2023-08-18 11:16:39 ET
Summary
- Tencent Holdings Limited's stock has remained stagnant over the past 5 years, but it offers Facebook-like positioning and a diverse set of businesses.
- The company has improved its balance sheet, generated multi-year highs in free cash flow, and accelerated its share repurchase program.
- The stock is trading at a discount to U.S. mega-cap tech titans even before accounting for the investment portfolio making up 25% of the market cap.
Tencent Holdings Limited ( TCEHY ) is a Chinese tech titan that has seen its stock go nowhere over the past 5 years. The stock is often overlooked by American investors in favor of Alibaba Group Holding Limited ( BABA ), but TCEHY offers Facebook-like positioning while also having the same conglomerate set of businesses.
Over the last several quarters, TCEHY has improved its balance sheet to a net cash position, and its cost savings initiatives are starting to bear fruit, with the company generating multi-year highs in free cash flow. The company curiously accelerated its share repurchase program near the end of the second quarter, a detail that I suspect many investors may have overlooked, as TCEHY and other Chinese stocks have seemingly traded solely based on perception of U.S.-Chinese political tensions. TCEHY stock trades at too deep of a discount to comparable U.S. operators - patient investors might be rewarded for their bravery here.
TCEHY Stock Price
I last covered TCEHY in November 2022, where I rated the stock a buy as it was trading cheaply even before accounting for its equity portfolio. The stock has rallied strongly since then, benefitting from a strong recovery in growth stocks overall.
But over the last 5 years, the stock has gone nowhere, as its solid growth during that time span has been offset by multiple compression. While TCEHY might not look like it’s trading at the same price as it did 5 years ago, the growth since then means that it’s significantly cheaper - this is a secular growth stock trading at value multiples.
Tencent Stock Key Metrics
In this past quarter, TCEHY saw a solid recovery in growth, with overall revenues growing 11% YOY. While TCEHY is largely known for its dominant video game portfolio, we can see below that video games made up around 30% of overall revenues with the remainder coming from social networks, online advertising, fintech, and cloud computing.
2023 Q2 Presentation
Due to the company’s large size, TCEHY has seen stagnant growth in its gaming and social network businesses, though it did see a 19% YOY gain in international gaming revenues on the backs of some new game releases.
2023 Q2 Presentation
TCEHY remains optimistic for the long-term growth of its social network business, noting that they have been able to drive notable growth in user engagement, which may help long term monetization efforts.
2023 Q2 Presentation
TCEHY saw the greatest financial recovery in online advertising, with revenues growing 34% YOY in this segment. This was in part due to easier post-pandemic comparables as well as momentum in their user engagement.
2023 Q2 Presentation
TCEHY also saw 15% YOY growth in its fintech and cloud businesses. TCEHY saw solid growth from its payment processing due to the Chinese economic recovery, and its cloud businesses finally returned to double-digit growth.
2023 Q2 Presentation
The strong recovery in revenue growth came as the company began to reap the fruits from its cost-cutting initiatives, as profits grew by 33% YOY.
2023 Q2 Presentation
If we exclude equity-based compensation, then net profits grew even faster at 40% YOY. Together with rationalizing in CapEx, TCEHY has been able to drive a strong upswing in free cash flow generation. After seeing free cash flow ("FCF") decline two years sequentially heading into the year, TCEHY has generated $132.4 billion RMB in free cash flow over the trailing twelve months, which would be the highest over any full-year period.
2023 Q2 Presentation
TCEHY has also managed to swing from a net debt to a net cash position, and that is before counting their $108 billion USD investment portfolio (the market cap recently stood at around $400 billion).
2023 Q2 Presentation
What I am most excited about is to see TCEHY seem to increase the aggressiveness of its share repurchase program, purchasing 36 million shares for $11 billion RMB (for reference, the company purchased $28 billion RMB in all of 2022). We can see below that the vast majority of those shares were purchased in the month of June alone.
2023 Q2 Release
I was disappointed to see a lack of discussion on the share repurchase program on the conference call , though there also weren’t any questions about it, to be fair. There, management reiterated expectations for recent Chinese regulations targeting under 18 video game usage to have “minimal” impact on their financial results (due to that not being their target audience), but also expressing confidence that the regulatory environment was trending towards normalization. I suspect that such commentary has done little to ease concerns about potential regulatory risk for the company, as that seems to be the main driver of the stock’s persistent undervaluation.
Is TCEHY Stock A Buy, Sell, or Hold?
TCEHY is a true tech titan in China, having market leadership in industries ranging from social networks to enterprise tech and peer to peer payments.
2023 Q2 Business Update
The crown jewel of TCEHY is arguably their WeChat app (known as Weixin in China), which has often been called the “Facebook of China.” It might be better known as being similar to Facebook Messenger, though Chinese citizens tend to use WeChat similar as they would Facebook. TCEHY touts over 1.3 billion monthly active users ("MAUs") in WeChat alone.
2023 Q2 Business Update
TCEHY is also often overlooked for its enterprise tech product offerings, but it should be considered one of the enterprise tech titans in China, similar to Alphabet’s ( GOOGL ) positioning with Google Cloud Platform.
2023 Q2 Business Update
In spite of owning many profitable businesses with strong secular growth stories, TCEHY stock recently traded hands at just under 18x this year’s earnings estimates.
Seeking Alpha
That comes in spite of consensus estimates calling for double-digit top line growth over the coming years.
Seeking Alpha
Sure, TCEHY isn’t as cheap as BABA, but its businesses are arguably more deserving of premium valuations, as BABA may be facing some price competition in its e-commerce operations. I note that TCEHY’s equity investment portfolio made up just around 25% of its current market cap, and management has expressed some willingness in prior conference calls to monetize their portfolio in order to highlight the undervaluation of the stock price. In contrast, names like Meta Platforms ( META ) and Microsoft ( MSFT ) are trading at 22x and 29x earnings, respectively. Assuming a re-valuation to a 20x earnings multiple, TCEHY might trade at around $57 per share by 2024, suggesting around 35% potential upside over the next 12 months. With management being as aggressive as ever in their share repurchase program, I view it as being a matter of time before Wall Street wakes up to the recovery in this growth story.
What are the key risks? The risks are high and numerous here. TCEHY may be facing threats from Chinese brand TikTok, and it is not clear if WeChat is losing market share to TikTok in a secular fashion. Like META in the U.S., TCEHY has rolled out short-form video in WeChat in order to fend off the competition, but it remains to be seen if these efforts are sufficient.
We mustn’t ignore the elephant in the room: rising geopolitical tensions are not the friend of investors. The Biden Administration has recently issued a ban on certain U.S. tech investments in China, and it is possible that at some point the U.S. may ban investing in Chinese securities altogether. Trading of Russian stocks remains restricted for U.S. citizens, providing some precedent to what might happen for Chinese stocks if geopolitical tensions were to escalate, perhaps if China decides to invade Taiwan. Even if such a ban never takes place, the possibility and fear of such a ban is likely to lead to a valuation overhang that may persist indefinitely.
I think that the valuation overhang is too pronounced here (especially after considering the investment portfolio), but it is possible that it widens further. An even more aggressive share repurchase program would arguably be enough to address such issues, but it isn’t clear if TCEHY would be allowed by the Chinese government to approve such a program.
While being mindful of the high risk profile of this stock, I reiterate my buy rating, as even after the rally from the lows, Tencent Holdings Limited is still trading at value-like multiples in spite of an improving growth and profitability profile.
For further details see:
Tencent: Wall Street Is Sleeping - Catalysts Are In Motion