A recent Wall Street Journal article was titled, “Tencent Holdings in Talks For $2 Billion Loan.” I assumed that this kind of headline would not warrant any further attention from any conservative investor out there, but after browsing through Tencent’s (TCEHY, Financial) debt-to-equity ratio, I figured the company was still consuming fairly conservative debt and therefore worth considering.
Including the $2 billion figure or 13 billion å…ƒ ($1 USD to 6.48å…ƒ) in the current total debt of 65 billion å…ƒ would produce a debt-to-equity ratio of 0.65 from 0.54 in Tencent’s December quarterly filing. This ratio can still be considered conservative for anyone seeking to invest in these "high growth" tech companies. Further, this assumption was made thinking that the company would not be issuing any more shares.
Regardless, increasing outstanding shares may also (again) be a negative for a value investor. In this case, I would like to emphasize that, despite Tencent’s growing number of shares, its earnings per share growth did not diminish for the past decade.
This is outstanding, considering that, in contrast, most Standard & Poor's 500 companies would spend billions of dollars to reduce their shares outstanding and demonstrate "growth" in their reported Generally Accepted Accounting Principles (GAAP) earnings per share in quarterly announcements.
Generally, Tencent exhibited good growth numbers in terms of its sales, profits and even free cash flow growth.
OK, it may look like these growth numbers are declining from pre-recession figures, but Tencent’s recent three- and five-year averages demonstrated high growth totals.
In addition, Mr. Market appreciated much of Tencent’s ADR shares in the past five years, too.
Four things about Tencent Holdings Limited
1. Tencent first went public on the main board of the Hong Kong Stock Exchange in June 2004.
2. Tencent is today’s largest Internet service provider in China through its two key social networking platforms, Weixin and QQ (Morningstar).
3. Tencent was founded in 1998 by Ma Huateng, known in English as Pony Ma, and Zhang Zhidong, or Tony Zhang.
According to Forbes, Ma Huateng is currently China’s third-richest man, probably through his undefined stake in the $198 billion company, Tencent Holdings. Zhang Zhidong, on the other hand, retired from working at Tencent in 2014. Retirement came at an early age (43) after serving the company for 16 years. According to Forbes, Zhang Zhidong maintained his 3% stake in the company and is the second-largest individual shareholder.
Finding institutional investors who were investing heavily in Tencent was a challenge since its ADR shares did not provide any information about institutional shareholders, much more in its 2015 annual report. Nevertheless, Morningstar provided a list of best mutual fund performers that invested in China for more than five years.
(Source: Morningstar)
From this list, I selected Fidelity Advisor® China Region Fund I Class and Oberweis China Opportunities, and I included Vanguard Emerging Markets Stock Index Fund Investor Shares. I selected these funds primarily because their long-term returns were above peer average. Vanguard, on the other hand, was selected because of its fund size, $51.5 billion compared to Fidelity’s $1.1 billion and Oberweis’ $104 million.
As shown in the table, investors actually lost money in Vanguard for the past five years. Nevertheless, figuring out its current exposure to Tencent would be interesting.
* Rank is defined as the standing Tencent Holdings represents in the corresponding mutual funds. For example, first means Tencent Holdings is the No. 1 (most invested) stock in the mutual fund.
According to the data I have gathered, both big funds, Vanguard and Fidelity, have Tencent in their top holdings. Further, Tencent was not the reason why Vanguard had this poor long-term return for the past five years. Tencent shares actually returned 30.24% for the past five years.
4. Weixin (微信, “micro letter,” or WeChat) is a social networking app that was launched by Tencent Holdings in 2011. Weixin is comparable to the U.S.’s WhatsApp or probably the Facebook messenger.
Weixin allows its users to download its app for free. Other things that can be done with the Weixin app are “hail a taxi, order food delivery, buy movie tickets, play casual games, check in for a flight, send money to friends, access fitness tracker data, book a doctor appointment, get banking statements, pay the water bill, find geo-targeted coupons, recognize music, search for a book at the local library, meet strangers around you, follow celebrity news, read magazine articles and even donate to charity … all in a single, integrated app.” (source)
Weixin also carries with it the WeChat “Wallet” or payments system whereby Tencent “is experimenting with processing payments offline via QR codes at brick-and-mortar stores, live events, vending machines, restaurants and hotels.”
According to Tencent’s recent annual filing Weixin has a large number of members and is growing, at 697 million monthly active users from 500 million in 2014. This user number indicates that half of China’s population uses Tencent’s online chat app. Interestingly, Facebook (FB, Financial), Twitter (TWTR, Financial) and YouTube are altogether banned in China.
Alibaba (BABA, Financial), another Chinese tech giant company that recorded the world’s largest IPO in 2014 with $25 billion, also wanted to penetrate this niche dug by Tencent. Alibaba produced its own chat app called Laiwang in 2013 and gained about 10 million users in 2014.
It was difficult to retrieve Laiwang’s monthly active users (MAU) in Alibaba’s annual report. Nevertheless, Laiwang’s 2014 MAU number is a fraction of what Weixin had back then.
Besides Weixin, Tencent has a couple of major apps that provide more than 800 million Chinese subscribers. These are Tencent QQ and Qzone.
Some more numbers
Book value and growth
Tencent exhibited great growth in the first half of the previous 10-year period (2006-2011) with a five-year average of 61%. The company logged a moderately slower pace in the latter half of the decade (2012-2016) with average growth of 37%.
Free cash flow and growth (in USD Mil, 1 HKD = 0.15 USD)
Tencent has a three- and five-year free cash flow growth average of 31% and 29%.
Valuations
Seeking value stocks in tech companies can dampen hope secondary to high valuations these companies are being provided. Currently, the Tencent ADR shares are selling for a slightly lower discount to its U.S. peers in terms of the traditional price-to-earnings valuation while selling at a wide premium in terms of price to book value.
The concern in the price-to-book valuation is that Tencent Holdings has been an active acquirer in recent years.
A slight write-down of these goodwill and intangible assets brought by recent acquisitions can bring Tencent’s price to book valuation much higher than the current value of 11. As of Tencent’s recent quarterly filing, goodwill and intangible assets represented just 5% of its total assets.
Intrinsic Value Calculations
Market price action (one-year time frame)
Simple multiple
Converting Tencent Holdings’ earnings per share of 3.06 CNY to USD, I arrived at 0.459 USD. Multiplying this value to multiples 9 to 15 and averaging it gave me an estimation of $6 a share. This value indicated that the current market price of Tencent’s ADR shares is overvalued by 71%.
Capital Asset Pricing Model (CAPM)
Values used that were not included in the table were as follows: Ten-year treasury rate of 1.84%, stock beta of 1.154, equity risk premium of 6.9%, weighted average debt return of 4% and corporate tax rate of 19%.
In this case, current market price of Tencent’s ADR shares was still overvalued by quite a margin. I may have been too conservative in my growth rates (15% and 8%) in this accounting, but this is my "comfort zone." Nevertheless, my calculations indicated that there was no margin of safety at present in trading Tencent’s ADR shares.
Happy Investing!
