Signs of life from Tencent's Q3 earnings?
Summary: Like many Chinese stocks, Tencent has declined significantly over the past few months. Did its Q3 earnings beat provide investors with reason to suspect the bottom is in?
Tencent reported Q3 earnings yesterday and while Q3 profit and revenue beat estimates, there is a dark cloud hanging over Tencent as the company’s main revenue stream is at risk due to the Chinese government’s suspension of licenses allowing new games to be monetised.
Despite the Q3 profit beat, more clarity is needed on the regulatory environment and how this will affect the business model long term before calling a bottom in Tencent’s slide.
• Q3 profit and revenue beat estimates.
• Q3 net income rose 29.6% to RMB23.3bn ($3.35bn versus an estimated RMB18.39bn).
• Revenue RMB80.6bn; estimates called for RMB80.41bn, so we saw growth of +24% year-on-year – the slowest pace since Q2 2015
• Online advertising revenue grew 47%, with online ad revenues accounting for 20% of overall revenues – a record high.
• Gross margins hit an all-time low.
• Smartphone game revenue grew 7% y/y, but PC game sales fell 15% and management delivered no clarity on the regulatory approval uncertainties pressuring the gaming business.
• Weixin/WeChat now has 1.08bn monthly active users, up 10.5% y/y.
Online advertising helped offset the slowdown in gaming revenues in Q3, with online advertising revenues now accounting for 20% of overall revenue. Online ad revenues grew 47% in Q3, highlighting the high demand from advertisers across Tencent’s many social platforms. While this provides some reprieve and could limit downside risk, the outlook for gaming will be crucial for the company and to drive a turnaround in Tencent’s share price.
The top contributor to the 30% rise in profit in Q3 was the one-time gain provided by Meituan Dianping’s IPO. One-time items accounted for RMB8.8bn ($1.3bn); the value that can be attributed to Meituan Dianping is unknown as the company did not provide a breakdown but it is unlikely to be repeated next quarter without a turnaround in Meituan’s fortunes. Since its September IPO in Hong Kong, the share price has fallen 17%.
Tencent has managed to purchase games that already have licenses from independent studios but this comes at a price as licensing fees must be paid to the game developers, thus putting further pressure on Tencent’s already compressing margins. In the near term, Tencent has 15 mobile games due to be released for which the monetisation licenses have already been procured before the freeze. This provides some respite amid regulatory uncertainty and will continue to cushion gaming revenues.
Given that gaming accounts for 60% of Tencent’s revenues and without a resolution enabling Tencent to monetise new games, there is risk of another weaker quarter of growth when Tencent next reports.
It is impossible to predict the timing of regulatory easing without insight into the Chinese regulatory bodies, but it is highly likely that resolution will prevail eventually. But as we have said before, without a resolution of the regulatory risks it is likely Tencent will remain under pressure. More clarity is needed on the regulatory environment and how this will affect the business model in the long term before calling a bottom in Tencent’s slide.
Taking a long-term view
Tencent experienced top-line growth of 24% in Q3, trading at 25x forward earnings as the share price continues to fall, and unless Tencent’s earnings and equity continues to rise the trend will not be sustainable. Estimated revenue growth is forecast to grow 34% for next three years, and EPS growth is estimated to grow in excess of 20% for next three years. However, it is worth noting that the company still trades at a premium to Chinese tech peers on both a forward earnings and an EV/EBITDA basis;in particular price/book value is still excessive and sits at a 168% premium to peers.
Overall, Tencent remains an exciting company in the long term, the company is operating in growing sectors that embody China’s “new economy”, leveraging a consumer-oriented millennial cohort by providing apps and services for all aspects of 21st century life in China.
The ecosystem contains a variety of interesting and diversified businesses with significant opportunities to drive growth and increase profitability for investors given the sheer scale of the market and innovative drive of the company. The longer we see divergence between price and valuation, the more interested investors are going to become in this stock. But given the opaque nature of the regulatory environment and corresponding improvements, it is prudent to wait for a shift in sentiment before scaling into a long position. More clarity is needed on the regulatory environment and how this will affect the business model-term before calling a bottom.
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