Nishlen Govender, Portfolio Manager, Citadel
12 November 2018: Since Naspers, the JSE’s highest market cap stock, announced in March that is was to reduce its holding in Tencent by 2%, the Chinese tech company has received considerable attention. Notably, Tencent shares have lost a third of their value so far this year.
So we need to ask: Is this price slump justified or does it reflect an outstanding buying opportunity?
Many in the investment world have become fatigued by the Tencent story and may end up undervaluing aspects of this business which we believe are truly significant. We’d like to look at just what makes this company different from others, both locally and globally, given that it operates in a complex region and an even more complex sector.
Let’s first look at what Tencent does.
According to the group’s website, Tencent Holdings is a leading provider of internet value-added services in China. While this statement is completely true, it underestimates the scale of services across which the business operates. The group offers digital content in the form of video, music, online literature, sports and live broadcasts (among many others). It also has a significant gaming operation across various platforms which include both online games, mobile games as well as titles that can be bought or downloaded and played offline.
There is also an online advertising business that companies can use, together with social media platforms and a fast-growing payments platform. Although not mentioned much, we should also include digital services which include cloud storage, browsers as well as a banking facility. Compared to a Western digital provider this business operates across regions and could, therefore, be considered to be a combination of Apple, Google, Facebook, PayPal, Electronic Arts as well as Steam (a popular game distribution platform).
While this significant scope is important, it is only relevant if the company is able to attract users and consumers to its platform, otherwise it is just a gargantuan technology company with a limited ability to achieve revenue and earnings.
So how does Tencent stack up in terms of attractiveness?
As a reference point: Facebook has 2.2 billion monthly active users while YouTube has 1.5 billion, WhatsApp has 1.5 billion, Instagram 800 million and Twitter 300 million. These are the behemoths of social media with significant user numbers relative to the global population. QQ, one of Tencent’s messaging services which also hosts a number of different services, features 800 million users while WeChat, another messaging service with global reach, has 1.1 billion users. Q Zone, a social networking platform akin to Facebook, has 550 million users while Tencent’s online games platform, app store and mobile payments businesses are all number one in China.
These figures speak to a business that is dominant across virtually all viable segments of internet services. What makes this truly remarkable is that 96% of its revenue comes from China alone, a fact that underscores to the group’s shear dominance in terms of market share given the size of the Chinese population.
This point is crucial and highlights the dominance of the company in what is a closed economy in terms of internet services. Even now, in 2018, companies like Facebook and Google cannot operate in China, hence the surge in users for Chinese derivatives like Tencent as well as other companies such as Baidu, a browser akin to Google. China-based companies work with the country’s government to regulate users and content, and receive investments from government for developing Chinese business. This fact creates significant barriers to entry into the market, which assists the likes of Tencent.
And while we do think Western competition will gradually enter the Chinese market – Google and Facebook in particular have spent a great deal of time trying to gain Chinese exposure through appeasing the government – as yet, this has not come to fruition. In the interim, Tencent has permeated so many parts of people’s lives that it is hard to imagine that these users will simply switch should a new entrant emerge.
When Tencent houses your messaging, internet browsing, video streaming, gaming, literature, social networking, payments and even functions that assist your business – such as advertising – it is difficult to leave that ecosystem. Tencent is also a global market leader on various fronts, including its monetisation of WeChat which is a model for how many analysts believe Facebook could monetise WhatsApp in future.
Should investors include Tencent is their portfolios?
The Tencent share price may have fallen, but this does not reflect a reversal of its fortune. After years of spectacular revenue and profit growth as well as a steady increase in users, the company reported a quarterly profit loss for the first time in 10 years. This slip came as a result of once-off events relating to the approval of games and the perceived slowdown of gaming revenue.
While certain market segments have matured and are moving ex-growth, other parts of the business (ex-gaming) are beginning to develop revenues and profits with good growth potential. Furthermore, the share price slide can also be attributed to an emerging market slump with markets punishing any counter that has disappointed, even if in the very short term and for non-recurring issues.
Our stock selection process aims to identify globally great businesses. We assess companies across various facets including market share, economies of scale, barriers to entry, brand loyalty, elasticity of demand and the competitive landscape in which it operates. From this process we are able to identify companies that we believe are globally great ones, such as Berkshire Hathaway, Google and Visa.
It is clear that Tencent, although an emerging market company with strong ties to China, is a globally great business from various perspectives. There is regulatory pressure from the Chinese government that prohibits external competition, it commands brand loyalty and has a captive audience. Tencent’s significant market share and low capital requirements mean that the group is able to maintain substantial margins and return on equity and capital, all while it continues to dominate across various platforms that operate synergistically in people’s lives. We believe the group is also sufficiently diversified and has opportunities to expand offshore in time.
From a valuation perspective, this represents an excellent time to enter the stock given the market’s misunderstanding of the business as a whole, especially with respect to its future prospects. For South African investors, the access to Tencent is via Naspers. At R2700, Naspers is currently trading at a 40% discount to our sum-of-the-parts valuation of R4500, indicating the potential pick-up available to investors.