Tencent Stock: There’s Nothing Like WeChat Outside Of China

Introduction

My thesis is that there is nothing like Tencent’s (OTCPK:TCEHY) WeChat outside of China. Starting in January 2017, Tencent launched mini-programs which are similar to the regular apps we see on Apple and Google smartphones. Today the WeChat super-app is more like a smartphone operating system than a regular app. In the West, small transactions via credit cards are painful for merchants because a large percentage of the transaction does not go towards the merchant. This is not the case in China where WeChat and Alipay (BABA) keep payment fees low on a relative basis regardless of the size of the transaction

At the time of this writing, 1 RMB is about $0.15.

People Basically Live On WeChat

Per Business Insider, Tesla (TSLA) CEO Elon Musk said there is no equivalent of Tencent’s WeChat outside of China and he wants Twitter to be more like WeChat:

You basically live on WeChat in China because it’s so helpful, so useful to daily life. I think if we achieve that or come even close to that with Twitter, that would be a success.

WeChat allows people in China to pay for rides without leaving the app. Per the Cashless Revolution book, QR codes for payments mean there is no need to coordinate with phone manufacturers or telecom companies. It’s easy for small merchants to use QR codes such that WeChat and Alipay are accepted everywhere. WeChat and Alipay don’t charge merchants much relative to card-based transactions in the West. This is especially important for small purchases like coffee and parking where the flat fee in the West of 20 to 30 cents can eat up a large part of the transaction. As such, WeChat and Alipay have opened up the economy in China with concepts like micro-tipping where independent publishers can be compensated at the individual article level rather than the restrictive all-or-nothing subscription model.

General Valuation Thoughts

Delisting is a serious risk but it is in China’s best interest to continue working with the West with respect to capital markets. The Cashless Revolution book by Martin Chorzempa makes the point that foreign capital has been very helpful to China’s economy in general and their homegrown tech sector in particular:

It’s difficult for the powers that be in Beijing to own up to the fact that the tech titans of China depended on foreign investment, especially by US-based venture capital and stock markets, to survive their early years. Tech companies popped up in China quickly, but local venture capital was scarce to nonexistent, and Chinese stock markets set the bar for listings too high for new companies like Tencent. The Chinese government was not willing to open sensitive technology sectors fully to foreigners, but it also pragmatically knew that it needed foreign capital to develop a homegrown tech sector. It tacitly allowed work-arounds that enabled Chinese tech firms like Tencent to accept foreign money through holding companies located offshore. Without this foreign help for companies in this sensitive sector, Tencent (and other companies) would not have survived the dotcom crash. A well-timed venture-capital infusion in 2000 from the US-based International Data Group (IDG) and the Hong Kong–based PCCW Global saved it from running out of funds. One of the best investments in history would come from Naspers, a South African conglomerate that took a 32 percent stake in Tencent in 2001 for around $20 million (years later, the stake would be worth over $100 billion).

[Kindle Location: 391]

I believe one of the reasons Tesla CEO Musk paid a premium for Twitter was because he sees tremendous potential for WeChat in China and other companies who can mimic WeChat outside of China. Tesla CEO Musk has said that there should be a way to make a micropayment of 10 to 25 cents in order to read an article through Twitter and Twitter would need to mimic WeChat for this.

My July 2022 article talked about the fact that Tencent should improve communication with investors and I’m happy to see that this has partially occurred with respect to unlisted investments in the 3Q22 earnings presentation. Management has also provided more clarity on the JD (JD) distribution. These developments make me more comfortable with the valuation range of investments along with the valuation range for the efficacy of deploying capital.

3Q22 FCF was RMB 27.6 billion and Tencent spent RMB 11.8 billion buying back stock in the period. I believe management spent nearly 43% of FCF on buybacks because they thought the stock was a good value.

Valuation Of Investments

We see the value of listed investments excluding subsidiaries is well beneath the 2Q21 apotheosis of RMB 1,446 billion:

Much of the decline above is from market prices going down but there have been distributions as well. Based on the JD closing share price on the dispatch date in March 2022, $13.3 billion in distributions were returned to shareholders from January to November 16th of 2022. Also, a $20.3 billion Meituan distribution is coming to shareholders in March 2023:

The cash position slide shows that there were buybacks of RMB 11.8 billion during 3Q22. Also, the carrying value of unlisted investee companies is shown as RMB 340 billion. This same slide for 1Q22 and 2Q22 did not contain the unlisted carrying values:

We see the $75 billion listed investments and the $48 billion unlisted investments in the pie chart below such that the combined total of investments is $123 billion:

Valuation Of Operating Businesses

The 3Q22 revenue is down slightly from 3Q21 per the 3Q22 earnings presentation:

The November 2022 corporate overview shows TTM FCF of nearly RMB 100 billion through September:

I don’t like part of one of the footnotes for the FCF above:

In 2019, interest paid was re-classified from operating to financing cash flows, comparative figures from 2018 were re-stated accordingly.

There are puts and takes between the FCF used by management above and the economic FCF used by shareholders who are trying to determine how much cash can be pulled out of the business. I view stock based compensation (“SBC”) as a cash expense when thinking about the economics. In some ways the above figure is overstated in terms of not deducting interest and SBC. However, the above figure is also understated in other ways such as growth investments in the capex line.

Tencent has some promising operating businesses that are not yet making meaningful contributions in terms of FCF. For example, they have tremendous potential with the metaverse given their gaming business. Of course there are also negatives with the gaming business such as China’s government limiting its scope. There is also the concern that systems could lower the credit score of individuals in China who spend too much time playing video games. On balance, I think the positives outweigh the negatives for Tencent’s gaming business.

I think the operating businesses are worth 20 to 21x the TTM FCF which was nearly $15 billion. As such, I think they’re worth about $300 to $315 billion.

Valuation Summary

In addition to the valuation considerations above, there is also extra value for companies that can deploy future earnings well. Given the visibility they have with their super-app, Tencent has made substantial gains by deploying capital effectively to young companies and I think this will continue. They hit a home run with the JD investment and I don’t think that was the last time they’ll be hitting it out of the park. I think their efficacy of deploying earnings is worth $20 to $30 billion.

I value Tencent as follows:

$123 billion investments

$300 to $315 billion operating businesses

$20 to $30 billion efficacy of deploying earnings

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$443 to $468 billion total

Per the 3Q22 HKEX announcement, there are 9,541 million weighted shares outstanding. Multiplying this by the January 12th ADR price of $46.47 gives us a market cap of nearly $445 billion.

It’s always a good idea to look at enterprise value in addition to market cap but we need to be mindful of a few things. The first consideration is that we don’t want to double count investments so we exclude those from the enterprise value. The second consideration is that FCF should be compared to market cap as opposed to enterprise value because FCF is typically lowered by interest payments so that debt is already accounted for. As such, EBIT is often used as a benchmark against the enterprise value. In the case of Tencent, however, this is confusing as they have a footnote saying interest is part of financing cash flows as opposed to operating cash flows. In any event, it is useful to see how the adjusted enterprise value compares to the market cap. Per the 3Q22 earnings presentation slide above, Tencent’s net debt position is $4 billion. The 3Q22 HKEX Announcement shows that we also have RMB 62,486 million in noncontrolling interests which comes to a little over $9 billion. We also have short-term lease obligations of RMB 6,207 million plus long-term lease obligations of RMB 18,082 million for a total of RMB 24,289 million or nearly $4 billion. As such, the adjusted enterprise value is almost $17 billion more than the market cap.

Mr. Market has the market cap value fairly close to my valuation range so I think the stock is reasonably valued.

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.