Strategic Recommendations for Improving the Share Price of Tencent Holdings

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Shubhra Ghosh's picture

Business Context

Tencent Holdings Limited is an investment holding company. The Company and its subsidiaries are principally engaged in the provision of Internet and mobile value-added services (VAS), online advertising services and e-Commerce transaction services to users in the People’s Republic of China. The Company operates in three major segments: social media services, games and e-Commerce transactions. It also engages in the provision of trademark licensing, software development services and sales of software. Its subsidiaries include Tencent Computer, Tencent Technology, Shiji Kaixuan, Tencent Cyber Company Limited (Cyber Tianjin) and Tencent Asset Management Limited among others1. The diagram below summarizes Tencent’s businesses and their respective year-on-year revenue growths till Q3, 2014.

Macroeconomic Shifts

In the recently ended quarter, the company’s performance has been influenced by several macroeconomic shifts. Three of these deserve a special mention.

  1. The games division of Tencent received a marked decrease in the number of people due to an update issued by iOS, which requires players to log-in first before playing the game. Currently, around 65% of Tencent’s mobile games are based on iOS which caused revenues to tumble.
  2. The company is shifting its focus from legacy games to casual games to drive mobile user growth. This may be a good move, except that casual games do not help earn as much revenue as legacy games.
  3. The company’s e-commerce division which was tied up with JD.com is experiencing difficulty because of the massive IPO of Alibaba due to which analysts are rather bullish about the 3rd party businesses that Alibaba drives rather than the 1st party businesses of JD.com

Tencent’s Financial Overview1

Tencent’s Y-o-Y revenue growth has been 28% which is 1% point less than the Wall street estimates of 29%. The company has maintained an impressive gross margin of 64% and an operating margin of 38%. The last 12 months’ EPS growth too has been impressive at about 39%.

Potential Opportunities

Some of the potential opportunities for Tencent lie in the fact that the firm has a huge user base in its social media platforms WeChat and QQ (400 million+). The company has delivered flawless execution on extending its WeChat ecosystem from a simple voice messenger to a comprehensive SNS platform with ecommerce, mobile payment, wealth management, taxi and air booking. However, it is perhaps holding back monetization to some extent while focusing more on user experience and platform activity. But the 400 million+ user base throws a huge opportunity to the firm to monetize its content nevertheless.

The second opportunity lies in a stronger focus in the experience based legacy games. And the third in tapping domestic and international customer base for increasing their WeChat and QQ revenues.

HOLT Lens Statistics

The HOLT methodology suggests that the stock is highly undervalued with an upside potential of 48%. The HOLT warranted price is HKD 176.15 as opposed to its current price of HKD 118.9.

The Relative Wealth chart shown below suggests that Tencent has been able to achieve returns consistently above the cost of capital. Even by the fading effect taken into consideration, the HOLT forecasted CFROI is over 20% which is impressive. However, the CFROI is continuously decreasing which must be addressed by Tencent. The asset growth chart shows that the asset growths haven’t matched the CFROI due to which there are small kinks in the total shareholder’s return as highlighted by the red circles.

In the sales, margins and asset turns charts we can see that Tencent’s sales record has been highly volatile. Recently, both sales and margins have followed a sharp downward trend indicated by the red arrows. The combined effect of these help explain the recent downward trend of CFROI too which must be addressed.

In the valuation metrics shown in the diagram below, we can see that the actual versus warranted prices have moved in sync with each other except between 2008 and 2010 and 2011 and 2013. The price differential has again started re-surfacing at the far right end of the graph which indicates that the stock is undervalued and Tencent needs to address this. The economic PE ratio has been consistent with the internet software industry. However, the Price to book ratio has been highly volatile. So far this has mostly been good for the firm because this ratio has stayed above the industry average.

The price tracking chart below shows a major mismatch between the HOLT warranted price and the actual price band since 2009 as shown in the below diagram. This, perhaps is the indication that the market is not perceiving Tencent Holdings in its fullest potential. The peer comparison chart plots Tencent somewhere close to the 70th percentile zone. This once again hints the fact that Tencent has failed to convince its shareholders about its actual value.

Recommendations

A common thread connecting the above observations is Tencent's inability to unearth the true potential in its huge customer base. A measure to monetize them would provide a huge boost to its revenue stream. Consequently, it needs to re-align it gaming business and e-commerce to drive its top line. An attempt should be made to integrate the social media and e-commerce business in the future. The three recommendations to achieve the above are as below:

Invest Strategically in JD.com

JD.com's biggest selling point is its nationwide fulfillment centers and its "last mile" delivery. Apart from large warehouses, JD.com has 1,620 delivery stations in 495 cities across China. More than 70% of its sales can be delivered on the same day or the next day. Right now, JD.com makes most of its money from its original business of selling consumer electronics and home appliances. But it is a low-margin, highly competitive business. In 2013, electronics sales accounted for more than 80% of JDcom's revenue and just 45% of total gross profit.

In 2010, JD.com started to encroach on Alibaba's turf, pitching its delivery infrastructure to third-party sellers driving impressive profits. In 2013 alone, the third party sellers grossed one third of JD's profits by accounting for just 25% of the products available for sale! But a fight against Alibaba would not be easy due to its sheer size. This is where a strategic investment from Tencent could be crucial. Just ahead of JD.com's IPO, Tencent bought a 15% stake in JD.com. That offers JD.com a prominent access to Tencent's WeChat and Mobile QQ social-media platforms, which together boast around 400 million monthly active users. An integration of these two platforms could do wonders by driving traffic to purchase from JD.com.

Monetize WeChat

Tencent's 400 million+ users alone present huge opportunity to drive revenues. We are already familiar with how WhatsApp and Twitter have leveraged their businesses to monetize their businesses. Tencent need to start monetizing its customer base too. A few heads-up in this direction would be - Advertisements (which in fact needs an aggressive move from Tencent) to charging a premium for the account owners. Further, as mentioned above, if Tencent can find a way to tie up with JD.com, it would be an excellent model to follow.

Strengthen Legacy gaming business

For the third-quarter in 2014, Tencent’s total revenue grew 28% from a year ago to 19.8 billion yuan, 4% below the consensus. Gaming was the culprit, growing only 2% from the second-quarter. Smartphone gaming revenue was even more troubling, falling by 13% sequentially. “Tencent’s mobile game transition from casual to mid- to hard-core games also resulted in weak performance. Gaming constitutes over half of Tencent’s total revenue so this is an extremely important area for them to focus on.

While in presence of maturing legacy titles, Tencent has made a shift to the lighter, casual games, the profitability has been hit. This means Tencent will have to sell more number of games to earn an equivalent revenue. This would be difficult because the entire Chinese Game industry is experiencing a slow-down. Thus a shift to strengthen the legacy gaming deserves the utmost attention, because they are high profit products which would strengthen the firm's bottom-line significantly. In light of the recent bearish sentiments driven by the Wall Street Analysts, a strong bottom-line would be the first step to prove to the investors the potential of Tencent, in order to drive up the share prices.

Following the above steps should be the starting points to arrest the share price fall and to signal the latent strength of Tencent's user base to earn the shareholder's confidence.