Tencent: Close To Breakout With Golden Share Catalyst (OTCMKTS:TCEHY)

Tencent (OTCPK:TCEHY) is the largest social media and gaming company in China. The country has the largest population in the world at approximately 1.4 billion people, which is over four times that of the U.S. Therefore it’s no surprise that Tencent’s WeChat service (which is basically like WhatsApp on steroids) has ~1.39 billion monthly active users. In addition, Tencent owns/licenses popular gaming brands such as League of Legends China, Call of Duty China, and FIFA China. But that is not all Tencent has the second largest cloud business in the country and approximately $75 billion in a series of technology investments from Tesla to NIO, Spotify, and many more.

Tencent is arguably the most diverse and strongest technology company in China. In previous posts on Tencent, I’ve discussed its business model and financials in great detail. In this post, I’m going to break down the technical chart of Tencent and reveal some recent positive news that could act as a catalyst. To top of this post I will also update my valuation model on the stock and reveal its “fair value”, let’s dive in.

Technical Analysis

Generally, when analyzing a stock I review the “fundamentals” only which include the revenue, earnings, etc. However, I believe it makes sense to also combine this with a “technical analysis” of the charts to understand historic buy points and patterns in trader behavior. If the chart below looks confusing, don’t be alarmed I will walk you through it. On the left side, I have added a “Fibnoacci Retracement” indicator, these colored lines represent various “support” and “resistance lines”. Starting at the bottom right, I have added a “stock price floor”, at ~$16/share which is the same level as a strong consolidation zone back in 2016. This is a “worst case” scenario, but given the recent positive catalysts, I don’t believe it will reach that point.

Continuing up the right side of the above chart, we can see Tencent’s stock price bounced off the “Buy Point 2” support line, before shooting higher, with strong bullish momentum. Its stock has nearly doubled over the past few months, from approximately $25/share in October 2022, to close to $50/share by January 2023. Tencent is now stroking a resistance line, at ~$48/share and is close to a breakout. This will require a positive catalyst to move higher so it would make sense to wait for the price to be at least 1 green candlestick above this resistance line.

On the second chart above, I have zoomed in on the right side. We can see the stock price is trading slightly below the 200-day moving average and thus will likely move higher. I have also added another indicator called a “MACD” at the bottom. Generally when we see the two lines cross over a change in stock price direction occurs. We can see this crossover previously happened in July 2021, when Tencent’s stock peaked before plummeting. We are now seeing the red and yellow lines approach a crossover point. We are not there yet but close to a breakout. A positive catalyst could help ensure a break out such as a strong earnings report or positive news on U.S-China relations. I will dive into a few recent positive catalysts in the next section.

Positive News Catalysts – Golden Shares

Taking a step back Chinese stocks were considered to be “uninvestable” by the consensus of investors due to the crackdown on Chinese stocks and possible delisting. However, as I mentioned prior Tencent’s stock price has doubled over the past few months. This goes to show that being a “contrarian” investor can be a solid strategy, but there have also been some positive news catalysts.

It has been reported that Chinese technology giant Alibaba has recently had “Golden Shares” purchased by the Cyberspace Administration of China through a subsidiary of the company. These “golden shares” give Chinese regulators a bigger say in how this company is run and likely include a board seat. Now although some people may see this as intrusive and negative, I actually believe it will be a positive for the companies. The regulators now have a vested interest in the success of the business.

The state regulator is expected to take a similar approach with Tencent, purchasing “Golden Shares”. This is expected to be done through an entity known as “Kuaishou” which is a short-form video platform similar to TikTok or ByteDance’s Douyin.

SEC Progress – Positive Catalyst

Chinese stocks have not just been impacted by regulatory challenges in their own country, U.S regulators have also been cracking down on the companies. The SEC previously made a “hit list” of Chinese companies to be delisted from U.S exchanges, if they didn’t disclose their detailed accounts. This news sent shockwaves through the market and many Chinese stocks plummeted. A positive is the SEC has made progress in its talks with China and a delegation from the Public Company Accounting Oversight Board [PCABO] flew over to Hong Kong in September. These regulators managed to interview Chinese auditors and review financials from top accounting firms such as PwC (China) and KPMG Huazhen. Now although the final report hasn’t been released yet, cooperation is progress. In general, Tencent is not directly affected by these measures as the company actually trades “over the counter [OTC]” in the U.S. However, a rising tide tends to lift all boats and positive news could also pave the way for Tencent to list on the New York Stock Exchange, which should improve liquidity in the business.

Advanced Valuation

Valuing Tencent is fairly challenging as it is a complex company with billions of dollars in investments. However, as a baseline, I have plugged its latest financials into my discounted cash flow model. In the previous (third quarter) of 2022, Tencent reported revenue of $19.7 billion (RMB140.1 billion) which plummeted by 2% year over year, but this did increase by 5% sequentially. These underwhelming growth numbers were mainly driven by a pullback in advertising spend and a cyclical downturn in the gaming market, which has been seen globally. I believe these are only short-term headwinds and Tencent’s market position is unchallenged. Thus I have forecast 15% revenue growth for next year. Then in years 2 to 5, I have forecast 19% revenue growth per year. This may seem optimistic but in 2021, Tencent grew revenue at 19% over the year and in 2020 it grew revenue at a rapid 37% year over year.

To increase the accuracy of the model, I have capitalized R&D expenses which has lifted net income. In addition, I have forecast a pre-tax operating margin of 24% over the next 7 years, which is 1% higher than the software industry average. I expect this to be driven by economies of scale benefits and as a result of a series of cost-cutting initiatives. In the third quarter of 2022, Tencent reported that it had slashed headcount and improved its server utilization to lower operating costs and boost margins. For my full financial analysis on Tencent, you can check out my prior post, I will do an update at the next earnings report.

Given these financials and forecasts, I get a fair value of $58/share, the stock is currently trading at ~$47/share and thus is ~20% undervalued.

Its stock also trades at a price-to-sales ratio = 5.88, which is nearly 89% cheaper than its 5-year average.

Risks

Chinese Government/Recession

Although there have been a few positive news reports recently regarding the Chinese government, the risk of intervention is still there. Often when investing in Chinese stocks you are investing via “ADR” American Depository Receipt, which basically connects to a holding company in the Cayman Islands. This means you are not directly invested, which is another risk. A recession has been forecast in the west, which could directly impact China due to its large number of exports. Barclays recently slashed China’s GDP growth forecast by 2% to 5% in 2023.

Final Thoughts

Tencent is one of the most diverse and ubiquitous technology companies in the world. The organization is the perfect way to play China’s huge population, its massive mobile penetration (>88%), and growing social media usage. The technical chart is close to a breakout and recent positive news catalysts look to be great for Chinese stocks in general. Tencent’s stock is also undervalued intrinsically and relative to historic multiples.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.