Tencent stock: buy and focus on the long term (OTCMKTS: TCEHY)

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Tencent (OTCPK:TCEHY) shareholders have faced multiple headwinds over the past 12 months and the stock price is down more than 50% from ATH in February 2021. Although I don’t want to ignore the macroeconomic and regulatory challenges facing the company, I suggest investors focus on the fundamentals.

In this article, I use the residual earnings framework to value Tencent – ​​and I anchor my calculations on EPS analyst consensus estimates, a WACC of 8.3%, and terminal value growth equal to the expected growth of the Nominal GDP. My analysis calculates a fair value per share of $58.51, which implies a considerable upside of >25%.

About Tencent

Tencent is a leading software and internet technology company based in China. Founded in 1998 by Ma Huateng, who still leads the company as CEO, Tencent has become China’s largest company by market capitalization. The company is active in several business segments, including games, internet payment services, artificial intelligence solutions, social networking services, online advertising and mobile value-added services. In theory, Tencent operates as a holding company with stakes in several subsidiaries. For reference, here is an indicative list of Tencent’s holdings: Link to Excel Spread.

Notably, Tencent is the world’s leading game developer; Tencent’s Weixin/WeChat is The communication leader in China supplier with a MAU of 1,268 million; Tencent’s payment arm, Weixin Pay, is China’s top mobile payment provider with over 1 billion business transactions per day; Tencent Cloud is the second largest cloud provider in China.

Tencent Business Overview

Tencent Investor Presentation, 2022

Financial overview

Tencent has seen incredible growth over the past few years, with revenue growing from $47.3 billion in 2018 to $86.8 billion in 2021, implying a CAGR of over 20%. In 2021, the company generated net income of $13.7 billion, or $1.41 per TCEHY share. Investors should note that Tencent’s net profit margin decline from 21.5% in 2018 to 14.3% in 2021 was mainly due to a one-time abnormal loss of $18.3 billion in 2021, which includes fines regulatory and unrealized losses on the company’s early investment. wallet. According to the company’s financial statements, value-added services, including games and social media, accounted for 52% of Tencent’s total revenue, followed by online advertising, which generated 16% of sales. , followed by fintech and business services accounting for 31%.

Revenue streams from Tencent

Tencent Investor Presentation, 2022

The company ended fiscal 2021 with $41.4 billion in cash and investments and $50.9 billion in total debt. Cash from operations was $27.16 billion. Looking ahead, analyst consensus expects Tencent to increase revenue to $104.5 billion in 2023 and write net income of $24.3 billion, or 2.4 shares. For 2024 and 2025, EPS are expected at $2.88 and $3.38 respectively.

Evaluation

To value TCEHY, I use the Residual Earnings Framework. I think the residual earnings framework is the best tool to value Tencent because: first, free cash flow is distorted due to growth investments; second, multiples do not reflect market value; third, the company pays no dividends. My main assumptions are:

  • I base my EPS estimates on analyst consensus through 2025.
  • I apply the CAPM model to derive the cost of equity and in a second step I calculate the WACC based on the trading leverage. My calculations return a fair WACC of 8.3%, which is very much in line with my intuitively estimated required return.
  • For the terminal growth rate, I apply the expected nominal GDP growth at 3.5%. While I think growth equal to estimated long-term nominal GDP growth underestimates Tencent’s potential, I want to be conservative in my assessment.

Based on the assumptions above, my calculation returns a base target price for Tencent of $58.51/share, implying that TCEHY looks undervalued by around 25%.

Tencent stock valuation

Consensus of analysts; Author’s calculations

Investors may have different assumptions regarding the required return of TCEHY and the growth of terminal activities. Thus, I am also attaching a sensitivity table to test different hypotheses. For reference, red cells imply overvaluation relative to the current market price, and green cells imply undervaluation.

Tencent Stock Sensitivity Chart

Consensus of analysts; Author’s calculations

Risks

Investors should be aware of the following downside risks that could cause TCEHY stock to deviate significantly from my base price target of $58.51/share: 1) China’s economy is currently facing multiple transitory headwinds , including inflation, the real estate crisis, Covid-19 shutdowns in Shanghai and Beijing and the potential for a global recession. While most of the challenges are arguably priced in, if the slowdown in the Chinese economy proves more severe than expected, Tencent’s business outlook should be revised accordingly. 2) Over the past 12-15 months, the CCP has shaped a stricter regulatory environment for major Chinese tech companies. While the CCP recently said the party would support platform companies such as Tencent, uncertainty remains and regulatory pressure persists. 3) Investor sentiment towards risky assets in general, and Chinese equities in particular, is very negative in June 2022. As long as low investor confidence and risk appetite persists, TCEHY will have upside potential limit.

Conclusion

Although Tencent will likely continue to face low investor confidence until key macroeconomic and regulatory challenges are resolved, the company’s size and fundamentals are too attractive to ignore. Comparing Tencent’s discounted earnings valuation with the company’s market valuation, I am confident that most headwinds are fully present and investing in TCEHY at current price levels is significantly reduced. That said, long-term investors might want to view the depressed stock price as a buying opportunity. I assign a buy recommendation and a fair base target price of $58.51/share.