Tencent drops 10% on earnings... what's next?

Eleanor Creagh

Australian Market Strategist, Saxo Bank Group

Tencent ADR tumbled 6.67% in the US after posting its first profit drop in 10 years. At the time of writing, Tencent shares traded in Hong Kong are down 2.92%, falling to a one-year low, but paring back losses from earlier in the session. 

Tencent’s profit fell 2% to 17.9bn yuan while revenue increased 30% to 73.7bn Chinese yuan, failing to meet analyst estimates.
As Saxo Head of Equity Strategy Peter Garnry notes, the weaker than expected numbers come on top of Beijing freezing game approvals nationwide due to the government’s intention to increase oversight over gaming and potential addiction among the population. This was likely the key negative factor, rather than a structural decline in growth due to China’s economic outlook and the trade war. 

Whats next for Tencent?

After the disappointing result, sell-side analysts still maintained a buy rating on the stock but lowered their price targets, with 50 buys, 0 Holds and one sell. The average price target is 476.13 HKD, representing a 46% upside to today’s price. 

The current regulatory backdrop has pushed back revenue. Given 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. It is impossible to predict the timing of regulatory easing without insight into the Chinese regulatory bodies, but it is highly likely resolution will prevail. Given that this is likely to be a temporary issue, it is prudent to focus on the fundamentals for the business when making a long term investment decision. Tencent ranks first in gaming revenue globally and maintains a 52% revenue share of China’s gaming market according to iResearch. This highlights the nature of Tencent’s current problems are due to temporary issues as opposed to structural issues.
In the near term Tencent has 15 mobile games due to be released in the coming quarter, for which the monetisation licenses have already been procured. This could provide respite amid regulatory uncertainty. 

Although gaming accounts for 60% of revenue now, there are other areas of the business that provide long-term growth opportunities for Tencent. In the next five years, gaming revenue is unlikely to be the central driver of revenue. Tencent has long-term prospects in payments, AI, cloud computing, advertising, and media. The heavy investments in long-term growth in new areas like cloud computing, AI, and offline retail may sacrifice margins in the short term but will drive long-term growth and shareholder value. 

Tencent still maintain dominance over the social networking space in China with WeChat reaching more than 1.07bn active users. WeChat represents a core platform of highly engaged social users which is currently being under-monetised. Tencent’s ability to ramp up monetisation on mobile advertising has strong potential due to healthy mobile traffic that is on the rise and strengthening over time, thus driving revenue growth in advertising.

According to Internet World Stats, only 54.6% of the population in China is online compared with 88.1% in the US. As internet penetration increases, it is likely that value of the WeChat ecosystem expands further. 

Tencent ranks second in mobile payments globally and has proven itself to be a worthy competitor to Alibaba, representing monetisation potential. According to McKinsey & Company's report "China’s digital economy – a leading global force" China’s mobile payments ecosystem is already 11 times larger than the US, as these trends continue to emerge it will be critical for Chinese consumers to be online. As WeChat’s user base expands, adoption of WeChat pay will rise also. 

Overall, Tencent remains an exciting company in the long term. The ecosystem contains a variety of interesting businesses with significant opportunities to drive growth and increase profitability for investors. 

As Garnry explains, While Tencent shares are down 30% from the peak, the valuation is still excessive with FY18 EV/EBITDaA at 22.6 compared to Facebook’s FY18 EV/EBITDA ratio at 14.4; in other words, Tencent trades at a 57% valuation premium to Facebook.

As the graph below shows, historically a basket of Chinese tech companies trades at a valuation premium to US tech when comparing P/E ratios. This premium is now the lowest since 2012 which may present an opportunity for long-term investors. 
 
Enlarge
Chinese tech, relative valuation (source: Bloomberg)
Historically Tencent also trades at a valuation premium versus its Chinese technology peers. The below graph illustrates Tencent’s historical P/E versus a basket of Chinese comparables (Alibaba, JD.com, Baidu, Netease). Tencent on a relative P/E basis is now trading below one standard deviation from the long run average percent premium versus its peers. 
Enlarge
Source: Bloomberg
Enlarge
Tencent share price (five-year, source: Bloomberg)

Access both platforms from your single Saxo account.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)