Tencent Holdings Limited: Historic Investment Opportunity (OTCMKTS:TCEHY)

Tencent Holdings Limited (OTCPK:TCEHY) shares have corrected sharply over two years. They are down more than 50% from their February 2021 high. However, its business remains solid, and its valuation is relatively cheap. Its cheap stock prices should be considered a buying opportunity for long-term investors.

In 2021, Tencent Holdings achieved a revenue of RMB 560.118 billion, up 16% year-over-year, and a net profit of RMB 123.788 billion, up 1% year-over-year. We can see that 2021 was the lowest year of net profit growth for the company in the last decade. Hence, a historic investment opportunity has emerged for Tencent Holdings under the Chinese government’s intention to promote the healthy development of the platform economy.

Why TCEHY is falling

Recently, the Chinese internet giant Tencent Holdings has seen its share price fall from a peak of nearly $900 billion market cap to its current $400 billion due to the Platform Anti-monopoly Guidelines. However, as long-term investors, we do not have to worry about it for the following reasons. The first is the potential impact of anti-monopoly efforts and the prevention of disorderly expansion of capital. Comparing Tencent’s FY2021 and recent years’ statements, the impact of anti-monopoly on Tencent is almost negligible. Its businesses have remained consistently healthy, with solid growth in investment income, despite a slight slowdown in operating income growth rate.

In addition, the disorderly expansion of capital is a very philosophical issue. At present, the Chinese government has also released positive signals to promote the orderly and healthy development of capital. Personally, for Tencent, the guidelines are more of a shock than a danger.

Tencent’s business structure

Tencent achieved a revenue of RMB 560.1 billion in 2021, with products and services covering four main areas: Games, Social Networks, Online Advertising, FinTech, and Business Services, which maintained a relatively balanced proportion.

Through the 2021 annual report, we can see that games had been Tencent’s largest source of revenue in previous years. In 2016, games accounted for half of Tencent’s revenue, but in 2021, its contribution dropped to around 30%.

Social networks’ revenue mainly comes from membership services such as Tencent Video and QQ Music, whose revenue share has been maintained at just over 20%.

Online advertising revenue is mainly divided into social advertising and media advertising. Since Tencent has been relatively restrained in online advertising in consideration of user experience, the revenue share has fluctuated from 15% to 20%.

FinTech and Business services revenue is mainly divided into payment, cloud computing, and business services revenue. It is one of the fastest-growing segments in recent years.

With the decline in in-game revenue, and the growth in the payments business, cloud computing, and enterprise services, I believe Tencent’s sales mix is becoming more balanced. It is not dependent on any single business. Moreover, its financial model is becoming more of a mature company that is expected to achieve stable growth over the next few years.

Tencent’s upstream and downstream

For B2C, Tencent’s business includes Value-added Services, Financial Payments, and B2B and B2G. It includes Online Advertising, Cloud Services, and Business Services. Moreover, the company’s customers can also be roughly divided into two types, individual users and enterprise customers, each accounting for half. The top 5 customers account for 6.3% of the company’s revenue. Its customer structure is balanced and decentralized and does not rely on large customers.

Since there is no problem with too high a sales ratio to a single customer and the revenue from each customer is relatively balanced. I think Tencent has strong pricing power and high stability of performance. There will not be a sudden and significant decline in the next few years.

The nature of Tencent’s business model

We can understand the Tencent ecosystem as “linking everything with WeChat and QQ.” Various value-added services are derived through the links, covering almost infinite possible scenarios. The 2021 statements show that Tencent has total assets of about RMB 1.6 trillion, with equity investments totaling more than RMB 800 billion. To understand the nature of Tencent’s business model through its balance sheet, we need to see its assets in a dichotomy method.

One is the “traditional Tencent,” commonly understood as the operator of social networks, games, video, and online advertising. This Tencent is mainly responsible for cashing in on traffic, with total assets of RMB 800 billion, including ¥400 billion in cash and the other ¥400 billion in actual operating assets.

Another Tencent can be understood as “Tencent Investment Company,” which we can regard as China’s Berkshire, mainly responsible for investment realizations. Its assets are also ¥800 billion.

The two Tencents help and empower each other. Therefore, the essence of Tencent’s business model can be recognized as the continuous synergy between traffic realization and investment realization.

In 2021, the traditional one generated gross profits of RMB 250 billion. After deducting period expenses of about ¥130 billion, it made pre-tax profits of about ¥120 billion. The other Tencent contributes pre-tax investment income of ¥150 billion, which exceeds the former.

Why invest in Tencent now

New economy enterprises usually implement Ecological strategies. A key to judging the investment value of such enterprises is whether the ecosystem’s operations continue to diminish marginal costs or even to zero. The asset turnover ratio is one simplified indicator of the diminishing marginal cost effect.

From Tencent’s business model and business structure above, we can see that Tencent is currently implementing a complete ecological development strategy. So I think Tencent is a New Economy Enterprise. The core of judging the competitive advantage of new economy enterprises is the effect of Diminishing Marginal costs, and the key indicator to measure it is the Asset Turnover Ratio. However, the financial statements of new economy enterprises are very different from traditional ones.

The asset turnover ratio of new economy enterprises cannot be calculated simply by dividing total operating revenue by total assets. On the balance sheet, the assets that drive value creation in new economy enterprises are often shown as off-balance-sheet assets, such as data and information assets. At the same time, there are fewer on-balance sheet operating assets, such as almost zero inventory and few fixed assets.

Tencent’s revenue in 2021 is RMB 560 billion, and its total assets are RMB 1,600 billion. If we divide total revenue by total assets, the asset turnover ratio is 0.3. If we do this simple calculation, this figure is not excellent.

However, we should use the “turnover rate of actual operating assets” to measure its diminishing marginal cost effect. Dividing the operating revenue of ¥560 billion by the actual operating assets of the traditional Tencent of ¥400 billion, the turnover ratio is 1.4. In the past five years, its turnover ratio has increased year by year. The growth means that the marginal cost of “traditional Tencent” is decreasing, and its competitiveness improves. Considering Tencent’s huge volume, this is an outstanding achievement.

In addition, traditional Tencent still has significant room for improvement in overseas games, channels, enterprise services, and industrial Internet in the future.

For “Tencent Investment Company,” the annualized return of Tencent’s equity investments is used to determine its competitiveness.

Besides subsidiaries, Tencent’s equity investments are mainly divided into three categories. The first category is investments in associates and joint ventures, which are recognized as investment income under the equity method at historical cost plus changes in the carrying value of the investor’s net assets. The second category is strategic investments that do not have significant influence, are held for a long time and measured at fair value, and are recognized in other comprehensive income. The third category is investments in financial assets that do not have significant influence, are held for a short period, and are measured at fair value through profit or loss.

Since the latter two investment categories are measured at fair value, the income has been timely reflected in the income statement or consolidated income statement and net assets on the balance sheet.

However, the first investment category is measured at historical cost, which means that its real investment income is not reflected in the statements promptly. As of 2021, the carrying value of Tencent’s category one investments is more than RMB 300 billion (the carrying value of the listed portion is currently about ¥200 billion, and the unlisted part is about ¥100 billion). According to the notes to the statements, the fair value of the listed portion is about RMB 600 billion, which is more than three times its carrying value of ¥200 billion.

By simple extrapolation of this figure, the ¥300 billion investment corresponds to a fair value of about ¥900 billion, which means an extra ¥600 billion. Measured by this method, the annualized return on Tencent’s investment reaches nearly 30%, a return no less than Warren Buffett’s Berkshire. In addition, if we add this ¥600 billion to Tencent’s current net asset book value, then Tencent’s current P/B ratio is only 1.9, which is very low compared to other tech giants.

For example, among the five most prominent technology companies globally, Apple’s P/B ratio is 35, Google’s P/B ratio is 6, Microsoft’s P/B ratio is 12, and Meta’s P/B ratio is 4.41.

In summary, I believe this is a historic investment opportunity.

Tencent’s financial information in the last years

The above chart shows that revenue growth has remained at more than 20% in the past four years. The Non-IFRS net profit growth rate is slightly higher than the revenue growth rate, except in 2021. The company’s fixed assets only account for about 5% of the total assets, a typical light asset model. It also reflects the features of a high-profit margin.

The company’s operating cash flow is constantly above 140%, and the percentage of accounts receivable is deficient, which indicates that the company is very profitable. Moreover, the annual free cash flow is approximately equal to the net profit, which means maintaining the current profitability does not require too much additional capital investment. The net profit earned each year is solid.

The company’s ROE has been close to 30% for a long time, resulting from a combination of high net profit margin and moderate leverage, reflecting a very high level of corporate operation and profitability.

Combining the above data, we can see that Tencent is an asset-light, high-margin company. Combined with its excellent free cash flow status, it reflects the characteristics of an industry leader and a company approaching maturity.

Risks of buying Tencent

While I am bullish on Tencent, various factors could emerge that could undermine my expectations for the company. For example, the Chinese government could further crack down on Tencent and other Chinese tech giants. In addition, U.S. regulators could decide to delist the company’s ADR. Increased competition could affect Tencent’s growth and profits. Also, the company may not see the robust revenue and EPS growth that analysts are factoring in for future years. Furthermore, a broad market decline could pull Tencent’s stock price lower with the general market and technology stocks. There are multiple risks associated with this investment, which is why the stock is very cheap right now. In my opinion, Tencent remains a high-risk/high-reward investment, and investors should double-check the risks before opening a position in Tencent stock.

The Bottom Line

It is evident that Tencent is now trading at overtly silly valuations. Tencent and Chinese stocks in general went through a transitional phase where overly negative news flow put significant pressure on the stock price. This problematic period lasted more than a year and caused shares, including Tencent, to fall to severely oversold and undervalued levels. Now that the negative news is behind us, given how the Chinese government has finally shown more restraint and promise in recent weeks, we may see more focus on positive developments for Tencent. Tencent has an excellent business model, light assets, strong profitability, abundant free cash flow, no need for additional significant capital investment, and solid industrial competitiveness. Tencent has maintained a growth rate of 24% in the past five years, so it is expected that Tencent will continue to maintain double-digit growth in several years. Tencent’s P/E ratio is currently just around 12, and it is not uncommon for companies with similar growth and earnings dynamics to trade at 20 to 30 times the earnings per share expectations or higher. As a result, Tencent should have no problem returning to a 20 P/E ratio in the next few years, and with market sentiment improving, Tencent’s shares are expected to soar significantly in the next few years. I rate Tencent stock as a Buy only for speculative long-term investors.