Tencent Stock – Chinese Dragon For Your Portfolio?

If you think that Facebook, Amazon, Apple, Netflix, Google as members of the FAANG group, or the GAFA companies (Google, Amazon, Facebook, Apple without Netflix) are the benchmark for market leadership in digital online services, you should look east to Asia.

With Baidu, Alibaba, and Tencent, heavyweights of comparable size have also established themselves there, forming the BATman group. In this analysis, I want to take a closer look at Tencent and examine in detail to what extent Tencent stocks can be considered as an alternative buy to the American stocks. I will also analyze whether there is a risky dependence of Tencent on the Chinese market or whether the often criticized goodwill of the Chinese government is problematic.

Tencent Aktie
Logo
Country	China
Industry	Technologie
ISIN	KYG875721634
Market Capitalization	480,4 Milliarden €
Dividend Yield	0,3%
Dividend Stability	0.90 (max. 1.0)
Earnings Stability	0.90 (max. 1.0)

The business model: How Tencent makes money

At first glance, Tencent’s business model appears confusing. The Group’s portfolio covers all content that can be used in the digital economy. In addition to the social networks Weixin and WeChat, this includes information services such as news and blogs, plus entertainment offerings across the entire range of music, movies, and online games. Besides, there are online payment systems such as WePay and other digital services that play an essential role in the everyday lives of many consumers (e.g., navigation solutions such as the Tencent Map). Another area in which Tencent plays a vital role is the offering of cloud solutions.

All these service offerings, some of which are managed by subsidiaries, form platforms that drive the parent company Tencent like gears in a giant machine. Looking at the number of daily and monthly users, Tencent is the leader in the Chinese market in many of the businesses mentioned above.

Source: Investor presentation

In the picture above, you can see that the most significant driving engine of this machine is the “Communications & Social” business. With its WeChat platform, Tencent addresses the simple consumer like you and me as well as entrepreneurs. To achieve this, Tencent relies on a variety of digital offerings and content. The following picture shows some of them:

Source: Digital content

You can see that Tencent’s offers cover areas of everyday life, for which consumers from the western world use different providers. Tencent is thus positioned more broadly than comparable companies in the USA and Europe. Accordingly, investors should consider WeChat less as a pure WhatsApp equivalent or similar, but rather as a browser with exclusive content from the Tencent universe. Tencent is a combination of YouTube, Facebook, Spotify, Apple Music, PayPal, Instagram, and more.

However, offering products and services does not automatically generate revenue. Fortunately, Tencent’s business model is explicitly geared toward such income. The company provides digital services wherever there is potential to make money. In addition to a transaction cost model, Tencent generates revenues primarily through subscriptions and the sales of virtual digital goods in online games, such as avatars or individual virtual items. Of course, the company also generates revenue with online advertising.

Source: Investor presentation

Besides, Tencent is trying to expand its position even further. For example, the company works together with other companies (for example, Hyundai and Tesla) on the further development of electric cars and holds 5 percent of Tesla stocks.

How Tencent keeps growing profitably

The revenue growth of Tencent is impressive and needs not to fear comparison with Amazon, Apple, etc. Like the Western technology giants, Tencent’s revenue metrics have exploded over the last decade.

Revenue growth Tencent

Tencent recorded a double-digit increase in all segments in the last financial year. Furthermore, Tencent built its growth on a broad foundation. When analyzing the revenue figures, you should keep the following in mind: Tencent reports in four segments. The largest business segment is the Value-added Services unit that includes all goods that consumers can purchase via the platform WeChat (virtual item sale). Other individual revenue sources are online advertising and financial services. Added to this are additional income and investments. Other income mainly comprises the rapidly growing business with cloud computing.

Source: Investor presentation

For the full year 2019, revenue growth was an impressive 21 percent. Tencent is a revenue engine. And although the business with cloud solutions is still relatively small, the annual growth rate of 57 percent is impressive. Furthermore, Tencent has managed to diversify its revenue sources more and more, making it more independent of its social media platforms.

Source: Investor presentation

Diversification by segment is essential for investors. Otherwise, Tencent would have to struggle with market saturation effects with the social media segment alone, such as Facebook. But diversification alone is not enough for further growth on a similar scale. That’s why Tencent is also expanding geographically.

Expansion plans minimize the risk on the domestic market

Tencent is consequently trying to grow beyond the Chinese market. The company is mainly interested in investments or takeovers to offer its services on the European and American markets. Especially in the gaming sector, the company is trying to expand its position as the world’s largest games producer. For example, Tencent has released the mobile version of the action shooter “Call-of-Duty” together with publisher Activision Blizzard. The market for games on smartphones and tablets is attractive. Here, publishers and developers can realize highly profitable in-app purchases and thus build up regular and high-margin income streams. In-app purchases are more likely to be accepted by the generally young consumers than in the traditional market for PCs and consoles. Publishers sell virtual items, characters, specialized equipment, and other gadgets via games that are available free of charge in basic modes, such as the very popular Fortnite (Tencent owns just under 50 percent of the shares in the publisher Epic Games).

But Tencent also invests on a large scale in financial services or entertainment. For example, Tencent acquired 10 percent of the Universal Music Group, paying EUR 3 billion to the parent company Vivendi. Tencent has also gained 5 percent of the Australian payment service provider Afterpay for approximately USD 250 million. Afterpay enables credit solutions for purchases where consumers want to buy first and pay later.

The expansion is quite important for Tencent and investors because, unlike its US competitors, the company does not operate in a free market in its domestic market, but is dependent on the goodwill of the Chinese government. In 2018, for example, the Tencent suffered enormous revenue losses when the Chinese government refused to license relevant new game titles from Tencent, which prevented the company from launching the games on the important Chinese market. When the Chinese government also decided to regulate the number of online games in 2018, Tencent (as well as other companies in the industry) suffered a loss in value of almost 20 billion USD. With the gaming segment accounting for 30 percent of sales, this reaction by investors is not surprising.

Besides, Tencent might get involved in the trade dispute between the USA and China. Although Tencent has never been in the spotlight as much as Huawei, the company is not entirely immune to possible attacks on the business. For example, the Chinese government has banned Tencent from broadcasting the last episode of the hit series “Game of Thrones”. So far, however, the trade dispute has not been able to do any lasting damage to growth. Furthermore, unlike Huawei, Tencent is not dependent on other US companies or US consumers, so there is already a lack of comparable leverage. In this respect, I assume that Tencent will be able to continue its growth course relatively unscathed by the trade war.

Healthy margins despite strong growth

In particular, the mobile games business provides high margins for Tencent. Investors are particularly pleased that the exponential growth in revenue has not hurt profits. After the high investments initially depressed the margin strongly, it has now stabilized again and should remain in a similar range in the future. The current gross margin of 44.42 percent and the operating margin of 24.61 percent show that Tencent is capable of long-term growth without losing profitability.

Development of Tencent’s margins

Low but rapidly increasing dividend

Rather sad news for dividend investors is that Tencent is paying only a very low dividend. The current yield is only 0.3 percent. Nevertheless, it is worth taking a closer look. Considering that the company recently spent 20 percent of its operating cash flow on innovation expenditures (CAPEX), there is a lot of room for the company to let investors participate a little more in its ongoing success. In this respect, the annual increases in the dividend are high. Whereas the dividend in 2013 was still HKD 0.2 per share, Tencent paid HKD 1.2 in 2019. Therefore, the payouts have increased sixfold since then. That said, it is fair to assume that the company will continue to increase the dividend in the future steadily:

How attractive is the current dividend yield compared to the past? Everything you need to boost your dividends is available here.

If Tencent maintains the dividend growth, the yield would already be almost 2 percent in six years. Sufficient room for further increases growth is there. Possible increases in the future make the stock interesting for long-term thinking dividend investors, who are looking for regular cash flow to live from it one day. Investors should consider, however, that Tencent only distributes the dividend once a year. For 2020 the ex-dividend date is 14 May. Tencent will pay the dividend on 15 June.  It is therefore still possible to secure the dividend payment for this year.

Is the Tencent stock attractively valued?

From a fundamental perspective, Tencent is currently only fairly valued. Based on the 10-year P/E ratio of 34.47 and assuming a 2020e EPS of HKD 12.14, Tencent stocks are trading at just slightly under its fair value of 53.99 USD per share. However, even for a growth stock like Tencent, a P/E ratio of 34.47 is no longer quite as favorable. Apple, for example, rarely trades above a P/E of 25 and has a much higher dividend yield. Furthermore, the last ten years were characterized by a bull market, which tended to result in higher valuation figures, especially for growth companies. In times of a more flat running economy and the possible accompanying operating downturns, it could become more difficult for Tencent to continue to justify such a high valuation. Even the current dividend yield compared to the 10-year yield of 0.27 percent does not indicate a real undervaluation.  All in all, Tencent is not a bargain:

Tencent fair value calculation (EPS and dividend)

Conversely, however, you can see that in the past, Tencent was sometimes also much more expensive than today, especially in the period from 2016 to 2018.

Tencent fair value calculation

Conclusion: Tencent stock – dynamic growth at a fair price

I consider the Tencent stock to be an investment that is both exciting and promising in the long term. Despite the trade war and the recent interventions of the Chinese government in one of the core businesses, Tencent was able to continue its growth course with full profitability. The high importance of Tencent’s software solutions in everyday life of millions of people, as well as the worldwide expansion, allow us to expect further revenue growth.

Thanks to its long-term dividend increase, Tencent stocks are also interesting for cash-flow oriented long-term investors. However, due to the meager dividend yield of less than 0.5 percent, it will take several years before the payouts will generate significant cash flow. Besides, not every shareholder likes the fact that the Tencent pays its dividend only once a year and that Tencent’s dependence on the goodwill of the Chinese government continues. Besides, the Tencent stock is currently not expensive, but rather fairly valued from a historical perspective, which also speaks for Tencent. Furthermore, the current P/E ratio of other tech stocks like Apple or Microsoft is significantly higher than their historical P/E ratio.

If you look for stocks with long-term profit growth to benefit from growing dividends and capital gains, register now. Basic membership is free of charge.

Excellent tool for investors looking for quality stocks in a fast and easy manner – TRADERS’. Magazine for traders and investors

Get free member