Description

Tencent (700 HK)

Recommendation: LONG

Current Price: HKD 165

Price Target: HKD 216-222 (+30%-35% upside in 1-2 years).  Continued teens or 20%s IRR over time

Summary:   Although not a 'value' idea,  I love Tencent as a GARPy / growth stock.  I think it's one of the best products / franchises / companies in the world.   If you fast forward a 1-5 years, the company will almost certainly be far larger, more profitable, and more dominant than it is now

Simplistically, Tencent is the Facebook+Android+Twitter of China, and is in early stages of monetizing its dominant social network, Twitter-like platform, and video platform. It’s similar to where Facebook was in 2013 when FB just started monetizing its mobile platform.

Upside: Based on continued growth, SOTP, and DCF I think there is 30-35% upside in Tencent stock over the next year, and continued teens+ IRR over the long term

Company Overview:

- Tencent is by far the leading mobile app/platform/ecosystem, social network, and chat application in China

- Tencent’s mobile platform is designed so that users don’t have to leave the app; from the WeChat & QQ apps, users can chat, talk, check their social network, use Twitter-like accounts, watch videos, play games, consume media, hail taxis, pay bills, shop, book restaurants, and more. In the US, users must shift between multiple apps.  In China, WeChat is basically a universal app / platform.  Indeed, Tencent has started to open up its platform to allow 3rd parties to develop apps within the WeChat app

- They are #1 in many important categories: #1 smartphone community (Weixin & WeChat – 650mm monthly active users - MAUs); #1 online community (QQ IM – with Smart device MAUs of 639mm and total MAUs of 860mm) ; #1 online (PC and mobile) game platform; #3 mobile video site (although the top 3 platforms have roughly equal share); #1 mobile browser; #1 app store; and a rapidly growing #2 mobile payment platform (like PayPal)

- Perhaps most importantly, Chinese citizens trust and love Tencent.  The company has the best reputation amongst the large Chinese internet firms.  This is of course a high barrier to entry and competitive advantage, particularly as its payments platform continues to grow and becomes integrated in the lives of the Chinese consumer and businesses.  

o Chinese citizens distrust Alibaba given Jack Ma's strong ties to the government (partly why tech companies are wary of using Alibaba's cloud platform and payments platform).  Also, Baidu has put profits ahead of the user experience - it's well known that BIDU's search results sometimes feature scams and fraudulent sites. 

- This is a GARPy / growth investment

My Long Thesis: Still significant growth runway

- Tencent is still in early stages of monetizing its platform by inserting ads in their social network news feed (aka ‘moments’), video platform, and Twitter-like service (aka ‘public accounts’)

o Their ad load is currently 1 ad every 48 hours per user, which is obviously extremely low. They are still being very careful with the user experience

o Culturally and by nature, the Chinese consumer can tolerate and even appreciates higher ad load than in Western countries.  Just look at any Chinese webpage,  it looks like Times Square

- Gaming in China (and the really the rest of the world) is a secularly growing industry

o Tencent’s gaming segment is actually a fast growing, diversified, stable, and relatively predictable business

o Online and mobile gaming is stickier, more stable, and growing because 1) Chinese kids and people don't like to play outside given the pollution; 2) Given the focus on studying and staying in their rooms, they just play video games; 3) Chinese consumers are increasing willing to paying for content and games as they become wealthier and piracy becomes more difficult on mobile;  4) much like in the rest of the world, paying for digital items and goods has become more acceptable and entertaining

o Tencent has a leading app store and can take 20-80% of the revenue given its dominance and reach ("take rates')

o Game publishers (e.g. EA, ATVI, etc.) finally have a way to monetize their games and intellectual property through mobile phones and PCs in China without as much fear of piracy (consoles never took off in China due to piracy issues)

o The global mobile gaming industry is quickly consolidating to a few scale companies that are taking the vast majority of the market (much like EA, ATVI, and TTWO have become the main console game publishers) as games become more elaborate and complicated. Also reach and distribution are key factors to success

o Tencent is one of 2 giants in mobile gaming in China – Tencent consistently has 50%+ share of the China market

- Tencent user growth on its apps continue to grow rapidly

o Tencent should continue to grow active users and become an even stickier platform as they add more content and functionality (news, videos, games, online-to-offline services, taxi hailing, payments, etc.).  Tencent has been rapid strides in payments and now has 300mm bank cards tied to WePay.  The ability to pay through the WeChat platform allows them to 'close the loop', which is very enticing to service providers, content providers, and advertisers

- Impressive moat, market position and growth – no other chat and social network in China comes close

o Chinese regulators block foreign social networks, which limits competition

o Revenue and EPS Growth rates are still in the ~20%-30% CAGR, with a huge opportunity set and share to gain in many large and expanding categories (online advertising, video, payments, online-to-offline commerce, games, etc.)

- Great management team

o They are forward thinking & leading edge. Tencent's management team has historically been great at capital allocation, and understands that they shouldn’t overspend and depress margins

o They keep new initiatives and venture type investments off balance sheet through JVs and VC investments, so core financial metrics aren’t distorted/blemished by investment spending (unlike at BIDU)

- Valuable JVs & Investment stakes

o Tencent also has partnered with or has stakes in numerous important and strategic companies like JD.com (the Amazon of China), Didi Dache + Kuadi (Uber of China), DianPing (Yelp), Meituan (GroupOn), WUBA (Craigslist), Sohu (3rd largest search engine), etc. They're also an early investor SnapChat (back in 2013)

o Basically they’ve partnered with or invested in other top companies (generally ranked #1-#3 in their niches).  This helps Tencent maintain its relevancy and reduces risk of being made obsolete (or at least lets them benefit financially)

 Tencent can and does direct traffic to their JVs and partners, who also reduce Tencent’s own spending needs, so there's a symbiotic benefit

o e.g. The Tencent / JD partnership has been very beneficial, and has helped JD gain mobile traffic while providing Tencent advertising revenue and more features

Catalysts:

- Continued growth in users, advertising, payments, gaming, etc.

- Advertiser uptake and interest in the WeChat platform

- Growth in margins as higher margin advertising revenues gains greater of Tencent’s revenue and earnings mix, which should improve Tencent’s multiple as well

- New partnerships (like the one they made with JD.com and Sohu) take off or get re-rated higher

Current Valuation & Price Target:

- 2016: P/E 30.3x (27.2x ex-cash) EV/EBITDA 21.4x EV/FCF 19.6x EV/Sales 9.0x

- 2017: P/E 23.6x (20.3x ex-cash) EV/EBITDA 17.5x EV/FCF 17.1x EV/Sales 5.8x

- Dividend yield 0.28%

- Comparables: cheap / fair compared to other US/Chinese internet companies especially given Tencent's growth and dominant position

o FB trades at 2016 P/E 34.5x, 2017 P/E 26.4x < although FB 100% advertising.  However, I'd argue that Tencent is more dominant than FB is in the US.  In China, there is far less internet & mobile competition due to the Great Firewall of China.  In the US, FB has to keep buying the next Instagram/WhatsApp, and SnapChat is indeed an existential threat.   However, Zuckerburg clearly understands this and is not willing to let FB become a relic (unlike Yahoo).  But that means that FB will likely have to purchase SnapChat for tens of billions, although I believe that the market will like that purchase.  

On the flip side, in China there is practically no substitute for Tencent as a chat / media / social platform.  It's far more engrained in the lives of Chinese netizens than any other app and has no compare

Overall, I think Tencent's WeChat and overall ecosystem is far more durable and has much more potential growth ahead of it than FB

o EA / ATVI trades at 2016 P/E 20.5x, and 2017 P/E 19x < although they are more hit driven and volatile. I believe that Tencent’s gaming platform is more valuable than EA given its industry leading mobile app store, which makes the business less volatile and less reliant on hit games / fads.  Just take a look at its past performance, it's a much more predictable and smooth business 

o GOOG trades at 2016 P/E 22x, and 2017 P/E 19x < although growth here is slower and there are fewer growth prospects in front of it

o BIDU trades at 2016 P/E 29, and 2017 P/E 21x < although growth here is slower and pressured by spending.  Plus their search results suck as they've placed revenues and earnings ahead of search quality.  But they're the only game in town, again thanks to the Great Firewall of China, so they get away with it, for now 

Upside: ~32-35% in the next year

Methodologies:

- Continued growth: 31% upside if the multiple stays the same and we just roll forward estimates

o Tencent's multiples should stay the same or increase as Tencent's revenue and earnings mix shifts higher margin and higher growth advertising and away from the lower multiple gaming segment

- SOTP: Using a SOTP approach on 2016 earnings, there could be 34% upside

o  This uses a 37x P/E multiple on the social networking and online ads,  and a 22x P/E on the gaming earnings.  Then adds the net cash+investments per share.  And then adds my back-of-the-envelope valuation for its burgeoning payments business, cloud computing, and online-to-offline services.  Tencent also has numerous stakes in valuable and strategic start-ups and companies like SnapChat & Uber of China.  

Tencent’s investments are worth about ~$111bn RMB at 12/31 book values (40% are publicly listed), and is arguably not reflected in valuation.  The stakes are worth about 9% of Tencent’s market cap.  Tencent has said that the IRR on their investments has been above 30%

o If they can get more meaningful traction in mobile payments/mobile banking, or mobile video, etc. those could be very profitable multi-billion incremental revenue/earnings streams

- DCF: 35% upside

o  Assumes a 10.2% WACC,  16x terminal EBITDA multiple,  implied 4.8% implied perpetual growth rate

Downside Risks:

- RMB devaluation

o Mitigant: this can be hedged by shorting other companies with high RMB exposure, or by FX hedging

- Hit driven nature of gaming

o Mitigant: Tencent has a roster of hundreds of games and is constantly refreshing its game library with proprietary games, JVs, companies that it has invested in, and other partners. Also, Tencent gets to take a cut of whatever game is popular at any time through its app store

o Tencent itself has demonstrated consistent growth and results from its gaming business over the years. The gaming industry in general is becoming more stable and predictable. Game franchises and companies are increasingly becoming recurring, predictable, and profitable long tail businesses

- Margins could be subdued because of strategic investments (e.g. payments or online-to-offline)

o Mitigant: Management has always been careful to spend wisely. They are careful to keep venture type investments off balance sheet through partnerships and VC investments

- Chinese / Global Macro Risks

o Mitigant: Tencent’s mobile and online advertising segment is certainly in a secularly growing area that should still grow despite a slowing economy

o Gaming is China is actually a rather sticky business due to lack of entertainment alternatives, and is also in a secularly growing area given increases mobile and PC penetration, as well as a shift to consumerism and leisure in the Chinese economy.

o Despite the recent macro volatility in China, Tencent’s gaming revenue and advertising growth have been very robust and consistent. Foreign game publishers are also eagerly introducing more games into China to monetize a previously untapped and developing market

o China is also shifting to a consumption driven economy, which will be more supportive of advertising and leisure, while being conducive for industrials industries

- Expert conversations & checks: Recent channel checks indicate continued business momentum and rapid growth in both advertising and gaming

o One digital advertising agency is seeing the social advertising portion of ad budgets go up from LSD % of total digital budgets to mid-teens % just QoQ from Q4’15 to Q1’16

o Advertisers are excited by Tencent’s growing mobile payments functionality combined with WeChat’s reach, making advertising even more attractive given the potential to secure a transaction (i.e. close the loops'). They really just want to on Tencent's platform

o Growth rates will likely continue to be in the same area as in the recent past

- Conversations with a Chinese game developer and a Tencent partner indicate that Chinese gaming demand is still strong. Smaller competitors are exiting the market or finding it difficult to raise capital, hence the big get bigger

- OTR Chinese advertiser survey: Tencent’s WeChat platform and video continues to maintain strong y/y growth momentum, despite macro concerns and shakier overall advertising spending environment

o Chinese brands are increasingly shifting online advertising to video, benefiting Tencent and Alibaba's Youku (whcih BABA bought recently)

o Online video share of spending has increased, social share stable, search declining

o WeChat remains the leading social media app and is attracting more advertisers as its Moments advertising pricing becomes more accessible to small advertisers (they recently changed the pricing to make it more attractive for SMBs)

o Tencent and BABA are leading in programmatic advertising, but it's still in early stages

Capital Structure (in RMB) as of Q4’15

Cash: 135.5bn RMB

Debt: 61.4bn RMB

Net Cash: 77.7bn RMB or $12bn USD

Current Price: 165.30 HKD

Share outstanding: 9.43bn shares

Market Cap: 1.559 trillion HKD, or $201bn USD

Upside & Valuation

- Upside – ~30-35% upside over 1-2 years

Valuation Methodologies:

P/E valuation: +32% upside

- Continued growth while holding the multiple steady: 32% upside in 1 year (target price of 218 HKD)

- I think Tencent should be able to maintain its multiple (or potentially increase it as their advertising and mobile growth accelerates and margins & ROIC increase) and they continue growing their topline and EPS at 25-35%+ rates CAGR over the long term

- I expect 32% EPS growth in 2016, hence 32% upside for the stock if the multiple stays the same

SOTP: +31% upside

- Using a SOTP on 2016 numbers, I get to 36% upside

Advertising Metrics and Comparisons – significant room to grow and catch up

- CPCs – still low

o Tencent’s CPC is roughly 1/6th of BIDU’s and ½ of Qihoo’s. Of course, search advertising is much more targeted and there is more ‘intent’ in a search query

o BIDU charges about 30 cents/CPC, while Tencent’s CPC are roughly around 5-10 cents

 Tencent is still in early stages of rolling out advertising, and wants to be careful to maintain the user experience, while providing advertisers a good value§

o In the US, Facebook charges about 70 cents/CPC and Google charges 90 cents

o As Tencent improves and grows its advertising platform, it should be able to close the CPC gap with BIDU or Qihoo

- Ad load – very low

o Tencent is still being careful not to dilute the user experience, so the ad load is miniscule at around 1 ad every 2 days

 Meanwhile, for FB I frequently see an ad every 5-10 posts.

 FB users can easily see 10-20+ ads a day

 Again, Chinese users enjoy cluttered looking websites and culturally can support much higher ad load·

 On another metric, Facebooks ad load (defined as ads per # of posts) is perhaps around 5-20%, while Tencent is less than <1%

o Anecdotally, Chinese netizens complain that they aren’t getting more ads. E.g. some wish they saw more Mercedes ads because it would make them feel higher class

- Tencent is the leader in Programmatic ad buying (their "GuanDianTong" platform), and has a broad range of mobile properties to monetize

o Chinese users on spend 42% of their mobile time on Tencent's platforms

o 448 minutes per month on WeChat (compared to 441 minutes on FB in the US)

o Tencent's ad exchange has opened 20 attributes for advertiser targeting (similar to FB)

o Tencent's click-through-rates on GuanDiangTong are 1-1.5%, vs. 0.5-1% on BABA and <0.5% on BIDU

- Here is some background on why Chinese people are more engaged on the Internet than Americans:

o Existing Chinese media is weak. Traditional media is censored. TV is seen as biased and government influenced. Netizens turn to Internet to gain a deeper understanding of what’s going on in the country and see what other people think

o People are moving to the city. Large numbers of migrant workers move far away from they grew up; the Internet is critical to reconnect with their roots

o Kids are lonely. Most kids grew up without siblings, the one-child policy has been around for over

Weixin Moment’s Advertising

Clearly, FB’s success and growth provides a relevant template for Tencent’s likely roadmap

WeChat moments currently charges advertisers only by CPM. It has three city tiers: core cities (Beijing and Shanghai), key cities (35 provincial capital and other key cities), and other regular cities. The CPM for graph ads in core/key/regular cities are RMB150/100/50, respectively. Video ad CPM is generally 20-30% above graph ads. This rate is comparable to Youku, whose banner ad CPM stands at RMB120-180 in core cities and RMB55-75 in regular cities but higher than traditional portable like SINA whose CPM ranges from low teens to high double digits.

China Ad Market - Big Picture

- China’s ad spending as a % of GDP is still low compared to developed markets

o Ad spend as % of GDP in China is relatively low at 0.4% compared to 0.9% and 0.8% in the US and UK in 2014 respectively, according to GroupM

- Online ad spending is growing in China as a % of total ad spend (as it is everywhere)

Venture Capital stakes / partnerships:

They have ~10-35% stakes in & partnerships with various #1 or #2 internet companies, e.g.

- The Uber of China (Didi Dache + Kuadi Dache – which merged earlier this year)

o they were the #1 and #2 uber-like services - now it'll be easier to compete against Uber

- The Yelp and major O2O companies of China (Dianping + Meituan – they merged late last year)

o both do "local services" and "online-to-offline" (O2O). Meituan is like GroupOn. Dianping is a local services company with a Yelp-like reviews site

Also, it's highly noteworthy that these large (worth tens of billions of USD) and dominnant internet start-ups have merged.  Obviously, the competition will be far lower as a result.  Much of the rivalry had been between Jack Ma (of BABA), Pony Ma (of Tencent), and Robin Li (of BIDU).   It seems that Jack Ma and Pony Ma have realized that cooperating is better.  Actually, Jack Ma has been retrenching from VC investments recently - he's been a shrewd market timer in the past (raising a lot of money before the dot.com bust, IPOing Alibaba.com before the Great Recession and then buying it back,  and IPOing Alibaba near the peak of the Chinese and US stock markets as well).  It seems that he's trying to call the top again,  but in either case it's good that he's become less competitive in O2O and payments

- Bing/Yahoo of China (Sogou) - Sogou provides Tencent a decent search engine so that users don't have to leave the Tencent ecosystem and go to BIDU.  Over time, given BIDU's issues and search quality, Sogou could benefit

- 2nd largest e-commerce / logistics company in China (JD.com) and South China City Holdings, etc.

- Snapchat, Lyft, Ele.me,

- These stakes arguably aren’t reflected in the stock price. And allow Tencent to benefit operationally and financially from the leading peers’ innovation.   I believe that Tencent’s investments are smart and position Tencent well for the future.

- The biggest risk facing Internet (and tech companies) is obsolescence or becoming irrelevant.

- Companies like Tencent, Google, and Facebook understand that they need to go where users are going, and become more and more sticky. Hence why FB bought WhatsApp and Oculus. They need to stay relevant or else risk going the way of Yahoo, MySpace, and others.

Stock Liquidity / Ownership

- Trades 20mm shares a day, or ~$370mm worth a day

- 33.8% is owned by Naspers (a South African publicly traded company with many VC stakes in internet companies)

- 9.1% owned by Huateng Ma (aka Pony Ma) – 4th richest person in China

- I don’t consider it a hedge fund hotel stock

Technicals

- It's a pretty beautiful chart.

- Consistent higher highs and higher lows

- Looks like it'll breakout of its long term ascending triangle wedge pattern soon.  A breakout of this pattern implies 50 points of upside, or +30%

Buy-side Sentiment

- Not surprisingly, Tencent is well loved by investors

- But unlike other well-loved stocks, Tencent’s business momentum, opportunity set, long term runway and upside, and untapped areas of growth keeps investors interested, confident, focused on the long term.  Many investors I speak to aren't as focused on the quarter to quarter,  they like it long term and are long term holders

- Combined with the valuation being attractive (and at the very least not off the charts) investors are eager to buy dips in the stock

Financials

- Profitability: 700 HK is quite profitable and has been so since 2001

o Generates 52% gross margins, 32% operating margins, and 24% net profit margin (15-20% effective tax rates, domiciled in the Caymans)

Earnings & calls

- Tencent is a steady company that usually beats comfortably

- there is no guidance, so there's less of that earnings game with the company

- the calls are generally low on color and financial guidance as well,  which is good and bad

Q4 earnings

Q4 (December end) - good results in advertising, games, user count, etc. 

- Revs  30.4bn RMB, vs. 27.8bn cons. 

   up +45% YoY,  +15% QoQ,  +10% above cons.

  - online revs +118% YoY

     - performance based adds +157% YoY < continues to roll out advertising across their platforms (in particular their Twitter like platform)

     - brand display ads +89% YoY < from their mobile media platforms (Video and News)

  - games revs +33% YoY

      - mobile games +87% YoY,  desktop +17% YoY < expanded  their game portfolio

  - social network revs +37% YoY < grew digital content subscription services (e.g. NBA, Paramount, Warner music, Sony), virtual item sales, and MAUs

- non-GAAP EPS 0.95 RMB  vs. 0.89 cons  +32% YoY,  +7% above cons

- GAAP EPS 0.75 RMB, +21% YoY <  0.16 RMB of the difference between GAAP and non-GAAP is due to an impairment in JD.com, in which they own a stake in

- EBITDA +52% YoY

- gross margins 58.4%, -190bps YoY  but slightly better than expected  < lower as they subsidize mobile payments (which grew rapidly),  but they've started charging more for mobile payments in Q1 2016,  so it should bounce back

- G&A/revs was down to 15.7%,  -320bps YoY

- EBITDA margins 42%, +200bps  YoY

- EBIT margins 37.9% -60bps YoY

- WeChat users +39% YoY, +7% QoQ

   - desktop monthly active users +5% YoY,  smart device users +11$ YoY

2015

- revs +30% YoY

   - online ad revs +110% YoY,  65% of advertising was on mobile < they're expanding their automated platform and location-based targeting,  also more video ads

- cloud service revs +100% YOY

- EPS +30% YoY

- EBITDA +40% YoY

Q3 earnings

Q3 – modest beat

-          Revs 26.59bn Rmb,  5% beat

o   +34% YoY, +14% QoQ

-          EPS 0.881 RmB,  2% beat

o   +28% YoY, +4% QoQ

-          Gross margin 58.6%,  down 520bps YoY

o   Was impacted by higher content costs and banking fees (as they drive mobile payments transactions and users)

-          Non-GAAP EBIT margin 39.5% down 220bps YoY

Segments / metrics – growth strong across all segments

-          Online ad revenues +102% YoY, +21% QoQ

o   Performance based social advertising +160% YoY, +16% QoQ < driven by mobile

o   Brand advertising +67% YoY, +27% QoQ

-          Games +27% YoY,  +11% QoQ

o   Mobile game revs +60% YoY, +18% QoQ

-          Online content and services (aka VAS) +28% YoY, +11% QoQ

o   Due to higher subscription revenues from membership and digital content, and digital game sales

-          Mobile MAUs - Weixin and WeChat (their main mobile chat platforms)

o   Monthly Active Users +39% YoY,  +8% QoQ

o   650mm MAUs

o   Payment platform reached 200mm users < still subsidizing the bank charges though

o   Desktop chat platform 860mm people,  +5% YoY, +2% QoQ

Catalyst

-          Continued growth in users, advertising, payments, gaming, etc.

-          Advertiser uptake and interest in the WeChat platform

-          Growth in margins as higher margin advertising revenues gains greater of Tencent’s revenue and earnings mix, which should improve Tencent’s multiple as well

New partnerships (like the one they made with JD.com and Sohu) take off or get re-rated higher