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

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.