Tencent hidden assets results in a cheap bet on a compounder that is a dominant player active in industries expected to grow at double digits.

Company

Tencent is the Chinese company famous for its 1.3 billion users’ app that is called WeChat. WeChat is not just a messenger type service but a super app. Under the WeChat hood there are mini-programs that act like apps. Once in WeChat, the user has few reasons to leave. The app allows them to do practically everything. For example, read the news, do your shopping, pay your bills, order dinner, borrow money, declare taxes, apply for a visa, get a tax, invest, listen to music, get insurance, book a doctor’s appointment, chat with friends and share (like Facebook). This report plans to cover the most important points that make me comfortable enough to initiate a position in the Hong Kong listing. For a detail discussion around the Tencent metaverse I recommend readers check out Not Boring articles (post 1, post 2). Vineyard Holdings long deep dive piece is also a must read for anyone interested in this name.

(Source: Tencent Investor Relations “Corporate Overview” August 18th, 2021)

The company is estimated to make $90 billion in sales and $31 billion in EBITDA in 2021. Revenues are generated via four segments: 1) Value Added Services, 2) Online advertising, 3) FinTech and Business Services, and 4) Other. Below are my estimates of revenue and gross profit, along with some of the assumptions. These will be covered in more detail further in this piece.

WeChat has been referred to as important as water and electricity. In a poll done on Twitter in August 2020, Eunice Yoon asked, if WeChat is banned from Apple’s app store, will you get a different phone or uninstall WeChat? Out of 717k replies, 95% said they would get a different phone!

The numbers are staggering. The average user spends 82 minutes a day on WeChat. There are 900m WeChat Pay users and 750m WeChat Moments users. $250 billion worth of transactions (gross merchandise value) were done in 2020 via the 3.2 million mini programs. (FYI, there are 3.5m Google Play apps and 2.2m Apple App store apps).

Mini-Programs

The mini-programs benefit both consumers and brands. From a consumer perspective, the mini-programs run quickly as they are small in size and an app doesn’t need to downloaded. There are over sixty different ways to access these within WeChat, can be easily shared, transactions are seamless with WeChat Pay, and the use of QR codes has increased efficiency both online and offline dramatically. If Facebook or Twitter disappear tomorrow it wouldn’t make that much of a difference. If WeChat disappeared, it could bring the Chinese economy to a halt.

Every minute over 100,000 people use WeChat Pay to pay for transportation which has increased stations’ operating efficiency by 300x.
60% of hospitals have WeChat Official Service Accounts, increasing operating efficiency 10x, and reducing wait time by an average of 44 minutes.
Customer footprint of supermarkets and convenience stores have increased from 2km to 5km.
2 hours are saved at tourism sites by using QR codes to purchase tickets.

As illustrated below, the Chinese consumer is 5 taps away from a doctor’s appointment.

(Source: a16z)

From a company perspective, the mini programs reduce development costs (vs a native app) resulting in a quicker to launch online business. They can still design their own store with banners, videos, mini-games, etc. They can use WeChat as a customer management system and for customer service, as well as setup loyalty systems and use data for analysis. 82% of businesses use WeChat to communicate with customers. For example, Pinduoduo (PDD) relies on WeChat for traffic as its customers share potential group purchases. Yves Saint Laurent gives points which lead to discounts to members who share photos with their products.

Investment Portfolio (Hidden Assets)

Tencent has stakes in over 700 companies according to its 2Q20 earnings call. Some of these companies are large and well-known such as Epic Games, Supercell, Activision Blizzard, Spotify, Roblox, Discord, Pinduoduo, JD, Sea, Afterpay, Nio Ubisoft, Meituan, Farfetch, Bilibili, Lilium, etc. If you haven’t played one of the games Tencent is invested in, then definitely your children have. Call of Duty: Mobile was developed by Tencent’s subsidiary TiMi Studios and within 3 days of release was the No1 app on iOS in 100 countries with 35+ million downloads. The massively popular Clash family (Clash of Clans, Clash Royale, etc) is majority owned by Tencent. The secret to the success of these games lies in how well they work on mobile/tablet, their addictiveness, high quality, and continuing development.

In general, a lot of money has been invested globally in gaming but in my opinion, there is significant waste. Many business models appear to just raise debt/equity and buy startups/games nonstop with the idea that some of the thousands of games purchased will be hits. This strategy may make the owners rich and generate short-term profits but will most likely fail in the long run. There are millions of games to flip through. Contrast that to the teams behind the companies Tencent has invested in. These games are not just highly successful but have teams that are constantly tweaking them to make it better for the players. The focus is on what the customer wants. How to keep them engaged and playing. Monetization comes second. Gamers are not stupid. Pay to win is a poor strategy. By focusing on the gamer’s satisfaction, monetization has followed in ways that don’t affect game play. (Author is guilty as charged for buying the Rambo skin in Call of Duty Mobile that doesn’t nothing but looks cool). More thoughts on this are available in a blog post here.

According to the interim results the company has an investment in associates of CNY 357 billion (of which CNY 234 billion in listed equities). The report states that these are worth CNY 1.1 trillion. If we assume pro-rata to the whole amount, then this implies a $270 billion value!

Projections

Tencent breaks down its revenue sources into 1) Value Added Services (which includes Social Networks and Games), 2) Online Advertising, 3) FinTech and Business Services, and 4) Others. I will be using historical info to derive some potential future earnings and valuation.

Value Added Services

Tencent makes money here from digital content subscriptions (music, video, etc), and in-app purchases. There were 229,4 million subscribers in 2Q21 versus 168.9 million two years ago. Year-on-year subscriber growth has slowed but remains in the double digits. I assume this continues for last 2 quarters of 2021 while for 2022 this slows by 2% per year (12%, 10% respectively).

(Source: author)

I’ve calculated the average fees per subscriber. Now obviously in-app purchases may be conducted by non-subscribers but for simplicity’s sake, I took this approach to project revenues. Year-on-Year average fees were flat, so I assumed no growth for projections. Assumptions are in yellow. This would also be in line with Chinese government statements regarding gaming companies not focusing only on profitability. Gross profit margin has decline over the last few years, so I assume a continuation of this trend.

Online Advertising

This includes ad on all Tencent’s media outlets and not just video. For example, the company “provided integrated marketing solutions for the Tokyo 2020 Olympic Games across Weixin, QQ, Tencent Video, Tencent Sports and Tencent News”.

(Source: Tencent Investor Relations “Corporate Overview” August 18th, 2021)

Ad spend appears strong, so I assumed a continuation with a 2% lower growth in 2022E and 2023E. Considering the bullishness around WeChat Moments (think posting photos and videos in your Facebook), then this assumption could be too conservative but I prefer to see the outcome of such an exercise with getting too bullish.

(Source: author)

FinTech and Business Services

Over 1 billion commercial payments happen on WeChat Pay daily. Tencent takes a small cut but also earns fees from numerous other business under this segment, including insurance services (WeSure), wealth management (LiCaiTong), consumer loans (WeiLiDai), cloud services (Tencent Cloud, WeCom, Tencent Meeting), etc. Both margins and growth are higher in Q1 and Q2 of 2021. I assume similar for last 2 quarters while for 2022 and 2023 I used the last 2 years average for growth and flat gross margin.

(Source: author)

Other

Other revenue is so small it’s practically not worth mentioning. No growth is assumed going forward while gross margin for 2022e and 2023e are assumed at the 3-year average.

Forward Growth

(Source: author)

My projections versus the ‘Street’

	Sophocles	Street
Sales (CNY)	831 bn	812 bn
Net Income (CNY)	161 bn	199 bn
EPS (HKD)	20	25

Over the next two years (2021E-23E) my simple model implies the following CAGR:

Total Sales: 19.2%
Value-Added Services: 10.8%
Online Advertising: 20.1%
FinTech & Business Services: 32.3%
Other Revenue 0.0%

While this growth may appear high, it appears to be in line overall with expectations within areas that Tencent operates:

According to Statista, mobile game revenue is expected to grow at a 10% CAGR over 2021-25, driven by higher number of users and higher spend per user.
Global live streaming market is expected to grow by 29% CAGR to 2027.
The global digital advertising market is expected to grow 12% CAGR to 2023 while the Asia Ad spend is expected to grow at a 13% CAGR over 2021-25 driven by growth in mobile.
Mordor Intelligence has mobile payments growing at 25% over 2020-26 which is again driven by higher consumer e-commerce via mobile devices.
The global cloud computer market size is expected to drop to $832 billion by 2025 (18% CAGR).

(Source: Statista)

Valuation

Based on an HKD 500 stock price, the company is trading at 25x my 2023 estimate for EPS. However, if we back out the investment portfolio the implied P/E 2023E drops to 14x. Obviously, that portfolio could be overvalued today, and a stock market correction would mean a high ex-portfolio implied P/E. But that ignores additional investments and acquisitions that Tencent does, as well as growth in those underlying investments. If the stock re-rates to 25x operating earnings (vs 14x) and the investment portfolio remained unchanged then the stock could be worth HKD 722 (44% upside).

Risks

The VIE structure. The biggest problem with all Chinese stocks listed on international exchanges is the variable interest entity (VIE) structure which is basically corporate engineering to get around the issue that it’s illegal for foreigners to own important Chinese tech companies. Bloomberg’s Matt Levine has a great article on this (post link). So basically, you don’t own the Chinese company, but a bunch of contracts with the Chinese company which give you pseudo-ownership. I’m pretty sure the Chinese government knows this is going on and just allows it by not saying anything. But they could easily wake up one day and declare all of these VIE contracts as illegal and then what do you own? Nothing. And this is the main reason I generally have been avoiding Chinese stocks over the last year. Now the Chinese government are not the bad guys here. Blame it on the investment bankers and investor greed. The risks of these structures are in the prospectus. I am aware of this risk, and the best way one can manage it is via size. If your whole portfolio at Chinese stocks with this structure, then that’s a problem imho. If it’s 5% then that’s your maximum loss.
Listing. I would avoid the depository receipt (TCEHY US) and only consider the Hong Kong listing (700 HK). Any anti-China regulation could affect TCEHY or perhaps resulting in a delisted for whatever reason. It’s not worth the having an additional risk to worry about.
Competition is intense in tech. There is no sugar coating this and we need to be aware of growing threats. Tencent though is a dominant player that continues to growth under a young management (executives age range 45-54 per Bloomberg) that includes co-founders with mostly long tenure (10+ years) and who keep a low profile.
Chinese GDP growth disappoints. Carnegie Endowment breaks down Chinese GDP growth into high-quality (as per Beijing) that is driven by household income, exports and business investment and residual growth that is driven by local government overbuild and malinvestment by the property sector. Essentially, in the past, debt used to fund productive investments, but not so much today. So overall, GDP growth could pullback from historicals as the government leans on quality growth and reduces the influence of the property sector and debt in general.
Government regulation & restricting profitability. Tencent overall appears to comply to regulation, has not been critical of the government and the management appears to keep a low profile. Their restrictions on children are even stricter than government requirements. Profitability is not excessive. One source put Revenue/Payment Value of competitor Alipay and PayPal at 0.1% and 2.4% respectively. We can assume similar at WeChat Pay. The government though could force Tencent to reduce profits in other areas. At the same time, it is more likely that the government will allow a couple of local champions to flourish as long as they are compliant and with operations that benefit society and the economy. As outlined above in benefits to consumers, I believe this is the case.

Conclusion

Considering the risks, I decided to buy some Tencent because:

I believe at worse it is reasonably priced. Ex-investment portfolio puts the P/E 2023E at 14x. This portfolio not only provides investment upside but solidifies its dominant position as it has established relationships with the most important global gaming companies that look to Tencent for assistance (eg. Call of Duty) and as an entry to China.
The themes/industries that Tencent is involved in are expected to continue to grow strongly. One could think of Tencent as a way to bet on gaming, fintech and cloud. Rather than trying to find best pure play gaming, Tencent gives me a diversified portfolio. Their 40% stake in Epic Games is important as Epic owns and licenses the Unreal Engine (which along with Unity) are the platforms behind a great deal of important game releases.
I feel more comfortable owning a Hong Kong listing as U.S. listings can be delisted (see China Mobile).
The management team is inline with the government (reducing risk), low profile, and young (many years to continue to grow the company).
Tencent allows me to participate in the China growth story without taking on the small-cap fraud risk.

Online Sources:

Tencent is cheaper than you think

Tencent hidden assets results in a cheap bet on a compounder that is a dominant player active in industries expected to grow at double digits.

Company

Mini-Programs

Investment Portfolio (Hidden Assets)

Projections

Valuation

Risks

Conclusion

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Sophocles Sophocleous

Tencent hidden assets results in a cheap bet on a compounder that is a dominant player active in industries expected to grow at double digits.

Company

Mini-Programs

Investment Portfolio (Hidden Assets)

Projections

Valuation

Risks

Conclusion

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Like this:

Disclaimer

Search

Sophocles Sophocleous