TENCENT HOLDINGS LTD 700:HK
September 28, 2018 - 11:47am EST by
O6I
2018 2019
Price: 323.20 EPS 0 0
Shares Out. (in M): 9,438 P/E 0 0
Market Cap (in $M): 3,050K P/FCF 0 0
Net Debt (in $M): 41,393 EBIT 0 0
TEV ($): 3,092K TEV/EBIT 0 0

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Description

Summary

 

Tencent is a deep-moat company that is essentially the de facto mobile operating system in China. It is also the gateway for brands/companies seeking to reach consumers in China. Redefines corporate venture investing with WeChat’s first-look of what’s hot or not, plus the ability to shape traffic for portfolio companies. Doesn’t hurt that the company is also the largest online games publisher/distributor in the world. Other half of an emerging payments system that segues into a full-service financial services company for much of the unbanked/under-banked in China and Southeast Asia. And the company is cash flow positive. This is a company with a long runway of compounding ahead. Reasons for being sold down are temporary or unrelated to fundamentals, which make for good catalysts for the upside. GARP opportunity going at 14.9x consensus 2020E EBITDA. Not hard to see upside of ~70% in 2 years’ time and above-20% compounding thereafter.   

 

About Tencent

 

Shoe did an excellent write-up on Tencent in April 2016, and the thesis has played out very well. I encourage readers to check it out. Shall be covering what’s new, as well as other areas worth highlighting. After all, this is a very dynamic company in a fast-moving industry.

Key businesses in the Tencent empire today include WeChat, QQ, value-added services (eg, Tencent Video, Tencent Music), WeChat Pay, mini-programs, and online games. Investments in other startups for the Tencent ecosystem are also important.

 

WeChat

 

What it is

 

Ask most Chinese today if they can live without WeChat, and they will likely tell you no. Ask an American about Facebook, and the answer might be yes.

WeChat started as a chat app that first monetized by selling cute stickers (think GIFs) you can pepper your chat with. This quickly evolved into a do-everything app that has elements of a news feed (aka “Moments”), B2C messaging and mini-sites (“official accounts”), payments, and 3rd party apps integration.

 

One can indeed do a lot on WeChat these days. Some folks even pay their utility bills or get a clinic queue number via WeChat. One of the more ambitious plans coming from Chairman Pony Ma these days is to even have WeChat serve as a digital passport for those crossing the border into Hong Kong. That the government even entertains this with discussions illustrates the importance of WeChat.

 

Since one can do a lot with this swiss army knife of an app, it really is the de facto mobile operating system in China. It doesn’t matter if you get iOS, Xiaomi or Huawei; you only care if you have WeChat.

 

Like normal human beings, the Chinese are social. As such, chatting on WeChat forms the backbone of the service’s usage. Given that WeChat has 1.06 bil monthly active users (MAUs) and 902 mil dailies (DAUs), it’s not necessary to persuade people to try something else. Thus while the risk of a more engaging rival chat app is always lurking, WeChat’s scale gives it the advantage of winning by just being “good enough”.

 

Marketing channel

 

Naturally, with an audience this large and engaged, marketers find WeChat to be the go-to channel for their needs. One can buy ads on WeChat Moments, though Tencent deliberately keeps ad load low at 2 ads per day and limits the types of ads shown (only high-quality stuff; no P2P loans or crypto get rich quick schemes).

 

Growth vs ad load

 

Obviously 2 ads/day is very little. Thus, the growth runway is huge if one were to compare it to services like Facebook or even Instagram today. Management is keeping this low to balance user experience and monetization.

 

These guys are not idealists; Shoe wrote about 1 ad per 48 hours back in April 2016. They are now at 2 ads/day. However, Tencent’s decision ramp-up did face pushback from WeChat’s product managers earlier this year, as documented by The Information (paywall). In short, this is a team that is thoughtful in balancing product and revenue.

 

I don’t believe the ramp-up is going to be wild, since China’s Internet population just hit 800 mil (57% penetration). There is still a huge pool of users that Tencent is looking to hook onto WeChat when they get their first smartphones. As a guide, more developed nations tend to have Internet penetration rates of ~80%. As such, unlike Facebook in North America, WeChat doesn’t face the problem of saturation at this point. It is logical to fully monetize at the point of saturation and hold back when user growth is still available.

 

Government control and equilibrium

 

Naturally, the question of Big Brother and censorship tends to come up. There is no doubt that the government monitors WeChat and censors it. Fortunately for Tencent, neither are the Chinese naïve about this. No Chinese in their right mind will think that their chats are private or that the content they see is unfettered.

 

Tencent has been working very well with the government with regards to this and it takes down offending content very promptly. Despite this, people still use WeChat. Again, this is back to the “good enough” advantage. There is simply no alternative in which Big Brother doesn’t feature.

This playing well with the government helps Tencent greatly since the government understands that the people need their distractions, and Tencent is very good at satisfying this need. Since Tencent behaves exactly like a teacher’s pet in this aspect, why take the risk by letting another company it doesn’t really understand take mind-share away from Tencent’s products?

 

But what if Tencent gets really big? Wouldn’t this bother the Chinese government? Maybe. But what would you do if you were Xi Jinping and Tencent crossed the line? You just shut WeChat down. This is thus the existential risk that Tencent is very well aware of. Given that these guys are not here to promote free speech or any of such ideals, management is likely to remain very rational in this area.

 

Low risk of fake news

 

Facebook had to lower margin guidance recently due to the need to invest in better content policing. Given that Tencent already pro-actively does this, the risk of surprising the market with large investments into content policing is low.

 

Competition and the odd case of QQ

 

There is really no competition here, since foreign firms like FB can’t enter China to give WeChat a run for its money. Yes, Telegram is blocked in China too. Of course, there are VPNs but the Chinese government makes it hard by shutting the popular ones down. And one needs to take a step back and think of the big picture here – WeChat’s users span the entire Chinese Internet; while those nervous about privacy might go to extreme lengths, most people just want to tell their friend that they are on the way, complain about their bosses or watch the latest variety show on Tencent Video. They don’t need a VPN.

 

How about the young upstarts looking to give WeChat a run for its money? Surely, there must be a Snapchat/Instagram somewhere right? Well, sort of. And China’s call to Snapchat appears to be…. QQ.

 

QQ was Tencent’s first communications product. It was a blatant ICQ rip-off initially (that’s why “QQ”). To Tencent’s credit, they managed to keep QQ relevant all through the PC age till mobile started getting popular in China. Management then set up another internal product team to come up with a QQ killer for the mobile age; WeChat was the result. This Hunger Games approach and intellectual honesty does say a lot about management, by the way.

 

Following the launch of WeChat, QQ started becoming less relevant. This was hardly surprising, given QQ was first launched in 1999 for the PC age. MAU peaked at 899 mil in 2016, and then fell to 783 mil in 2017.

 

Then, an odd thing happened. QQ started becoming cool again by appealing to the Gen Z crowd. The product was re-thought and it resonated with the young. User numbers inched up above 800 mil again for 2018. Digging deeper, MAUs for under-21s actually showed double digit growth for 2Q18. QQ is hip again. This article sheds light on this highly unusual situation.

 

Of course, QQ being the flavour of the moment doesn’t preclude some other app from redefining coolness for Gen Z in China. But network effects for chat apps tend to be strong. Thus, if QQ keeps up with the momentum, it could start enjoying the “good enough” advantage soon. Helps to be integrated into the WeChat service ecosystem (eg, Tencent Music with sharing features), which makes churn less likely.

 

Last but not least, there is absolutely no angle for privacy focused chat apps in China today. You can start one, but I’m pretty confident that you either sell-out with some Brian Acton (WhatsApp) mea culpa thereafter, or you get shut down.

 

Value Added Services

 

VAS is a broad category that includes services like Tencent Video (think Netflix), Tencent Music (Spotify), China Literature (Kindle publishing/Marvel/Disney; this is interesting; might write on this), and others. Also includes app store revenue (there’s no Google Play in China despite Android being king).

 

These services naturally benefit from WeChat’s distributing prowess and thus their customer acquisition costs are way lower. Marketing costs need not be high too, since Tencent simply makes them more visible on WeChat.

 

Given the broad reach of WeChat, these platforms tend to buy/attract more supply in terms of content/apps, thus setting off a virtuous network effect.

 

The key thing to note is that some of these apps have a mixture of ad or subscription-based revenue. While ad revenue depends on attention and is thus susceptible to competition from more compelling forms of content, subscription is less so. Management has consciously been building up this stream to diversify the revenue profile.  

 

WeChat Pay

 

China leads the world in digital wallets. Alipay (from Alibaba, or more accurately, Ant Financial) and WeChat Pay are at the forefront of this new wave. Both are highly sophisticated operations with product offerings well beyond payments. Users can earn a better yield on their savings with money market funds and take personal loans. The innovation is unlikely to stop here (think insurance).

 

The cost structure of running a fully digital financial services firm is a clear advantage too.

Alipay got built on the PayPal template (ie, default payments provider for the dominant e-commerce platform) while WeChat Pay was built off the high frequency usage of WeChat. These are sensible ways to build a digital wallet but given that both are players are so large today, they are growing on their own momentum now.

 

QR codes

 

Few people use cash in China and unlike the West, cashless means scanning a QR code with your app instead of a credit card. In fact, the QR code is a ubiquitous feature across shops in China. That is why many tourists tend to feel somewhat embarrassed when holding up the line while fumbling for cash.

 

Market share

 

Alipay is the leading player here with 53% market share while WeChat Pay has a 40% share. WeChat Pay has come a long way, given Alipay’s market share was 70% in 2014.

 

It is interesting to note that while WeChat Pay has more users (900 mil MAU vs 500 mil) and processes more transactions, Alipay does more in absolute value. This is because a material use case for Alipay is to pay for stuff bought on Alibaba’s online malls, which carries larger transaction values. As such, one needs to look beyond headline numbers to really understand how WeChat Pay is the more popular service and why Ant Financial/Alibaba is so sensitive about competition from it (eg, banning investors in Ant Financial from investing in the Tencent ecosystem).

 

Won’t be surprised to see WeChat Pay surpass Alipay in market share very soon.

 

Not a zero-sum game

 

While the media fixates on who’s eating whom for lunch, this isn’t a zero-sum game. After all, China’s mobile payments market grew 28% in 2017. There are no signs that this growth rate is going to be slowing anytime soon.

 

There is no doubt that both parties are competing fiercely against one another with subsidies and fee waivers. However, the more important outcome of this competition is that it grows the digital payments market, which will lead to a much larger upside for both players even if market share percentages remain static.

 

Martin Lau, President of Tencent, puts it well during the 4Q17 earnings call:

“Now in terms of Alipay, right, I would say, yes, we have seen a significant increase in terms of our peers' subsidy level. And starting from the beginning of this year, we have also rolled out a pretty aggressive program of providing subsidies to merchants and users and has received great result. So I would say, going back to what James said, right, in a market where the opportunities is much bigger than what we see today in which there is a lot of growth opportunity, then it makes a lot of sense for any player, right, to invest more, so that we can expand the market further even if we cannot grab share from each other, right? So that's why we have said we would be investing more in this year in the payment platform, so that we can catalyze faster growth in the overall market, and hopefully, we can also grab more share.”

 

Put another way, Visa and MasterCard have been co-existing comfortably as a duopoly for the longest time and nobody really thinks that the market can only take one. Why is the Chinese market any different? Will Beijing really want just one payments network? Will the merchants happily take sides and deal with the uneven bargaining power that comes with it?

 

Not just China and Chinese

 

The ambitions of both players don’t just stop at China. They have been very aggressive in engaging shops catering to the Chinese tourist to accept their QR codes. This is a logical step in international expansion. It is also a smart defensive move against users moving on to credit cards when they start travelling abroad.

 

Given that the Chinese outbound tourism has strong tailwinds (only about 8.7% of Chinese have passports vs 36% for the US and 75% for the UK), this provides a strong tailwind.

 

Furthermore, another growth avenue that has gained momentum of late is the push by Alipay and WeChat Pay into the unbanked/under banked population in Southeast Asia. This Reuters article provides a good outline. Basically using remittance for Filipino and Indonesian domestic helpers in Singapore and Hong Kong to act as the Trojan Horse for their relatives back home to start using Alipay or WeChat Pay. Once these folks start getting comfortable with the idea that money can be stored in a phone, they will start using it. QR codes will then appear, increasing usage. More money goes into the wallet and savings products will start to become relevant. Micro loans will follow too. This has been the playbook for China after all.

 

The user base can be very big.

 

“Buying Visa or MasterCard in the early days”

 

Came across a Tweet recently saying that buying BABA today is like buying V/MA in their early days. This is very true.  In fact, V/MA need to worry about their Chinese counterparts if they are not already doing so.

 

The value proposition of accepting Alipay and WeChat Pay is very strong when one considers the typical interchange fee of 2.4% to 2.75% that V/MA charges. This Bloomberg article comes with a nice table that breaks down what goes into that interchange fee.

 

Alipay and WeChat Pay are the “card network” here. There is no issuing bank since these are essentially debit card transactions (cash is already in the digital wallet). There is no acquiring bank or payment processor since all it takes is a QR code sticker on the countertop. As such, Alipay and WeChat pay just need to charge the same 0.13 bps (per the article) and they will be earning the same take rate as V/MA. Even better, 0.13 bps might be all that the merchant needs to pay under this system. Alipay and WeChat Pay can double up to 0.26 bps, and they are still 90% cheaper than a V/MA’s interchange fee.

 

Now take this model from the 1.4 bil folks in China, and then move it into Southeast Asia. That is 30% of the world’s population in total (albeit much lower income, though growing).

 

Any other financial services layered onto this makes the economics even more promising.

 

With V going for a market cap of USD 333 bil, MA at USD 230 bil, Ant Financial’s most recent USD 150 bil valuation is not all that ridiculous (though it is high). Now consider Tencent’s USD 350 bil market cap.

 

Threat to Chinese banks

 

Moving back to China, there have been concerns that Alipay and WeChat Pay have been getting too big and the Chinese banks are fearful of becoming irrelevant. This matters, since state owned enterprises (SOEs) are funded by China’s Big 4 banks. If money is going to continue flowing into these digital wallets, the banks’ cost of funds will need to go up, resulting in higher cost of capital for SOEs.

 

The old school bureaucrat will take a fly swatter out for a smack down, but these ain’t flies. Furthermore, Chinese regulators have become more progressive and sophisticated in recent years. How then to deal with this problem without rocking the boat?

 

Enter a new regulation announced in Jan 2017. It will fully come into effect in Jan 2019. By Jan 2019, all customer deposits for digital wallets will have to be placed in a “single, dedicated custodial account at a commercial bank”. This account will pay no interest.

 

To the user, there is no change. Given that the bank is likely to be a Big 4 bank, the average user is unlikely to lose sleep over this.

 

Ant Financial and Tencent stop earning interest income on customer deposits. There were some mentions about this during the recent earnings call, but nobody is too concerned. After all, the business model is not predicated on earning a net interest margin on that deposit.

 

The biggest winner is the banking system. This is a large and growing pool of funding that is F-R-E-E. Doesn’t matter if Ant Financial puts it into ICBC or BOC, it all gets reallocated via the central bank. The status quo persists, and everybody is happy.

 

While this doesn’t prevent regulators from waking up on the wrong side of the bed one day and regulating the hell out of these companies, the keep-the-status-quo approach does suggest that the government understands the importance and dynamics of the industry. The signalling value looks positive.

 

Mini-Programs

 

How they work

 

Mini programs were introduced in early 2017 and it is yet another smart idea that worked out beyond expectations.

 

Mini programs are like on-demand apps within WeChat. Instead of having to download an app to perform a function that one rarely uses, the user can just call up the mini program, complete the task, and then forget about it. It’s clean, it’s easy and it doesn’t clutter. Quite neat.

 

Developers like it

 

On the back end, the low code requirements of mini programs were also designed to attract app developers to try a light-weight app within WeChat first. If it works, the developer can then move on to developing a full app. Attracting these app developers for Tencent’s app store provides revenue from in-app purchases and advertising.

 

The great friction leveller

 

It didn’t take long before companies caught on. QR codes were introduced so that instead of searching for the mini program, scanning a QR code calls it out. This led to many restaurants and F&B establishments using mini programs to manage loyalty programs. No more stamps on cards or standalone apps. It might be nuanced, but the reduction in friction of downloading an app makes a world of a difference. The user no longer stands in line, fumbling to download an app to clock his 1st of 10 cups of tea. Neither does he have to remember to download the same app when he changes phone.

 

Other use cases took off as well. Today, some of the most popular usage of mini programs include F&B (loyalty programs, self-ordering), public transportation, stores/supermarkets (self-scan via mini program and self-pay via WeChat Pay), as well as mini games (got 5 min and want to try a new game?). Given that it is still new, there is bound to be a lot more creative use cases that will take off due to the reduced friction.

 

Invasion of the offline world + payments synergy

 

If one looks again at the last paragraph, one might notice that a lot of the popular use cases are offline (eg, restaurants, public transport, supermarkets). The reduced friction and payments integration make it a lot easier for these offline establishments to serve their customers better.

 

It allows the business to become plugged in and lever technology. One can start building a customer relationship with loyalty programs.

 

The ability to accept payments helps too. At the very least, this solves leakage at the tills. Taking digital payments also brings in a larger pool of QR code-only customers. Think of how retailers accept V/MA’s interchange fee for access to the cashless crowd.

 

Ant Financial joins the party

 

Given how effective mini programs have been in helping WeChat Pay penetrate offline establishments, it wasn’t surprising when Ant Financial recently announced that it is getting into the game. This might provide some competition, but just like living with 2 payments networks, this is not a zero-sum game.

 

WeChat’s more established first-mover advantage does help in being the larger mini programs “app store”. Again, by way of analogy, there is the Apple App Store, and there’s Google Play. They both do fine.

 

How Tencent makes money from mini programs

 

Management has said that monetization is not the priority for now since they are building the product and market. This being a huge opportunity, especially when the offline economy is larger than the online one, the strategy makes sense.

 

Nonetheless, Tencent does monetize mini programs today. This article provides some useful numbers. Tencent takes 50% to 70% of any ad revenue generated, and 40% of in-app purchases. Seriously, these are huge take rates. Apple and Google only take 30% from their app stores. Not sure if management is being cute by saying they are not monetizing aggressively but Tencent does waive its take rates to help developers get going. Thus, it might not be inconsistent with management’s statements. Nonetheless, these eye-popping take rates give an idea of the potential here.

 

Investments

 

Like BABA, Tencent invests in lots of startups. I shall not go into too much detail on what it owns since I’m not building a sum of the parts case here. Just trying to highlight what’s special about Tencent’s investing program.

 

“Ecosystems” = Bundling

 

They both do so to grow their “ecosystems”. This is just a fancy term for their family of services. Growing the ecosystem with new investments keeps it fresh and prevents users from “churning” out of the bundle of services. Users can also discover other services within the bundle and increase their spending/attention (ie, ad dollars). The ecosystem matters.

 

However, I suspect that they will grow out of this in due time. There are signs of it, like how Didi Chuxing was a merger of the BABA and Tencent-supported ride hailing services since they both realized it was rather silly to keep wasting money in subsidizing users for market share. These guys are rational at the end of the day.

 

Till then, they are still busy growing their own ecosystems and fighting hard while at it so as to grow the bundle and reduce churn.

 

Different approaches

 

Between the 2, BABA’s CEO Daniel Zhang has stated that he prefers to buy the whole company, while Tencent appears to be very comfortable with a large minority stake. To each his own, though I find Tencent’s approach to be more sensible in terms of capital allocation. There is no need to buy the other company if all Tencent needs is a long-term partnership.

 

Tencent’s unique advantages

 

Tencent’s investing program enjoys unique advantages. For starters, they can see which apps/services are popular given the amount of data WeChat generates. Most apps have a WeChat strategy since WeChat is social media in China. This allows Tencent to move in early for a big investment. This is data based, not gut feel a la Masayoshi Son.

 

Once invested, Tencent then adds value its investment by highlighting the service on WeChat. This greatly lowers the customer acquisition cost of the startup and helps it scale rapidly. Naturally, this does wonders for the valuation of the investment. Some go on to list on stock exchanges, which highlights the value created (eg, JD, Pinduoduo, Meituan Dianping, China Literature). Stock price fluctuations aside, one needs to take a step back and ask where these companies would have been if Tencent didn’t invest in them. It’s not just the funding; Tencent provides a customer acquisition funnel.

 

So here you have an investor that has access to (legal) material non-public information and strong levers to pull for operational improvement. What would members on VIC give for this?

 

Tencent is a good corporate owner

 

While the history of Tencent as an investor is not particularly long, there are no signs that it mistreats its portfolio companies or rips them off to its own advantage. It would be dumb to do so, since it is fighting with BABA to attract the best company to be part of its growing ecosystem.

 

May the best service win.

 

Online gaming

 

Online gaming used to be a huge part of Tencent. As of 2Q18, this has come down to 34.2% of Group revenue. It was 42.2% of 2Q17 revenue and 48.0% in 2Q16. The trend is clear. WeChat and other services are getting much bigger. I don’t have precise insights into the margin profiles of the different businesses but it’s not hard to see how online gaming is probably on the lower end of the margin spectrum as far as Tencent is concerned.

 

This segment generally clocks ~20% revenue growth rate.  

 

Not just a Chinese games company

 

Tencent is the largest online gaming company in the world by revenue today. Tencent publishes its own games, which it distributes within China and globally. They also own or have large stakes in popular game publishers abroad. Some hot titles with Tencent behind them include Fortnite, PUBG, Clash of Clans, and League of Legends.

 

If you or your kids have an out of control spending problem on Fortnite these days, do note that 40% of the profits belongs to Tencent.

 

Gatekeeper and competition

 

More importantly, foreign game publishers can’t just drop their games into China and start selling. They need to work with local partners. Tencent is one of the largest distributors. Netease is another.

 

This allows Tencent to take a good chunk of the revenues of these global games publishers. Perhaps this infuriates Trump, but I don’t see how tariffs are going to matter.

 

Furthermore, China is too big a market for game publishers to ignore.

 

Nonetheless, Tencent’s pro-active approach in investing in promising games developers allows it to secure a pipeline of high-quality games it can localize for distribution.  

 

The Chinese are crazy about gaming

 

620 mil people in China play online/mobile games. This is out of an Internet-enabled population of 800 mil.

 

One third of the global audience for esports comes from China.

 

The Chinese love online games.

 

Esports and live game streaming

 

Tencent understands that live game streaming is an important part of the online gaming ecosystem. As such, it has invested into the 2 largest game streaming platforms, Douyu and Huya. This gives it a quasi-monopoly over the industry. Guess whose games are going to feature more going forward?

 

There are also other synergies from games streaming. Again, this is how Martin Lau thinks about it (from 4Q17 earnings call):

“Well, I think in terms of the game broadcasting, right, we felt it is an -- a great stand-alone business emerging as well as having great synergies with our gaming business. And we're seeing an increasing number of our gamers spending more and more time on the broadcast communities. So we felt there's a lot of synergies that the broadcasting sites can have with us, including -- it's an extension of the user -- gamers' usage time. It also allows a lot of gamers who don't have the time to play the game to stay abreast of the games they like. And it also is a great way for people to engage in community activities, right? So I think, over time, games broadcast can also support the eSports industry. And we'll see there is games which is like sports. There will be sports fans who are beyond the number of people who play the sports. And they will be watching ESPN, for example, and these broadcast sites will be like this media. And at the same time, these platforms because they are communities, they're interactive, they can facilitate more communities being brought around games and entertainment interests. So we believe these broadcasting sites cannot only allow us to build more synergies with our games, it would also develop new business models, both in conjunction with our games as well as on their stand-alone basis. So they will be attractive stand-alone business on their own. And at the same time, there will be synergies with our games. I think it's at an early stage of development. The industry would benefit from having multiple entrepreneur teams who are innovating in the industry. So we felt it's important for us to support a number of these companies and develop our own integration with them.”

 

The recent games-approval holdup

 

One of the key reasons Tencent has fallen of late was due to the Chinese gaming regulators holding up the approval of new games. Historically, gaming companies required the sign-off of 2 ministries before the games can be released and monetized. However, a recent reshuffling of government departments/ministries resulted in a pause in the approval process since April 2018. Fear of career risk at work here.

 

Tencent got PUBG approved and launched it, but since it wasn’t approved for monetization, Tencent wasn’t able to generate revenue from it. This contributed to a weak margin profile since expenses were incurred in rolling the game out. Because of this, Tencent reported a decline in net income for the first time since more than a decade.

 

Furthermore, the market was concerned that this holdup in approvals is going to last for a while. Hence, the weakness in the stock price.

 

The pain continued when the Ministry of Education came up with a circular to prevent myopia (short-sightedness) in kids shortly thereafter and called on one of the game-approving ministries to cooperate by limiting the number of games approved.

 

The stock took a slight hit but most industry observers expected all this to be sorted out by around Sep 2018.

 

Another curveball came next. As part of the ministry reshuffling, one of the approving ministries (Ministry of Culture) got grouped under the Ministry of Culture and Tourism (MoCT). Based on circulars released in Sep 2018, it appeared that the MoCT lost its authority to oversee online gaming. Interestingly, there has been rumours that the MoCT was upset about this and is appealing to higher authorities to wrest back control of its half of the online gaming approval authority. This created a new concern that if this request gets approved, the State Council (ie, higher body) will need more time to apportion the responsibilities between both new ministries again. That means there is going to be a longer delay.

 

Still, given that Beijing’s deadline was for all these restructurings to be done by end-2018, everything should be sorted out by year end.

 

In addition, the government has established a “green channel” to grant temporary approval for monetization of new games as it understood that online gaming companies have been hurting. This wouldn’t have been necessary if the goal was to inflict pain or choke the industry.

 

In short, this is a temporary regulatory problem afflicting the entire industry. It is not a Tencent-specific issue.  

 

And no, it is not a demand problem. Smartphone games’ DAU grew by “double digit percentage” year-on-year for 2Q18.

 

This has happened before

 

Deutsche Bank pointed out that a similar restructuring of the ministries took place about 9 years ago and this got sorted out in about 6 months. This explains the analyst community’s optimism around a September resolution, since approvals stopped coming in around March/April.

 

The MoCT’s push for authority unexpectedly lengthened this timeline, but the impact is likely to be marginal.

 

Doesn’t the government hate vulgar content and will ban gaming?

 

No. If this were the case, China’s gaming sector wouldn’t be flourishing today. If the Chinese government can block Google and Facebook, they could have done the same to online games if they chose. They don’t fundamentally have an issue with online gaming; they just don’t want violence, unsuitable content and addiction. Tencent and Netease thrived because they play well within the government’s guidelines.

 

More compliance = good for Tencent/Netease

 

Throughout the noise of the past few months, the government also started requiring gaming companies to restrict the number of hours young people spend playing games. Tencent and Netease already have systems to ensure this. Most smaller gaming houses do not. This just made life more difficult for the smaller players and thus market share is likely to accrue to Tencent and Netease when all is said and done.

 

Why does this opportunity exist?

 

Games approval holdup

 

As mentioned above. Temporary issue.

 

Trump breathing down China’s neck

 

While it’s hard to find direct angles of how Trump’s threats or tariffs impact Tencent’s operations or revenue, the tough talk has had an impact on the Chinese stock market. Tencent’s stock price wasn’t spared.

 

This is indiscriminate macro selling that will probably look silly 2 or 3 years from now (ie, after Trump exits the picture).

 

Trump is probably using China as a whipping boy for the mid-terms. The tough rhetoric is likely to tone down after the mid-terms are over in November.

 

Do note how respectful Trump remains when referring to Xi Jinping. Trump has been a lot more insulting towards Kim Jong Un (“fatty” and “rocket man”) and Mexico (unprintable). Today, Chairman Kim is “a very talented man” and the US just signed a trade deal with Mexico. Given the baselines of Kim and Mexico, Trump’s respectful tone towards Xi suggests that China is not going to get slapped so hard when Trump is finally serious about negotiating after the mid-terms.

 

If all else fails, I find it rather unlikely that the US re-elects Trump or replace him with someone similar. Trump has about 2 years left in office. Most sane politicians won’t be so extreme with a trade partner as important as China.

 

But then again, I’m no expert on international relations or politics, so these are just my observations.

 

Emerging markets sell down + Passive funds

 

Emerging markets are not popular these days. When Mauricio Macri hinted at signs of panic during his YouTube speech, people sold EM stocks. When Erdogan expounded on interesting concepts about how higher interest rates result in high inflation, people sold EM stocks.

 

All these matters, because Tencent is a heavyweight in EM indices. Below is the weighting of Tencent in some key indices:

  • MSCI Emerging Markets Index = 4.65%

  • MSCI China Index = 14.86%

  • MSCI South Africa Index = ~21.5% (?)

    • This is Naspers’ weighting

    • Bulk of Nasper’s value comes from its Tencent holdings

    • ETF hedgers do use Tencent as a proxy

    • Who knew you would be selling Tencent when you sold your South African ETF?

  • Hang Seng Index = 10%

  • Hang Seng Enterprise Index (ie, H-shares) = 4%

 

As such, the selling pressure on Tencent on a bad day for EM stocks is not small.

 

Unless you believe EM stocks are going to stay depressed for a long time to come, this source of selling pressure is also likely to be temporary. Would like to point out that the MSCI Emerging Markets Index is trading at a PE of 12.9x today vs 25.0x for the S&P 500.

 

Valuation

 

Tencent’s EV/EBITDA has ranged between 21x to 34x over the past 5 years, with 21x being near the lows when Shoe published his thesis back in 2016.

 

Current price of HKD 323.20/share works out to 23x FY18 consensus EBITDA. Do note that this EBITDA figure is somewhat depressed given the non-monetization of new games due to the regulatory approval holdup. It roughly works out to 21x EBITDA if FY17’s margins were applied. You’re getting in at the lows Tencent’s historical EV/EBITDA range today.

 

To be fair, FY18’s margins might not be as high as prior year’s due to heavier investments into growth, but these are not indicative of steady-state margins either; they are more like growth capex. This is a minor point; the difference is only a 10% difference in EV, which is no big deal.

 

I see no reason why the historical EV/EBITDA range doesn’t hold either. EBITDA margin has been roughly the same and revenue growth rate is also within the same ballpark, barring 2 monster years in FY16/17.

 

Taking the mid-point of historical EV/EBITDA range works out to 27.5x, which gives a HKD 606.50 price based on FY20 consensus EBITDA. 25x is probably more prudent given this has been FB’s range in recent years (before it fell on idiosyncratic concerns). 25x gives a HKD 550.70 target price (70% upside over ~2 years).

 

Taking a really conservative view, one can keep today’s 21x multiple and still end up with a HKD 461.40 target price by YE20 (43% upside over ~2 years).

 

Consensus revenue growth rate for FY18 and FY19 are 37.0% and 33.1%, respectively. The growth rate will probably fall, but given the long runway suggested by the qualitative factors discussed above, it is quite unlikely to dip below 20% anytime soon. As such, one can continue to participate in an above-20% compounder for a while.

 

Conclusion

 

Tencent’s recent sell down can be explained by indiscriminate macro selling and a temporary regulatory holdup that is likely to get resolved by year-end. The dissipation of these near-term issues will thus act as the catalysts to drive the stock back to a more reasonable multiple. The strength of Tencent’s moat and strong prospects are likely to provide a long runway for compounding. Today’s price level offers investors a cheap ticket for the ride.

 

Risks

 

  • Chinese regulators continue to fear career risk and go into the fetal position, holding games approval up indefinitely.

  • Tencent does something out of character and crosses the line; WeChat gets shut down.

  • Pony Ma or Martin Lau end up in the news for the wrong reasons (eg, Richard Liu of JD.com). Note that key man risk here isn’t any higher than that posed by Jack Ma at BABA.

  • A cool new chat and social media service takes China by storm and displaces WeChat. It is possible, but odds are low in the near to medium term. And no, Bytedance isn’t a threat as far as the social media angle is concerned.

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • China starts approving online games again in 2019.

  • Trump tones down on his China bashing and comes to a non-apocalyptic deal with Xi Jinping after the mid-terms.

  • EM sentiments improve.

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