Tencent: WeChat’s Dominance, Global Gaming And Promising Annual Returns (OTCMKTS:TCEHY)

Investment Thesis

I believe Tencent Holdings Limited (OTCPK:TCEHY) stock is a buy. The company’s ‘super-app’, WeChat, underscores its unparalleled dominance in China’s tech landscape, reaping the benefits of network effects and offering a comprehensive range of services that cater to diverse user demands. Beyond this, Tencent’s global gaming endeavors, despite the temporary regulatory challenges in China, have showcased robust growth and resilience on a global scale. The company’s strategic foray into FinTech and Business Services highlights its vision to tap into the digital transformation wave, further diversifying its revenue streams. This multifaceted approach, combined with Tencent’s foundational strengths, sets it on an upward trajectory. With the potential to deliver a conservative 14% annual return, Tencent’s stock presents a compelling opportunity for investors interested in being a contrarian investors in Chinese equities.

Company Overview

Tencent Holdings, a tech powerhouse from China, has masterfully designed a business model centered on comprehensive digital ecosystems. Its strategy thrives on creating platforms that cater to multiple facets of users’ online experiences, ensuring sustained engagement and diverse revenue avenues. WeChat, Tencent’s crown jewel, began as a messaging app but has evolved into a ‘super-app’. It now encompasses services from social networking to digital payments and e-commerce, all under one roof. This consolidation not only retains users but also boosts advertising and transaction-based revenues. Gaming is another cornerstone of Tencent’s model. As a global gaming leader, Tencent produces its own titles and invests in international studios. This strategy ensures a mix of direct sales and royalties, fortifying its revenue streams. The fintech segment, highlighted by WeChat Pay, showcases Tencent’s prowess in leveraging its massive user base. Integrated payment solutions within its platforms mean consistent transaction fees and heightened user activity. Additionally, Tencent’s foray into cloud and enterprise solutions offers businesses digital tools for modernization, further expanding its market reach.

WeChat is China’s Super App with Powerful Network Effects

WeChat, developed by Tencent Holdings, stands as a testament to the evolution of digital communication and service platforms, especially in the Chinese technological landscape. Tencent’s dominance is evident not just in its innovative products but also in its market share. As one of the largest technology conglomerates, Tencent has carved out a significant portion of the market, especially in the realms of social media, gaming, and digital payments.

Unlike many of its Western counterparts that are designed to serve a singular function, WeChat has emerged as a ‘super-app’, a comprehensive digital tool that seamlessly integrates a multitude of services. This means that within a single application, users can effortlessly chat with friends, make payments, book appointments, and even shop, eliminating the need to juggle multiple apps for different tasks. This all-in-one approach has not only streamlined digital interactions but has also played a pivotal role in its widespread adoption.

Boasting a user base of over a billion, WeChat’s unparalleled reach in China is a clear reflection of its dominant position in the market. But it’s not just the sheer numbers that highlight its significance; it’s the depth of its integration into the daily lives of its users. For many Chinese citizens, WeChat isn’t just another app on their smartphones; it’s an indispensable tool that aids in a myriad of daily tasks. From splitting bills at restaurants, paying for utilities, to even interacting with local government services, WeChat has transformed into a digital Swiss Army knife, essential for navigating the intricacies of modern life in China.

One of Tencent’s most formidable competitive advantages is the network effect it has cultivated. As more users join and engage with Tencent’s platforms, especially WeChat, the value of the platform increases for both existing and new users. This creates a self-reinforcing loop where the growth in user base attracts more businesses, developers, and advertisers to the platform, further enhancing its utility and appeal. This network effect acts as a durable competitive moat, making it challenging for competitors to break Tencent’s stronghold in the market. This deep-rooted integration, combined with Tencent’s significant market share and the robust network effect, underscores the company’s influence and potential for continued growth in the tech industry.

Gaming Business Navigating Global Success and Domestic Regulatory Challenges

Tencent’s foray into the gaming industry has solidified its position not just as a leader, but as the world’s largest gaming company. Domestically, Tencent has been the driving force behind some of China’s most popular gaming titles, catering to a vast and diverse audience that spans casual mobile gamers to hardcore PC enthusiasts. Games like “Honor of Kings” have not only achieved monumental success in China but have also set benchmarks for mobile gaming worldwide. Tencent’s gaming platform, WeGame, offers a plethora of titles and has become a central hub for Chinese gamers. However, Tencent’s domestic gaming endeavors have not been without challenges, particularly from China’s government. In recent years, the Chinese government has implemented stricter regulations on the gaming industry, citing concerns over gaming addiction among the youth and the content of certain games. These regulations have led to freezes on game approvals, impacting Tencent’s ability to monetize new titles. The government’s push for “healthy gaming habits” has also resulted in restrictions on gaming hours for minors, further affecting Tencent’s domestic gaming revenue. I believe this restriction was the largest contributing cause of the 0% YoY revenue growth experienced in Q2 2023, however this should prove to be a short-term effect as once Tencent laps the timing of the government restrictions, revenue growth should return.

Internationally, Tencent’s influence in the gaming sector is equally profound, boasting 19% YoY revenue growth in Q2 2023, mainly driven by Valorant, Nikke and Triple Match 3D. The company has astutely invested in a myriad of gaming studios and companies across the globe. It holds significant stakes in renowned studios like Riot Games and Supercell. These strategic investments ensure that Tencent remains at the forefront of global gaming trends. While Tencent’s dominance is evident in its innovative products and market share, its title as the world’s largest gaming company underscores its unparalleled influence and reach in the global gaming landscape. Yet, the challenges posed by the Chinese government’s regulations serve as a reminder of the dynamic and often unpredictable nature of the domestic gaming market.

Strategic Diversification into FinTech and Business Services

Tencent’s expansion into FinTech and Business Services underscores its ambition to diversify beyond its core of social media and gaming. This strategic move has positioned Tencent as a formidable player in China’s rapidly evolving digital financial landscape. At the forefront of Tencent’s FinTech business is WeChat Pay, a digital payment solution seamlessly integrated into the WeChat super-app. With hundreds of millions of users, WeChat Pay has revolutionized the way Chinese consumers transact, offering a convenient and secure method for everything from online shopping to bill payments. Its success is a testament to Tencent’s ability to leverage its vast social media user base to drive adoption in the financial sector. Beyond digital payments, Tencent’s FinTech portfolio is expansive, encompassing wealth management, insurance, and lending services. The company’s cloud-based solutions cater to financial institutions, providing them with tools and platforms to enhance their digital offerings, streamline operations, and harness the power of big data analytics.

Parallelly, Tencent’s Business Services division is making significant strides. Tencent Cloud, its cloud computing arm, is rapidly gaining traction, offering a suite of solutions ranging from data storage to AI-powered analytics. As businesses in China and beyond accelerate their digital transformation journeys, Tencent Cloud is well-positioned to capture a significant market share, competing with other global cloud giants.

In 2Q23, there was a resurgence to low double-digit year-over-year revenue growth. This uptick was primarily fueled by fees garnered from live streaming eCommerce transactions on Video Accounts and a slight increase in cloud services revenue. Additionally, there was a significant year-over-year rise in gross margin, attributed to cost optimization measures and the introduction of new fee-based revenue channels.

Financial Analysis

Over the past 5 years, the company has demonstrated remarkable financial performance. Its revenue has shown consistent and strong growth, increasing from $45,459.62 in 2018 to $82,862.57 in the last 12 months in 2023, representing a compound annual growth rate (CAGR) of approximately 13%. The earnings per share (EPS) has been equally impressive, growing steadily from $1.20 to $2.85, reflecting the company’s ability to translate revenue growth into bottom-line success. The book value has seen a consistent upward trend, growing from $51,785.56 in 2018 to $122,513.40, indicating a CAGR of approximately 19%. This suggests that the company has been successful in increasing its intrinsic value over the period.

As of the most recent quarter, the company reported cash and cash equivalents of $47,924.67. The company’s total debt stands at $40,508.70, an amount that reflects the company’s approach to aggressively reinvest back into the business for future growth. The company’s current ratio, a measure of its ability to cover short-term liabilities with short-term assets, is 1.53, which is generally considered healthy. Tencent’s management team in the past has been prudent in managing debt, with the existing obligations not currently exceeding 2 years’ worth of free cash flow based on free cash flow from the last 12 months.

I expect Tencent’s upcoming quarterly earnings results to be positive with revenue and earnings improving compared due to the previous year due to an improving macro environment in China and Chinese Government stimulus. For at least the next 12 months, I expect margins to expand compared to the prior year, driven by a recovery in the advertising market, further gaming releases compared to last year and an improving macro situation.

Valuation

When considering valuation, I always consider what we are paying for the business ((the market capitalization)) versus what we are getting ((the underlying business fundamentals and future earnings)). I believe a reliable way of measuring what you get versus what you pay is by conducting a discounted cashflow analysis of the business as seen below.

Tencent’s current TTM Cashflow per Share as of Q2, 2023 is $2.32. Based on the integrated ecosystem of social media, gaming, fintech, and cloud services, believe that Tencent’s TTM Cashflow per Share, should grow conservatively at 12% annually for the next five years. Therefore, once factoring in the growth rate by Q2 2028 Tencent’s TTM Cashflow per Share is expected to be $4.09. If we then apply an exit multiple of 22, which is based off a conservative price to free cashflow ratio for Tencent based on the previous 10 years, this infers a price target in five years of $79.56. Therefore, based on these estimations, if you were to buy Tencent at today’s share price of $40.61, this would result in a CAGR of 14% over the next five years. Also keep in mind that this valuation has not incorporated Tencent’s $98 billion long-term investment portfolio which should also grow around 10% per year over the next 5 years. Consider the portfolio a margin of safety just in case 12% annual growth isn’t achieved in the core business.

Risks

Investing in Tencent, like any major corporation, comes with its set of risks. Firstly, Tencent operates primarily within China, making it susceptible to the country’s regulatory environment. The Chinese government has shown an increasing interest in regulating tech giants, and any sudden policy shifts can have direct implications on Tencent’s operations and profitability. For instance, stricter regulations on online gaming or data privacy can impact Tencent’s primary revenue streams.

Secondly, the competitive landscape in China’s tech industry is fierce. Tencent faces stiff competition from other tech behemoths like Alibaba and ByteDance. As these companies continue to innovate and expand their product offerings, there’s no guarantee that Tencent will maintain its dominant market position in all its sectors.

Additionally, Tencent’s international investments, while providing growth opportunities, also expose the company to geopolitical risks. In recent years, the geopolitical landscape has become increasingly complex. Tensions between China and other major economies, such as the U.S., India, and several European nations, have been escalating. These tensions manifest in various forms, from trade wars to bans on specific technologies and services. For instance, certain Chinese tech firms have faced bans or restrictions in foreign markets due to security concerns or political pressures. Such actions can directly impact Tencent’s investments, potentially leading to reduced market access, financial losses, or strained business relationships.

Moreover, the global narrative surrounding data privacy and security has intensified. Tencent, with its vast data pools and digital platforms, might find itself under scrutiny in foreign markets, where there’s growing apprehension about Chinese tech firms handling user data. Regulatory environments in these countries might impose stringent data localization norms or operational restrictions, complicating Tencent’s overseas ventures.

The Variable Interest Entity (VIE) structure is also another significant point of contention and risk when it comes to investing in Chinese companies like Tencent. The VIE structure is a complex arrangement that allows foreign investors to indirectly invest in Chinese companies, especially in sectors where foreign ownership is restricted or prohibited by the Chinese government. While VIE contracts give foreign investors economic benefits, they don’t confer actual ownership rights. This distinction can become problematic in situations where the company’s interests don’t align with those of foreign shareholders.

Lastly, the broader macroeconomic factors, such as economic downturns or trade tensions, can influence Tencent’s growth trajectory. While the company has shown resilience in the past, it’s not immune to global economic shifts. Trade disputes, especially between major economies like the U.S. and China, can have multifaceted implications for Tencent. These tensions can lead to tariffs, which might increase the cost of any hardware or technology Tencent imports. Additionally, trade wars often escalate into technology wars, where companies can face bans, sanctions, or restrictions in foreign markets. Tencent, with its global investments and partnerships, could face challenges in markets where anti-China sentiments rise due to trade disputes.

Conclusion

Tencent, with its flagship ‘super-app’ WeChat, has firmly established its dominance in China’s tech ecosystem, benefiting immensely from network effects and a suite of integrated services that cater to a myriad of user needs. This dominance is further complemented by its global gaming business, which, despite facing regulatory headwinds in China concerning youth gaming, continues to flourish on the international stage. Diversifying its portfolio, Tencent has astutely ventured into the realms of FinTech and Business Services, positioning itself to capitalize on the burgeoning digital transformation wave sweeping across industries. This strategic diversification, coupled with its core strengths, places Tencent on a promising trajectory. Investors can optimistically anticipate the company to yield a conservative annual return of 14%, reflecting Tencent’s potential to consistently enhance shareholder value in the foreseeable future

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.