Tencent Holdings (TCEHY, Financial) (HKSE:00700, Financial) is a Chinese tech investment holding company. It owns WeChat, which is sometimes called the "Facebook (FB, Financial) of China," and it is described as a technology-focused Berkshire Hathaway.
The firm has grown revenues stupendously over the past few years, and a $10,000 investment into Tencent stock in 2004 at its IPO would be worth $7.9 million today. However, now the firm's stock price is facing serious trouble due to the regulatory crackdown on big tech in China.
According to the Wall Street Journal, the firm could face a record fine for breaking anti-money-laundering rules, which has sent the stock plunging down even further.
WeChat Pay, which is one of the most popular payment methods in China, allegedly allowed the transfer of funds for illicit purposes such as gambling, which is banned in mainland China. Tencent also failed to check the identity of merchants, individuals and the source of their funds.
Tencent crashed 10% on the news, but more worryingly, the stock is down 59% from its highs in February 2021. Is Tencent now a deep value investment, or will it turn out to be a value trap?
The positives
Tencent is the market leader in social media and gaming in China. They have the number one mobile chat company WeChat, which has over 1.2 billion users, and are number one in China for both PC and mobile gaming.
In addition, Tencent is the second-largest cloud services provider in China, behind Alibaba (BABA, Financial) Cloud and close to Huawei Cloud in terms of market share. This rivalry draws parallels to Amazon (AMZN, Financial) Web Services and Microsoft (MSFT, Financial) Azure in the U.S. cloud industry.
The firm also operates the "Zoom (ZM, Financial) of China," Tencent Meetings, which has become the largest app for cloud conferencing in China.
Source: Tencent investor presentation
Incredible investments
Tencent has one the world's most lucrative tech investment portfolios with an incredible track record of success. It holds 83 companies worth over $1 billion in its portfolio. The even more impressive thing is that 52 of these companies are unicorns (private companies worth over $1 billion).
Tencent's investment portfolio includes major companies such as Tesla (TSLA, Financial), NIO (NIO, Financial), Spotify (SPOT, Financial) and many more.
Strong financials
Revenue has grown 13.5% year-over-year, which is great for such a large business, but quarter-over-quarter growth is only 3% thanks to slowing in advertising, which was down 1.5%.
The company's margins are fantastic and stable, which is characteristic of a software-based tech company. 4The gross margin is 4.1% and the operating margin is 28.7%.
The firm has a strong balance sheet with $40 billion in cash, and they even repurchased approximately 5.6 million shares at a cost of an massive 2.2 billion Chinese Yuan ($334 million) during the third quarter of 2021.
Is the stock now deeply undervalued?
In order to value Tencent stock, I have plugged the latest financials into my discounted cash flow model. In addition, I have looked at the fine of $2.8 billion Alibaba received for violating anti-trust regulations and subtracted this from Tencent's balance sheet. This is only an estimate, but at least it should give some measure as to how well Tencent's business can stomach a large fine. With close to $40 billion on their balance sheet, even a massive $2.8 billion fine barely dents their financial position.
Using the assumptions and calculations above, I get the fair value estimate for Tencent of $60 per share, making it approximately 39% undervalued at $40 per share. Thus, the stock has a fairly large margin of safety for the long-term investor who has a strong stomach for market fluctuations and regulatory issues.
The firm is also significantly undervalued according to the GF Value line, a unique intrinsic value estimate from GuruFocus which takes into account a stock's historical earnings multiples, its historical shareholder returns and analysts' estimates of future business performance.
Final thoughts
Tencent is a dominant market player across social media, communications, gaming and even the Cloud in China. The firm is poised to ride a number of trends to continue its growth trajectory. The major risk to the company and all Chinese big tech firms is the government's regulatory crackdown, which has so far been all bark and no bite.
The good news is, Tencent's robust balance sheet and diverse range of international investments in stocks such as Spotify, Tesla, etc. should help to insulate the firm slightly. The stock is 39% undervalued by my estimates, even with a large $2.8 billion fine that could be applied. Thus, I think this could be an opportunity for a long term investor who has been looking for a good entry point for this stock.
If you like the stock but want more downside protection, you could invest via Prosus (XAMS:PRX, Financial), a tech holding firm which owns a substantial stake in Tencent. This is the method by which Mohnish Pabrai (Trades, Portfolio) has invested in Tencent, according to interviews.
As a reminder, this is not financial advice. All opinions in this article are my own. Good luck investing!
