A Deep Dive into the Fundamentals for Tencent

01 Oct 2021

By Eric Lee, Account Manager, Phillip Futures

With the sell-down in the Chinese stock market, especially to the high-profile tech stocks, there have been some interest among investors to learn more about the Chinese tech sector. One such company we would like to take a deep dive into is Tencent.

Company Profile:

Tencent (HK: 700) offers online gaming, social network services, FinTech and cloud services, and online advertising services, such as media, social, and other advertisement services. The company is also involved in production, investment and distribution of films and television programs for third parties, as well as copyrights licensing, merchandise sales, and other activities. In addition, it develops software; develops and operates online games; and provides information technology, information system integration, asset management, online literature, and online music entertainment services.

As you are aware, Chinese tech stocks had been sold down drastically since its peak in February this year, due to the regulatory enforcement by the Chinese government, who are concerned about the social ills brought to their society due to the excessive growth of industries relating to education, online gaming, property, etc. As such, Tencent, being the largest gaming company in China and the world, suffered a heavy sell down.

In August 2021, China’s state-media likened online gaming as spiritual opium. A few days later, Chinese government then implemented a policy to restrict children under 18 years old to 3 hours a week of online gaming.

Will Tencent’s income suffer badly from the gaming ban on children under 18?

Tencent had all along been very compliant and cooperative with regards to Chinese governmental policy. As can be seen from the Chairman’s statement, they had implemented measures even before the recent policy had been announced. Their revenue contribution from players under 16 only accounted for 2.6% of their gaming revenue.

Shown above is the 6 months ended 30 June revenue of Tencent categorized according to its business segments. Out of its 6 month revenue of RMB273,562 million, gaming contributed 32% at RMB86,620 million. To be conservative, instead of the 2.6% of revenue from players under 16 being affected by the new policy, let’s assume 10% of the gaming revenue will be impacted, amounting to RMB8,660 million of lost revenue to Tencent’s top line. Even then, this only amount to 3% of Tencent’s total revenue. Though the market sentiment to this new policy had damaged the share price greatly, the actual impact to its business operation should not amount to much.

Company Analysis:

Since its high in Feb 2021, Tencent suffered a peak to trough drawdown of 47%. This is not the first rodeo ride for Tencent, as we had witnessed a 47% sell down 5 years ago in 2016 as well. Throughout these times, its business continues to grow, adding value to shareholders. You can see from the chart below, using my proprietary indicator P/B, P/E and P/S Cycle Indices, investors who bought into Tencent every time the 3 indices fell into the Buy Zone, as indicated by the green arrows, the stock price had always recovered and trended higher. Of course, history may not repeat itself again. Thus, we need to study the business operations that Tencent engaged in to determine if it is able to continue its growth trajectory.

Tencent had demonstrated that it continues to grow at a high return on invested capital and the management is able to reinvest its operating income back into its operation, thereby compounding its earnings at a high rate of growth for its shareholders.

Source: Compiled from Tencent Annual Report 2011 to 2020

The table above shows Tencent’s revenue from its various business segments. Over the past 10 years, there had been some changes like the short-stint from its eCommerce segments from 2012 to 2014 and the inclusion of a new segment from Fintech & Business Services segment in 2019. Management started to further categorised its Value-added Services (VAS) segment into Online Games and Social Networks; as well as its Online Advertising segment into Social Advertising and Media Advertising since 2017.

Looking at the last column for the year 2020 (highlighted in yellow in the image), we can see that the main revenue generator for Tencent comes from Online Gaming, Social Networks, Social Advertising and Fintech & Business Services. The percentage gains from these 4 business operations are quite evenly contributed. This is good, as it implies that its source of revenue is diversified and thus Tencent is very likely to weather through this rough patch as it is not overly dependent on online gaming as its primary source of revenue.

The word Fintech was first mentioned in Tencent’s annual report 2017. We noticed a strong revenue growth from its Others segment that year and in 20218 and subsequently, the management started to report a new segment under Fintech & Business Services from 2019 onward. Considering that they only started focusing on this segment in 2017, Fintech & Business Services segment had grown at a very fast pace such that it has now become the 2^nd largest revenue generator after Online Gaming. Thus, this is an important space to keep a watch on, especially given Chinese government’s concern towards online gaming and the impact it brings to the society. Increasingly, Fintech & Business Services segment may become Tencent’s main source of growth and revenue generator.

Let’s assume that, due to the various policies enacted, Tencent’s revenue growth begin to taper down from its mid-20s percentage points to eventually to 15% 5 years from now. During this time, its price multiples continue to remain challenged, trading at around 6X in terms of the Price-to-Sales ratio, it does seem like a strong possibility for investors to expect a compound annual growth rate (CAGR) of between 10-13% over the next 5 years.

Technical Analysis:

On a short-term basis, we can see that %R is a good indicator to use for catching the short-term up move in Tencent. As indicated by the arrows, every time the indicator falls to oversold region, the share price will find a support and bounce up on a short-term basis.

With the view that the long-term growth is still intact and its valuation is at an attractive level, traders or investors alike can make use of indicator such as %R to time their entry for buying into Tencent’s long-term growth.

Eric Lee is an Account Manager with Phillip Futures. With expertise in Futures, Forex, Stocks, and Unit Trust, Eric makes an all-rounded advisor. Make informed trading decisions without spending time combing through endless information as Eric readily provides clients with trade alerts and insights via WhatsApp. Over his years of experience, Eric developed systematic strategies in trading and investing. Book a complimentary coaching session below to leverage on his expertise as he imparts his knowledge to enhance your trading journey.

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