Tencent reported 2Q22 results on 17 August. Below, we highlight some of the points from these results that stood out for us:
- In absolute terms, the results were weak (revenue was down 3% YoY to CNY134.03bn [US$19.8bn] – the first time Tencent has reported a decline in revenue, and non-IFRS operating profit fell by 14% YoY). However, this was widely expected after steady downgrades in expectations over the past few months. In fact, while revenue was slightly below expectations, the bottom line was not as bad as initially feared, based on some analysts’ forecasts and Bloomberg consensus analysts’ forecasts.
- Where, at its 4Q21 results, Tencent announced a pivot to focus on cutting out non-profitable businesses and driving efficiencies, a criticism in the 1Q22 results was that there was not much evidence of it in practice. This time (2Q22), there is much more evidence of cost efficiencies driving a better bottom line result than many had expected. Management was clear that this would also be more evident in the quarters ahead.
- Along with clearer evidence of profitability improvement from cost-cutting and cutting low-return revenue streams out, management is also saying that it is now pushing several new revenue-generating initiatives that are likely to impact profitability favourably in the short term. The one initiative management spoke about at some length was the introduction of advertising into its short-form video account platform (its version of Tik-Tok). This, together with the efficiency drive, means Tencent will start to grow earnings in the quarters ahead even without any improvement in the Chinese economy or a major turnaround in gaming.
- The company also said that recent press reports around Tencent selling its stake in food delivery business Meituan were wrong. With regards to unlocking value, management pointed out that Tencent generates mid-to-upper teens US dollar billions of free cash flow p.a. and the combination of its listed (US$90bn) and unlisted (US$50bn-US$60bn) investment portfolio, which the market effectively puts no value on, has to be seen in the context of Tencent’s market cap of US$360bn (39% of market cap). Given its view that the market is not ascribing the appropriate value to the Group, rather than deploy the free cash being generated into expanding the investment portfolio as it has in the past, returning capital to shareholders through dividends and share buybacks are going to be prioritised.
- Management also made several comments about the regulatory situation in China and that it is becoming clearer and more favourable for the business. It described the regulatory environment as having moved from “rectification” last year to “normalisation” today, from which we infer that the business disruption and penalties that characterised the environment for much of last year are behind the Group.
In our view, the general tone of the company was a lot more positive than it has been over the past few quarters. Obviously, a lot remains outside Tencent’s control, but it seems there is now some tangible traction from the actions it has begun to take in response. We are unsure as to whether investors have baked in much of an expectation on this front.
From a valuation perspective, Tencent trades on a 12-month forward P/E of 18.6x – close to the lowest rating at any time in the last decade, before considering that the US$150bn investment portfolio contributes a small loss to reported operating earnings. Note that this forward multiple is based on earnings forecasts that have already been heavily downgraded, implying less earnings disappointment risk. Another perspective on valuation is that if the investment portfolio is deducted from the current market capitalisation, it implies that the rump of the business trades on a free cash flow yield of c. 8%. To put this in perspective, this compares to free cash flow yields of 2.5% and 3.5% for Microsoft and Apple, respectively. This is not to suggest that Tencent should trade at a similar rating to these US blue-chip tech stocks when one considers the risks that have become all too apparent recently of operating in China. The discount has become extreme, however.
In summary, our take would be that the result looks slightly better than feared, and management’s confidence in the prospects for an earnings recovery, even if the macro environment remains as bad as it has been, should be seen positively. We would exercise patience with Tencent, whether through direct investment in the company or via holdings in Naspers and Prosus. The case for the extremely negative investment sentiment surrounding Tencent receding in the months ahead looks stronger on the back of this result.
If you have any questions or would like to discuss the subjects raised in this article with someone at Anchor please email us at info@anchorcapital.co.za.
