGR of 26.11% and in the last five years with a CAGR of 20.86% making the assumption of 10% growth in the years to come realistic (and not too optimistic).
Bigger Picture
While I remain optimistic that Tencent will grow at a high pace, we should not ignore the bigger picture and the storm that seems to be brewing for the Chinese economy. In an article published in 2021 I already wrote about the Chinese debt problem, which seems to worry more and more people. When searching for “China” and “debt” we find countless articles – especially in the last few months – that seem to identify this as a major problem. Right now, household debt to GDP is 61% in China and government debt to GDP is 77% after it constantly increased in the last few years. According to a New York Times article , total debt in China is estimated to be about 280% of the country’s economic output and concerns about a hard landing arise.
On the other hand, we should not ignore that many Chinese stocks are still trading at extremely depressed levels and therefore a lot of negativity is priced in already. For Tencent I already showed above how fundamental numbers and the stock price are diverging. And the stock prices of Alibaba ( BABA ), JD.com ( JD ) or Baidu ( BIDU ) also seem to reflect a lot of negativity – while many stocks in the United States are still (or once again) trading close to all-time highs.
And the uncertainty regarding Chinese politics is still rather high, but it seems like the picture is slowly improving .
Conclusion
When looking at the major technology companies in China, the four stocks we are looking at here are still trading 50% below its previous high and although the high debt levels are concerning and the economy (not only in China) could struggle in the years to come, I remain optimistic.
Especially for Tencent I see further upside potential and the stock is clearly undervalued in my opinion and we are dealing with a high-quality business. It is difficult to overstate the wide economic moat Tencent has around its business. WeChat – the only “everything app” out there – is such a powerful asset Tencent has and is combining almost every type of moat we know.
For further details see:
Tencent: Still At Least 20% Undervalued