Did Tencent make a T?

Is Tencent still strong? Its performance is as stable as Mount Tai, and this financial report is truly flawless, so let's briefly discuss the data, along with its valuation and two small episodes in the report, which seem to be more interesting than Tencent's performance itself.

1

First, let's talk about two interesting small episodes in Tencent's financial report:

The first episode mentions that the company's share of profits from joint ventures and associates in the second quarter was 4.5 billion, down from 7.7 billion in the same period last year, and 6.3 billion under non-International Financial Reporting Standards, down from 9.9 billion in the same period last year. The main reason for the decline in this profit segment is a decrease in estimated earnings from a large joint venture.

Tencent currently holds very few large joint ventures that are publicly listed, mainly Pinduoduo and Kuaishou, and the one being referred to here is likely Pinduoduo.

This might also explain why Chinese concept stocks surged overall last night, while Pinduoduo's performance was relatively weak.

However, this is understandable, as Pinduoduo's management strongly warned in last year's second quarter report that high profitability was not sustainable. The second quarter of last year was still a high base quarter, so the decline in Pinduoduo's profitability in this year's second quarter should have been expected; the only question is how much the decline would be.

The second small episode is that Tencent mentioned it increased several investments in the second quarter, mainly in local lifestyle service platforms, game development, financial technology, and other internet-related businesses.

A source has informed me that the local lifestyle service platform involved in these investments is Tencent purchasing a portion of Meituan shares through the market.

The total investment amount is approximately 43.5 billion, and Tencent's newly acquired Meituan shares will not exceed 3.5% of Meituan's total shares, as it already holds 1.5% of Meituan shares. If the total holding exceeds 5%, it will trigger the information disclosure mechanism of the Hong Kong Stock Exchange.

Moreover, the 43.5 billion investment includes wealth management investments and corporate investments, with the amount expected to be invested in Meituan around 10 billion.

On November 16, 2022, Tencent announced in its third-quarter report at that time that it would distribute its Meituan shares to shareholders in the form of a special dividend. As of the market close on January 4, 2023, shareholders holding Tencent shares were eligible to receive these Meituan shares, with the actual receipt date being March 24, 2023, and Meituan's closing price on November 15, 2022, being HKD 166.

If the information I received is accurate, then Tencent has effectively made a trade after nearly three years, selling at 166 and buying back at over 120, while saving nearly three years of time cost, which is quite a good "trade."

This investment is also quite intriguing.

On one hand, Tencent's major shareholder has recently been vocal about selling approximately USD 4 billion worth of Meituan shares. Although it hasn't been explicitly stated, everyone knows that one of the reasons for the sale is that Meituan's overseas delivery platform Keeta operates from Hong Kong to the Middle East and then from the Middle East to Brazil, all of which are territories of Tencent's South African major shareholder's wholly-owned or controlled delivery platform Meituan is essentially chasing after Naspers.

At this time, Tencent's move to buy into Meituan is, to some extent, a form of support. Of course, Tencent's increased holdings also occurred in the second quarter, while the South Africans shouting about selling Meituan was in July, but their relationship is intricate and the circle is quite small. It is a normal process for South African shareholders to communicate through the board and internal informants before making statements to the media.

On the other hand, JD.com has launched an attack on Meituan. Both companies were key investment targets for Tencent and have gone through stock splits, yet they still maintain a tenuous connection. If Tencent buys into Meituan, it is also a statement of attitude.

Additionally, after entering June, JD.com's food delivery service has basically quieted down. Interestingly, the JD.com financial report released today shows that marketing expenses in the second quarter exceeded 27 billion, an increase of 15.1 billion compared to the same period last year. Inter-segment business data also indicates that new business costs were 14.4 billion, most of which were food delivery subsidies. This means JD.com's food delivery service burned nearly 15 billion in a single quarter, resulting in what we see now.

Who still cares about JD.com's food delivery?

Now it's a duet between Taobao Flash Sale and Meituan, back on a familiar stage with familiar sounds. Regardless, this is a moment for Meituan investors to catch their breath:

The fierce competition has ended, and the familiar battlefield may be long, but at least it is with familiar opponents, and a more respectable one at that, with a more regulated way of engaging in battle.

If Tencent's investment is genuine, it may indicate Tencent's strategic intentions and showcase its strategic judgment.

2

Now let's talk about Tencent's performance itself.

Revenue was 184.5 billion, a year-on-year increase of 15%, far exceeding market expectations, with growth accelerating for five consecutive quarters.

Gross margin was 56.9%, possibly a record high? I haven't tracked data before 2023, but at that time, advertising was mainly media advertising, which had a lower gross margin. Financial technology and enterprise services were still in the early stages of scaling, with much lower gross margins. The gross margin for value-added services might be similar, but overall gross margin was likely not as high as it is now.

Non-IFRS profit was 63.05 billion, with a year-on-year growth rate of 10%, lower than the revenue growth rate. Is this the only flaw? Not really; it is actually the result of significantly increased capital expenditures, with this quarter's capital expenditure at 19.1 billion, a year-on-year increase of 119%. Not increasing capital expenditure during a critical period for AI would be the real issue.

Even with high capital expenditures, the quarterly net profit margin still climbed to 34.2%, reaching a historical high.

For a company of this scale, a net profit margin exceeding one-third is quite significant; it is essentially a money-printing machine concept.

At this point, it is easy to draw parallels with Meta after the downturn in 2022:

Similar revenue growth acceleration, similar gross margin improvement, similar profit growth acceleration (not considering capital expenditure factors), and similarly defending against strong enemy attacks, with the opponent being the same—Douyin/TikTok, and similarly strong growth in advertising business Meta has risen to 9 times its lowest point and more than 2 times its pre-adjustment high; Tencent is just over 3 times its low point and has not yet reached its pre-adjustment high.

This difference is largely due to their backgrounds and the valuation environment of the capital markets, both of which are excellent.

Marketing expenses were 9.4 billion, accounting for 5.1% of revenue, with the year-on-year decline mainly benefiting from improved operating leverage, while the quarter-on-quarter increase was primarily due to increased marketing efforts for new games and virtual currency.

Administrative expenses were 31.9 billion, with an absolute increase but a significant quarter-on-quarter decline in revenue proportion.

Looking at it by business segment, value-added services are stable, marketing services are strong, and financial technology enterprise services are rising.

If viewed over a three-year dimension, compared to Q2 2023, this trend is even more pronounced, with value-added services growing by 23% compared to two years ago, with an annualized CAGR of about 11%; among them, domestic games grew by 27%, with an annualized CAGR of about 13%; international games grew by 48%, with an annualized CAGR of about 22%, serving as the core driving force; social networking grew by 8%, with an annualized CAGR of about 4%, representing traditional mature businesses that have entered a stable development phase, which are very suitable for cash flow discount valuation.

Marketing services grew by 43.2%, with an annualized CAGR of about 20%, undoubtedly also being the core driving force behind overall revenue growth.

Financial services grew by 14.2%, with an annualized CAGR of about 7%, which is moderate, but benefited from a significant improvement in gross margin.

In summary, although international games are also a core driving force for revenue growth and financial services have significantly boosted gross margins, only the marketing services business serves as a dual driving force for both revenue and gross margin improvement, making it the primary contributor to Tencent's revitalization over the past two years.

The company's balance sheet remains robust, with a quarterly current ratio of 1.25, operating cash flow of 74.4 billion, cash and cash equivalents and deposits of 468.4 billion, and free cash flow of 43 billion, mainly due to capital expenditures consuming part of the operating cash flow.

3

This is a comprehensive, above-expectation, and flawless financial report. Now we consider, what risks does Tencent face?

Social networking is the business model with the deepest moat in the history of the internet, and Tencent's management team is very excellent, with capabilities in managing this business even surpassing those of Meta However, Tencent hardly relies on social networks themselves for profit. The stories of making money through QQ Space, QQ Show, and levels in the early years are no longer attractive. Its core revenue comes from content, advertising, and enterprise services, while social networks are merely the carriers for its services.

There are many categories of content, including games like Honor of Kings, news websites like Tencent News, video platforms like Tencent Video, online literature reading like Yuewen, and music streaming like Tencent Music.

Advertising now mainly relies on video accounts, media networks, and social networks.

Enterprise services include cloud services, digital payments, and wealth management.

Apart from content categories, Tencent hardly charges users directly; instead, it makes money by providing services to enterprises. Content payment mainly depends on the quality of the content itself, and the proportion of paying users among its service users is still less than 10%—the highest, Tencent Music and Video, have less than 125 million paying subscribers.

At the same time, the services it provides to users are so important and frequent that Tencent's user stickiness and stability are extremely high.

Stickiness and stability are two different things. Social networks have high stickiness but may not have high stability; stability actually depends more on the level of user recognition.

Meta's core business model is based on advertising, which tends to disturb users more. Users can't live without it, but the experience is not as good as WeChat.

Therefore, in terms of business model, Tencent has achieved almost perfection:

A super large and powerful social network, while causing almost 0 disturbance to users, makes the lifecycle of this network extremely long and stable.

So what are Tencent's main risks?

The first risk is that under the new technological revolution, significant changes in smart devices and interactions may give rise to new social communication methods. Under the AI technological revolution, this risk still objectively exists and is on the rise. This is why Tencent must invest heavily in AI, not only for business itself or for offense but also to go all in.

In fact, the era of mobile phones as the center of human smart devices will not last long. We may soon see new smart devices replace the current status of mobile phones, just as mobile phones replaced computers. This trend is irreversible; we just cannot determine what the next big device will be—smart robots? Smart glasses? Or perhaps a more fragmented smart device experience, where mobile phones remain one of the centers but not the only one.

The second risk is that there may be problems with content creation, which is its core revenue source. Tencent is not a company with exceptionally strong content production capabilities. There are companies in the market that are better at making games, better video platforms, and better news websites. However, combined with social networks, Tencent only needs to achieve a content capability score of 8 to achieve a long-term effect score of 10. Is it possible that Tencent's content production capabilities may face issues in the future? Content production itself is inherently unstable; no Hollywood company can guarantee a blockbuster every year, and neither can Tencent Video or Tencent's gaming department Or Tencent's content is still very good, but there will always be some astonishing content production companies emerging in the market, whether in games, videos, or other categories.

4

Among Tencent's various revenues, different businesses are at different stages of development. For example, the social network revenue in the value-added services segment has already entered a stable period, with an annual growth rate of around 4%, which is suitable for discounted cash flow valuation, while advertising, gaming, and financial services still have significant growth potential and can be valued using the PE method.

In the past 12 months, Tencent's social network revenue was 125.5 billion yuan, with a gross margin of 60% for the entire value-added services segment, and the social network is estimated to be similar, achieving about 25% free cash flow, generating approximately 30 billion yuan in free cash flow per year. Assuming it maintains this 4% growth rate perpetually, it can be valued at 780 billion yuan using an 8% discount rate.

The gaming business had a revenue of 219.7 billion yuan in the past 12 months. This segment is relatively mature in China, while international business is still growing, with different gross margins. We uniformly apply a net profit margin of about 20%, corresponding to approximately 43.9 billion yuan in profit. Currently, overall revenue still has about 10% growth, while profit growth is estimated to reach around 12%. Considering the stability brought by its social network synergy, such platform-based gaming companies are generally valued at 20-40 times internationally. Given our objective environment, a PE of 25 times corresponds to an estimated valuation of about 1.1 trillion yuan.

Advertising revenue in the past 12 months was 132.7 billion yuan, with a gross margin of 58%. The net profit margin is expected to reach 30%, corresponding to approximately 39.8 billion yuan. With its current revenue growth rate (around 20%), profit growth is estimated to be around 25%. A PE of 25 times corresponds to an estimated valuation of about 1 trillion yuan.

The financial services business had a revenue of 219.6 billion yuan in the past 12 months. Internationally, cloud computing companies can be valued at 10 times PS, while financial service platforms generally range from 5-12 times PS. Here, we conservatively use 6 times PS for valuation, corresponding to approximately 1.3 trillion yuan.

The fair value of the company's listed and unlisted assets is 714.3 billion and 342.3 billion yuan, respectively, totaling 1.05 trillion yuan.

The total market value summed up from the above items is 5.23 trillion yuan. The company has about 470 billion yuan in cash, cash equivalents, and deposits, translating to a valuation of 300 billion yuan, bringing the total valuation to approximately 5.53 trillion yuan, corresponding to HKD 6.04 trillion, with a reasonable price of about 660 HKD. Considering that Tencent is expected to have about 10% revenue growth and 15% net profit growth in the next 12 months (excluding capital expenditure impacts), the 12-month target price is 720 HKD.

Risk Warning and Disclaimer

The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account individual users' specific investment goals, financial conditions, or needs. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investing based on this is at one's own risk