Tencent Holdings (OTCPK:TCEHY) (OTCPK:TCTZF) maintains a leading position across several verticals of the Chinese gaming, social networks and tech sectors. Despite historical pressures in value-added Services, non-VAS segments are now the majority of revenue and growing at healthy rates while expanding margins. Domestic gaming may offer upside optionality to meet submerged demand in case regulatory pressures are softened. These trends may underpin improving underlying fundamental trends for Tencent, although it remains a high-risk play, mainly due to geopolitical jitters.
Headwinds and How Tencent Navigates Them
Tencent is historically associated with its leading Chinese messaging app WeChat with 1,359m monthly active users, as well as its leading position in the Chinese gaming market in terms of the number of users and revenue. Tencent is also the world’s largest gaming company by revenue and the number one company in China in terms of paid subscriptions for video, music and literature; it owns the #1 mobile browser; it’s first in terms of MAUs and DAUs for mobile payment applications; and has a growing Cloud business across IaaS, PaaS and SaaS.
I have recently analyzed Baidu (BIDU) and shared some concerns regarding the firm’s stagnating growth in the core advertising business (in terms of MAUs and revenue), as well as pricing pressure in the AI Cloud segment, supposedly exposed to strong structural tailwinds but caught in the middle of a price war among tech giants including Alibaba, Tencent, Jd.com, and ByteDance, among others.
I have also shared some concerns regarding the misunderstood risk/reward profile of an investment in a share like Baidu due to geopolitical risks, a large part of which is shared by Tencent as well.
However, I do believe Tencent’s situation presents key differences. First of all, the problem of revenue and profit stagnation has not affected Tencent the same way it affected Baidu, despite the fact that Tencent has been facing structural headwinds in the domestic market as well. The strongest one, which has been affecting their gaming segment in particular, is the Chinese government’s focus on reducing time spent gaming and other “unproductive” activities, which resulted in measures such as daily caps on time spent gaming as well as a limited number of games managing to be approved for sale.
Tencent has been navigating its domestic headwinds fairly well. While internationally highly competitive, Tencent managed to increase revenue from international games to offset part of the stagnation in Domestic gaming. The segment is volatile, but despite volatility brought by tailwinds and headwinds related to the COVID cycle, Tencent managed to keep growing the international gaming segment throughout 2022 and 2023. As a result, value-added services (Social networks and gaming) kept expanding revenue despite difficult comparisons with the COVID period boost. However, there is clear pressure from the huge size of the customer base as the business has been struggling with growing mobile MAUs, but a growing ecosystem of apps and increased monetization have helped keep revenue afloat.
Fintech and Business services have also been growing at a very healthy rate, outpacing and widening the gap with Social Networks and Gaming and being the main driver of revenue diversification.
Online advertising, with the intrinsic cyclicality and volatility of the business, suffered during COVID-19 but has rebounded strongly on the back of an upgraded ad-targeting model that leverages AI.
The most positive aspect of the diversification trend is that growing businesses of online advertising and fintech & business services are experiencing strong gross margin expansion alongside healthy revenue growth, and are growing as a percentage of the group’s total gross profit. Together, the two segments now account for nearly half of the group’s gross profit.
Videogaming Offers Upside Optionality and Prospects Might Be Improving
Like other Chinese tech giants, Tencent’s core business has been stagnating. However, if we look at domestic gaming (half of value-added services and nearly a fourth of group revenue), regulation has been holding down the segment’s growth prospects.
In 2021, China’s video game regulator implemented restrictions on online gaming for minors. These restrictions limit playtime to one hour on Fridays, weekends, and holidays for users under 18 years old. The impact on the Chinese video gaming industry and Tencent as the largest player in the field have been felt throughout the period. After some indications of a further potential curb on videogaming in late 2023, China has recently shown signs of a more moderate approach, but the situation remains ambiguous.
Despite China being already the largest videogaming market in terms of average weekly hours spent playing, it might have grown further without the Chinese government intervention, and there is likely artificially suppressed demand that could generate further upside if restrictions are removed or softened.
Until that happens, there remains significant volatility related to the timing of releases and the related game cycles. Despite some weakness in flagship names, such as a decline in gross receipts for HoK due to a high base in 2023 and weak monetizable content for Peacekeeper Elite, record high gross recipes in names such as Fight of the Golden Spatula, CrossFire Mobile and Arena Breakout helped the domestic revenue segment expand nearly 2% in Q1’24. The trend in gross receipts for the weak games was improving in March due to better monetization cadence, but it’s difficult to say whether this will continue. There is however a pipeline of potential high-value games such as DnF Mobile, Tarisland, Need for Speed Mobile, One Piece Mobile, and Delta Force: Hawk Ops.
Despite the volatility intrinsic in video gaming, I like the upside optionality of a domestic market where demand is artificially suppressed, and regulatory pressure shows signs of potential easing, while the international segment is still exposed to a global market expected to deliver 14% revenue CAGR.
Good Prospects for Diversifying Businesses Despite Cloud Pressure
Advertising is showing strong trends with revenue growth totaling 26% YoY driven by increased engagement and AI-powered ad targeting, with spending from most major categories increasing YoY. This is a segment where Tencent is showing the value of an upgraded targeting technology that leverages AI.
As discussed previously, there are positive margin trends in the Fintech and Business Services division. Gross margin expansion was in part driven by the cloud business restructuring, the introduction of high-margin revenues from Video Accounts eCommerce technology service fees, and increased monetization from other business services, alongside the growth of high-margin products within FinTech services. For Q1’24, further margin expansion was mainly driven by higher contributions from high-margin wealth management services revenue, eCommerce technology service fees, and improved monetization of WeCom. A key theme in this space is the negative impact of declining pricing in Cloud. Alibaba Cloud started an ongoing price war in February, slashing prices by as much as 55% on over 100 core public cloud products. This has continued with further rounds of price cuts by ByteDance, Alibaba, Tencent, JD.com and Baidu, among others. While growth in the space is potentially attractive, price wars are always negative and can significantly offset the benefits from the structural tailwinds. While Tencent remains exposed to the negative impact of this trend, I estimate that the share of group revenue exposed to this is less than 8% (based on data from Canalys and business services growth in Q4’23 and Q1’24), making the potential impact at the group level much softer than in Baidu’s case.
Solid Balance Sheet, Cash Flows and Buybacks
The commitment to HKD 100bn buybacks in 2024 (nearly 3% of market cap) and a low but growing dividend should also help a little bit in the investment case. The business has around RMB 352bn of gross debt, but around RMB 100bn of net cash once cash and liquid assets are subtracted. Despite the large video-gaming business, the group continues to have relatively modest capex needs, with capex at only ~21% of operating cash flows in 2023, and good cash flow conversion.
Valuation and downside risk
Like most Chinese tech stocks nowadays, Tencent looks very cheap at face multiples (~15x PE), but the risk profile of Chinese tech stocks is often misunderstood due to the VIE structures.
The main reason Chinese tech companies choose VIE structures to access foreign capital markets instead of direct ownership is due to restrictions in Chinese law. These restrictions limit foreign investment in specific sectors, such as certain value-added telecommunication services. By using a VIE, the company can raise capital internationally while adhering to these regulations.
Investors often assume lower valuation multiples indicate lower risk. However, this might not hold true for these stocks, as a downside is now protected by a potential crackdown on the VIE structure and/or foreign investors’ ability to invest. The situation surrounding Taiwan’s independence and the possibility of a Chinese invasion pose a significant threat. Even if an invasion seems illogical, Russia’s war on Ukraine highlights the difficulty of predicting such events. China would likely face sanctions and a strained relationship with major trading partners, while a potential government crackdown on VIEs could devastate investor holdings.
It’s difficult to assess whether 15x is cheap or not, given how difficult it is to estimate the probability of a large downside scenario related to geopolitics. Low multiples certainly help the business buy back more shares with the same cash flows.
Conclusion
The opportunity I see with Tencent is in the potential for fundamental trends to improve, as non-VAS already accounts for the majority of revenue and might soon account for the majority of gross profit. Some pressures in the Cloud should be monitored, but they appear less problematic than for other businesses like Baidu. At the same time, there is optionality in domestic gaming (half of VAS revenue) in case regulatory pressures are softened, which could unleash suppressed demand. This remains a high-risk play due to geopolitical risks that shouldn’t be understated, and I plan to keep following the name and update on my thinking around it.
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.
Read the full article here