Tencent: Front-Runner In A Potential Chinese Stock Market Rebound

seekingalpha09-30

Tencent reported solid second quarter results, with revenue growing in the high-single digits and the bottom line almost doubling.Similar to many other Chinese stocks, Tencent jumped in the last week,...

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Several stocks were increasing in the high single digits or even double digits for several days in a row. Baidu, Inc. (BIDU) increased from $86 at the end of last week to $102.50 right now, Alibaba Group Holding Limited (BABA) increased from $88 to $105 in the same timeframe. Tencent Holdings Limited (OTCPK:TCEHY) (OTCPK:TCTZF) increased from RMB 388 when trading closed last Friday to RMB 442 right now and JD.com, Inc. (JD) jumped even from $28.50 to $38 in the same timeframe. And it is not that I haven’t been bullish about Chinese stocks in the last few quarters. I have written several bullish articles about Tencent and Alibaba as well as JD.com and Baidu. Although I am convinced these companies (and stocks) are great long-term investments, I was also surprised by the performance in the last few days. In the following article, I will pay closer attention to Tencent, which increased 25% since my last bullish article and clearly outperformed the S&P 500, which increased only 11% during that timeframe. And we can argue that Tencent is among the four mentioned companies the furthest along on its path towards a rebound. Since its bottom in October 2022, Tencent has already increased more than 130% and for those investing close to the bottom, it was a great investment so far. And after such a bullish run, we can certainly ask if the stock is still a good investment or if the time to buy Tencent has passed. Quarterly Results When looking for reasons why a stock might jump in the short term, earnings might be the obvious candidate. However, Tencent already reported its second quarter results on August 14, 2024, and the recent rally was most certainly not a delayed reaction to the quarterly results. Nevertheless, the last quarterly results were certainly solid. Revenue increased from RMB 149,208 million in Q2/23 to RMB 161,117 million in Q2/24 resulting in 8.0% year-over-year top line growth. And while revenue increased only in the high single digits, operating profit increased in the double digits and grew 39.8% year-over-year from RMB 36,283 million in the same quarter last year to RMB 50,732 million this quarter. Diluted earnings per share almost doubled year-over-year and grew 85.3% from RMB 2.695 in Q2/23 to RMB 4.994 in Q2/24. Tencent Q2/24 Presentation And finally, free cash flow increased from RMB 29.9 billion to RMB 40.4 billion – resulting in 35.1% year-over-year growth for this extremely important metric. Gross margin also increased from 47.5% in Q2/23 to 53.3% in Q2/24 and the non-IFRS operating margin increased from 30.9% in the same quarter last year to 36.3% this quarter. Tencent is becoming more and more a conglomerate of many different business segments and is very diversified. However, in its core we still can see Tencent as a social network and therefore monthly active users is still an important metric. The combined MAU of Weixin and WeChat was 1,371 million on June 20, 2024, and the number is increasing compared to 1,359 million on March 31, 2024 (previous quarter) and to 1,327 million on June 30, 2023 (same quarter last year). And the number of fee-based VAS registered subscriptions increased 12.4% year-over-year from 234 million on June 30, 2023, to 263 million on June 30, 2024. Sentiment Change Quarterly results were probably not the reason for the recent stock price increase. And when looking for reasons why stock prices are suddenly surging, we are often presented with simple stories as if the stock market was just the result of simple cause and effect relationships. And I certainly don’t deny that news stories will impact the stock market in one way or the other. We can read news stories about Baidu unveiling upgraded AI platforms at a Beijing event and the company reporting that Ernie is now processing over 700 million inquiries daily. Or about Alibaba unveiling over 100 open-source AI models, including a text-to-video tool. And although connections between these news stories and the Alibaba share price are made, these explanations are usually false. When looking for news stories that probably had an impact, it was rather the announcements and actions by Chinese authorities in the last few days. On Tuesday, the PBoC announced that interest rates are cut 20bps and existing mortgage interest rates were lowered by 0.5 percentage points. The lowering of interest rates was combined with a lowering of banks’ reserve requirements. China is also planning to issue special sovereign bonds worth about 2 trillion yuan (about $285 billion) to stimulate the economy. The stimulus measures also included help for the troubled property sector and additional social security benefits for graduates who are unemployed. And these stimulus actions certainly can help to push the stock market higher, but we also saw stimulus measures in the last quarters and the stock market continued to decline. It remains to be seen, if it is working this time and if the stock market is moving higher. And in the end, for the stock market it is important if sentiment is changing. The stimulus could lead to a more bullish sentiment and with sentiment changing from very negative to rather positive, it will push stocks higher. But without a more bullish sentiment, stocks will probably remain where they are. Investors have to believe in stocks going higher – without investors believing that they will make money from the stock, nobody will buy, and the stock will not go higher. Stimulus might have contributed to the sentiment, but it is not such a simple cause and effect relationship. Therefore, just arguing that stimulus is enough to drive the stock market higher is too simplistic. Stock markets as a complex system are never working according to such simple rules. We must see what will happen this time, but it seems like the major indices marked a double bottom, and we could have actually seen the cyclical low. Of course, this is just speculation, and we should be very cautious. However, in my opinion, it seems like a possibility that the Chinese stock market found its bottom. Growth Potential While sentiment is responsible for driving stocks in the one or other direction in the short-to-midterm, I remain convinced that over the long run, the stock performance will match the fundamental performance of the business in almost every case (there might be exceptions). Tencent is demonstrating this quite well in its investor presentation. Since the IPO 20 years ago, the stock performance more or less matched the fundamental performance of the business. Tencent Corporate Overview Presentation The share price increased 399 times since the IPO, but adjusted EBITDA grow 493x and revenue increased even 533 times. The difference between the fundamental performance and the stock price can be explained by sentiment with several options being possible: The difference can for example be explained by a rather bearish sentiment right now leading to a lower stock price than what would be reasonable. Another explanation could be an overvaluation of the stock at the IPO and Tencent growing into its valuation over time. Looking back at the past performance is certainly interesting, and the example is showing us that the fundamental performance is important, and the stock price is matching the business performance in the long run. And therefore, we have to take a closer look at the potential performance of Tencent in the years to come and what might drive growth in the next few years or decades. Tencent Q2/24 Presentation In the past, it was especially FinTech and Business Services, which drove growth, but in the recent quarter (Q2/24) the segment was struggling a bit. Revenue still increased from RMB 48,635 million in the same quarter last year to RMB 50,440 million this quarter – resulting in 3.7% year-over-year growth but making it the segment with the lowest growth rate for Tencent. Management was pointing out that commercial payment revenue is still growing, but the average value per transaction declined and consumer loan services revenue decreased as WeBank and Tencent got more cautious with its credit extension policies. Tencent Q2/24 Presentation While revenue growth for FinTech and Business Services rather stagnated, the gross margin still improved in the last few quarters and is now coming close to the margins the other two business segments can report. Revenue for Value Added Services increased from RMB 74,211 million in Q2/23 to RMB 78,822 million in Q2/24 – resulting in 6.2% year-over-year growth. And Online Advertising increased revenue from RMB 25,003 million in the same quarter last year to RMB 29,871 million this quarter – resulting in 19.5% year-over-year growth. Tencent Corporate Overview Presentation But over the long run, management is confident it will continue to grow its FinTech business by using the existing ecosystem and increasing its wealth management business by offering money market funds and low risk fixed income mutual funds. Additionally, Tencent will also expand its consumer loans, and it is reporting success in the installment payment services. Tencent Corporate Overview Presentation Management is not only expecting FinTech to contribute to growth, but also revenue from its online games – especially international games – can be a contributor to growing revenue. Tencent Corporate Overview Presentation And although Tencent is not among the major names regarding AI so far, it is one of the leading technology companies in China, and we can be confident its long-term investment in growth and AI will pay off. A year ago, Tencent already released Hunyuan, the company’s proprietary large foundation model on Tencent Cloud. And Tencent is already reporting that its upgraded ad-targeting model is driving significant revenue growth. Overall, I assume that Tencent will be able to grow its revenue – especially the FinTech business, international games and also online advertising have the potential to grow. Intrinsic Value Calculation Aside from looking at the sentiment and fundamental growth potential of a business (or its ability to generate free cash flow in the future) there is at least a third perspective we need to take, which is extremely important – the stock price in relation to the fundamental performance. Or to put it a little different: We must calculate an intrinsic value to determine if the current stock price is a fair price for the business. As always, we are using a discount cash flow calculation and need to make several assumptions. Aside from calculating with a 10% discount rate (the annual return I like to achieve with any investment) we are using the last reported number of diluted shares outstanding (9,445 million). And as basis we are using the free cash flow of the last four quarters, which was RMB 177.6 billion. Tencent Corporate Overview Presentation Now it is getting a little more difficult as we need to make some assumptions about free cash flow and growth rates in the years to come. But we can look at some numbers like the growth rates in the last few years. And although Tencent was clearly struggling, the business was still able to increase revenue with a CAGR of 8.10% in the last three years. With the Chinese economy hopefully recovering in the next few years, we can assume higher growth rates again. And although Tencent might not be able to reach its high double-digit growth rates of previous years again, growth rates in the teens should be a possibility in the next few years. And according to analysts, earnings per share are expected to grow with a CAGR of 14% in the years between fiscal 2024 and fiscal 2028. Additionally, analysts are also getting more optimistic for the years and quarters to come and are constantly increasing estimates, which is also a good sign. Seeking Alpha Looking at these numbers and estimates, it seems reasonable to assume at least 10% growth for the next ten years. Following that, we assume 4% growth until perpetuity. When calculating with these assumptions we get an intrinsic value of RMB 467, which is resulting in HKD 518 and therefore Tencent is still trading about 15% below a price I would see as fair and reasonable for the stock. We can even be a little more optimistic and assume 12% growth in the next few years followed by 4% growth until perpetuity, which is leading to an intrinsic value of RMB 534 and HKD 592. Of course, 12% growth is certainly not a conservative assumption, but I would argue it seems realistic and reasonable. For starters, Tencent will most likely continue to buy back shares, which could contribute about 1-2% to bottom-line growth. Additionally, we can assume gross and operating margins improving further over time as the different business segments are getting more mature and therefore more profitable. And finally, I still think Tencent has many different ways to grow its top line (as mentioned above) and a business that managed to grow at least in the high single digits while the entire Chinese economy was struggling should be able to grow with a much higher pace during a recovery. Tencent Q2/24 Presentation Conclusion The United States is also going from all-time high to all-time high and the stock market is marching higher and so far, investing in U.S. stocks is a good idea. And in the last few weeks, it was a good idea to invest in Tencent or Alibaba, but it was also a good idea to invest in Meta Platforms or Amazon. However, when looking at the last few years, there is a huge difference between investing in most U.S. stocks on the one hand and most Chinese stocks on the other hand. When looking back at the last few years, almost everybody would argue it was much better to invest in the United States than in China. That being said, the stock market is forward-looking and, in my opinion, the United States and China are at two completely different points in the cycle. While the stock market in the United States is very close to its cyclical peak with the risk of a “lost decade” following, we can make the argument that the Chinese stock market is close to its cyclical bottom and much better days are ahead. And Tencent is certainly not the cheapest stock we can find in China – even among the major technology companies, other stocks seem cheaper. But Tencent is a high-quality business with a wide economic moat around and the possibility to grow with a high pace for a long time. Additionally, the stock is at least reasonably valued and even after the stock already increased 130% from its cyclical low, Tencent is still among the better investments one can make right now.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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