To The Moon

Summary

• Tencent's brilliant capital allocation business could be disrupted by regulations.
• The company recently sold its stakes in JD.com and Sea Limited.
• Capital allocation is the biggest edge Tencent has over other big tech mega caps.

Nikada/iStock Unreleased via Getty Images

In this analysis I will explain why Tencent Holdings ($TENCENT(00700)$ ) might no longer be the company that it was a year ago. I've been following Tencent for over one and a half years now, and I decided to sell my 8% position because I see its capital allocation business being crippled going forward. Tencent had an extraordinary business with many wide moats - or at least that was the case in the past.

An overview of Tencent's business segments

First off, let's quickly introduce the different segments of Tencent's operation. The business is split into four parts:

• Value Added Services (52% of Q3 revenue/75.2 billion RMB)
• Online Advertising (15.8% of Q3 revenue/22.5 billion RMB)
• FinTech and business Services (30% of Q3 revenue/43.3 billion RMB)
• Others (<1% of Q3 revenue/1.4 billion RMB)

VAS includes the Social Networks, namely WeChat with over 1.2 billion MAU and QQ with 574 million MAU, and their domestic and international games. The WeChat App especially has a wide moat. The lives of hundreds of millions of Chinese people center around this app. A lot of their other services are integrated into WeChat, and their miniPrograms (basically mini-apps inside of the app) in particular enjoy vast and rising popularity and profitability.

VAS also includes their gaming segment, which has been hit by regulations. The government has put harsh regulations on the amount of time children are able to play video games for each week. This regulation doesn't impact the topline a lot, because the vast majority of domestic gaming revenue comes from adults. Nevertheless, it is an unfavorable development and in line with my thesis of an eroding moat.

Their Online Advertising business is leveraging their Social Media platforms to sell personalized advertisement space. One of the big bidders for this business used to be the online education sector. With the crackdown on the entire sector in 2021 and with the China basically declaring parts of their business model as non-profit from now on, the bidding from this customer group slowed down dramatically. Once again, these are declines in revenue primarily due to regulatory actions.

The FinTech and Business Services segment includes the WeChatPay fintech, which serves hundreds of millions of people and businesses alike. The business services here includes the Tencent Cloud offering, with many different services like IaaS, PaaS, SaaS (like their Tencent QiDian CRM), and more. Aside from that, they also are offering business software similar to the Microsoft Office suite with services like videoconferencing software. Although the cloud has an enormous runway ahead of it, I am concerned that selling to businesses outside China will be difficult and thus restricting the TAM for this still gigantic opportunity. Tencent's rival Alibaba($Alibaba(BABA)$ )took a hit from exactlythat in their last Q4:

Slower revenue growth during the March quarter was primarily due to revenue decline from a top cloud customer in the internet industry, which decided to terminate the relationship with respect to their international business due to non-product related requirements.

Capital allocation as the differentiator

Now that we've talked about their three main lines of business, I want to talk about their biggest edge over other Mega Caps: Capital allocation and Investing.

Mega-cap Net Cash to Market cap (my own excel sheet)(Author)

In the table above we can see that all of the Mega Caps and Chinese Big Tech companies have substantial cash reserves currently, with the exception of two companies: Tencent and Amazon($Amazon.com(AMZN)$ ). All of these businesses have great cash flow generative operating businesses, but can't reinvest their profits effectively. As an example, Alphabet($(GOOG)$)spent $50 billion on share buybacks in 2021 and still has $111 billion in cash, earning 0%-1% interest. If only half of that money could be effectively invested, let's say a conservative 7%, that would mean an additional $3.885 billion in earnings for Alphabet.

In the long term, a lot of the outperformance of a company comes from smart capital allocation. A great case study into this can be found in William Thorndike's book calledThe Outsiders.Thorndike talks about eight different CEOs achieving significant outperformance through smart allocation of their capital.

The reason why Amazon is able to invest so much money and have even net debt is that they have a much more capital-heavy business model compared to these other tech companies. In particular, warehousing and logistics eat up a lot of cash flow through capital expenditures, totaling capex spending of over $61 billion in 2021 alone for Amazon.

Tencent manages to effectively allocate their capital by investing it into stakes in publicly, but also privately held companies. As of Q3 2021, the fair value of Tencent's shareholdings in listed investee companies (excluding subsidiaries) was approximately $185 billion. That's roughly one-third of their market capitalization. Some of the highlights of the investment portfolio include 5% of Tesla(NASDAQ:TSLA), 18% of JD.com(NASDAQ:JD), and 20% of Sea Limited(NYSE:SE).

This gives Tencent an incredible edge, because it allows them to invest their huge cash flows effectively into high yielding investments. Legendary value investor Mohnish Pabrai recently made an interesting analogy aboutTencent's two business models, calling them the "two Bazookas of Pony Ma" (the CEO of Tencent):

The first business model is their army of software developers. They spend around $1 billion on hiring new Software Developers every year, but it's hard to scale that up. You can only find so many great Software Developers for hire. That is the first Bazooka.

The second Bazooka are 30 digital Warren Buffetts, who take all the remaining cash flow and seek out angel investments and opportunities in public markets. This is the second Bazooka.

According to Pabrai, the first Bazooka generates returns of 60% per year, while the second Bazooka still historically generated 20%. All of this sounds amazing, so why did I mention that this business might be disrupted by regulations?

Recent capital allocation decisions are troubling

Recently, Tencent came out with two big news items in quick succession:

• On Dec. 22, 2021,Tencent announcedthe sale of $16 billion worth of JD.com shares as a special stock dividend to shareholders, cutting their stake in the e-commerce giant from around 17% to 2.3%.
• On Jan. 4, 2022,Tencent announcedthe sale of $3 billion worth of Sea Limited shares, cutting their stake from 18.7% to 21.3%. The proceeds were kept by the company in cash and all remaining shares were converted to non-voting shares, effectively giving up all their influence over SE.

I find these developments very troubling because it seems as if Tencent is changing their approach to capital allocation - the backbone of my investment thesis for Tencent. In an ideal capital allocation world, Tencent would use cash from selling assets to invest into their business or invest in better risk/return investment opportunities. Considering that the valuation of Tencent stock is favorable right now, I also would have appreciated a buyback; $16 billion would reduce shares outstanding by around 3%. Instead they chose to pay it out as a special dividend - a stock dividend, but still a dividend.

Tencent currently has some net cash, so I don't understand why they would raise only $3 billion with the Sea Limited sale. The sale also happened after Sea Limited already fell a significant amount, so it wasn't due to opportunistic pricing in the stock either. On the other hand, giving up the voting rights in SE makes sense because India has special rules for companies with majority Chinese ownership.

Valuation

From a valuation standpoint for Tencent, I like to look at the P/E ratio (both the trailing and forward multiples) and the FCF/EV yield. I like to look at FCF/EV yield because it shows how much free cash flow attributable to shareholders the company is able to produce. Tencent has historically been between a 2% and a 4% FCF/EV yield. They are currently on the top of that range with 4.04%.

Based on the trailing P/E multiple, Tencent is at a historical low of 18.1x. On a forward P/E multiple they are still cheap historically, but not at a historical low. We can also observe that the forward multiple is projected to be higher than the current multiple. This results from an expected decline in net income due to missed revenue in several of their business segments. I also believe that a deteriorating capital allocation efficiency is already priced into this multiple.

Tencent valuation metrics (koyfin.com)

Conclusion

All of these factors led me to the conclusion that Tencent is no longer the same company it used to be. The future is uncertain and we don't know which business segments will be able to thrive and which investments they'll be able to make. Prior to the big crackdown, Tencent was, in my eyes, the best business on the planet. It was especially painful to sell my own position here, but it is no use to hold on to an old and most likely broken investment thesis.

On a historical basis, they are currently attractively priced, but I don't think historical multiples help if you are dealing with a very uncertain regulatory environment and a possible change in management style. I will continue to monitor Tencent over the next few years, and if I come to a new conclusion about their capital allocation ability I will once again look into the Tencent investment case.

Source: Seeking Alpha