Making Sense of TenCent

Company : Tencent Holdings, 700.HK

1) Thesis / Decision to buy :Hong Kong market and the technology / gaming sector has been heavily battered, and presents a margin of safety.  Ten-cent has suffered 20% decline in its stock price due to the tightened scrutiny on the addiction of video gaming on the residents (Moat of the product line is too strong to the point of requiring government intervention)  . I believe these headwinds are temporary as the government is not totally shutting down the industry, and is merely putting a hold on the monetization pipeline of the soon to be released games. Its short time revenue is affected but should not damage its fundamentals.

Ten-cent is not in a dire debt position and has considerable free cash flow. A delay in the next 2 quarters while the government undergoes restructuring, should not affect the superior economics of its  premium gaming  franchise. In addition, it has a powerful super-app in the form of We-chat, which is dominant and enjoying network externalities in China. Utilizing my scuttle-bug analysis, a lot of the social networking and payments features are still not available in Singapore and as such it is still a whatsapp equivalent in foreign countries. We chat is also still early in its monetisation and it still has room for revenue growth.

Ten-cent is immensely hard to analyze due to its opaque nature of its high volume acquisitions, and could present considerable book value accounting inflation through goodwill and revenue . It has recently announced a restructuring program which should hopefully streamline it's corporate structure. Due to high market price, a minimum lot of 100 shares is equivalent to SGD6,000 position (high conviction bet). Despite my strong interest in the gaming industry, it will be wise to simply enter a minimal position in the company, then explore its developments across the course of time. The US interest rate hike on 25-26 Sept 18 will introduce a further bearish sentiment. 

2) Business Outlook
Lines of business + Prospects

Wechat

Large untapped monetization potential of WeiXin 

QQ is the equivalent of Skype / Lync in china

Large payment enjoying network externalities and float. Possible development meet of clearing house with Central Bank. 

Social media function with instant communication. In China, Wechat is used in conjunction for corporate and personal use and the moat is stickier than whatsapp. 

Emojis, microapps, social networking and dating services  serve as large potential revenue generators. 

Gaming

Casual gaming (copycat) 

Premium gaming (super cell, riot) 

Distribution network (Wegames )

Investment in streaming platforms (advertising revenue) 

Gaming acquisitions 

Tech investment fund / conglomerate + ecosystem acquisitions

Social media  + micro blog and v blog 

Games

Music (tencent music IPO+distribution)

E commerce with JD

Ride sharing 

Video and film

Credit rating

Cloud services (storage facilities) 

QQ (Skype / lync) for personal and corporate use. 

4) SWOT and PEST
Strengths/ Opportunities

Powerful superapp resulting in considerable network externalities. Acquisitions to add on to a sticky ecosystem. 

Strong free cash flow and operation cash flow. Debt is relatively high but not excessive. Undergoing restructuring which should be considered positive news. 

Strong product features and unique value proposition, although this reputation is under criticism by tech writers stating that company is losing its vision and transitioning from innovator to acquirer 

Acquisition of gaming companies with innovative ideas and immensely popular games. Gaming. Industry performance can be monitored through twitch TV streamer viewcounts 

We chat is lowly monetised. Strong monetisation potential 

Weakness / 

Threats

Game distribution business is mainly entrenched in China and vulnerable to political approval and censorship. Any disapproval could lead to large volalitiy and share price. 

Highly volatile company due to its future growth orientation which cannot be easily determined. Share price be very bumpy and not for the faint hearted. 

Fast moving tech industry could lead to the tech leader being disrupted away. Although with its financial power and network externalities, it is very hard to displace it. 

Copycat strategy and rapid acquisitions  can lead to fast growth of company. As the company matures, it need to restructure and develop organic growth capabilities.

Political

Highly vulnerable to the political regime. Without political support, company can easily be replaced. 

Nonetheless, foreign companies cannot disrupt tencent domestic industry, due to great firewall of China 

 Local start-ups does not have financial capability or political connections to easily challenge tencent position. 

Economic

Super app creating entrenched ecosystem that is similar to google. We chat presents a utility like business that every company has to go through in order to establish itself online. 

Dominance of payments system and first mover advantage make is difficult to displace. 

Social

Tencent success could be unique to china as it has an moat and let understanding of cultural norms and acceptances in China. Beyond china borders, it is much harder to gauge whether will it be successful. 

Technological

It is an equivalent of a technology conglomerate and investment fund. I am effectively investing in tech start-ups through tencent. 

5) Porter 5 forces (Pricing Power)(Franchising)
Barriers of entry (BOE)

Domestic China market is relatively insulated from foreign competitors due to great china firewall and political connections required to establish a foothold (think yahoo CN, google facebook) Development beyond china borders will not be easy to forecast. 

Stiff competition from China local tech companies. Fast moving nature of the industry is a prevent threat, but the moat is stronger than other traditional industries. 


Threat of substitutes (TOS)

We chat and QQ - No. The larger and stickier the ecosystem, the stronger the network externalities. 

Gaming platforms - No. There are local competitors as well as foreign entrants (steam) trying to set a foothold. 

With the headwinds of the gaming industry, the local smaller distributors are facing sizeable challenges. Hopefully only the stronger players (tencent) can remain and consolidate the industry. 

China gaming is also subject to censorship and adaptations to meet local cultural norms. Foreign entrants does not present a credible threat. 

Ecosystems - No. Individual acquisitions could face significant threat of substitutes. The ecosystem as a whole should be less affected. 

Bargaining power of customers (BPC)

No. The deeper the entrenchment, the more difficult it is to switch vendors. 



Bargaining power of suppliers (BPS)

No. There is only tencent and Alibaba. It is effectively an IT duopoly that the suppliers of services can refer to. 

Intensity of rivalry (ICR)

YES. Alibaba and local start-ups are in a constant struggle for MAU and startup funding to capture market share. The strong pace nature of the industry makes the outcome hard to forecast. 


Organisational Life Cycle

forecasted growth factors, cash flow charateristics, forecast revenue growth in 5 years

Strong growth in its major revenue generators. Strong operating cash flow and free cash flow. Shall not forecast cash flow due to its erratic nature. 

What type of stock it is and what I am looking out for. 

Fast growth (transitioning to slow grower) 





6) Financial Ratio Health Analysis with peers
Wall street Journal
Morningstar
POEMS

Profitability
Cash flow amount and charateristics
Gross Margin
Operating Profit Margin
Net Profit Margin
Liquidity/ Leverage
Current Ratio
Quick Ratio
Long Term Debt to Equity (%)
Total Debt to Equity (%)
Interest Coverage Ratio (TTM)
Free Cash Flow to Firm (TTM)



Operating cash flow
Investing cash flow
Financing cash flow



Return on Asset - 
Sales Turnover -
Earnings Per Share -



Return on Investment -
Tax Retention Rate (tax efficiency, higher better) = (EBIT - tax exp) /EBIT
Interest Expense Rate (lower better)  = int exp / Total asset
Return on Equity
Dupont ROE analysis - Profit Margin x Asset Turnover x Financial Leverage
ROE = Net Income/Net Sales x Net Sales/Total Asset x  Total Asset x Common Equity

Profit Margin trend
Asset turnover (ROA) trend

Financial leverage trend
General ROE Trend



7) Valuation ratios

Historical P/E Ratio

P/E Ratio (TTM)
P/BV (latest interim)
BVPS (latest interim) (SGD)
EPS TTM (SGD)








9)Valuation Checklist (Incorporation of Graham value based Margin of safety Buffer , Fisher 15 points on growth)

1) Is business simple and understandable?
(choose companies within your circle of competence, not the size of the circle but rather how defined are its parameters)

A: Not really. Such is the nature of technology companies. The economics of the prominent product lines like We-chat and video gaming is incredible but the large myriad of acquisitions make the company hard to decipher.


2) Does Business have consistent operating history?
(Operating performance, Cash Flow especially for SME)

A: Yes. Its historical growth trends seem to not exhibit immediate returns but over the course of time, the effects of the superior product lines start to kick in. 

The franchise video gaming division seen a strong pipeline of great games due to acquisition of creative game developers that can deliver a new gaming experience.

For We-chat, The management seem to be sensitive to market norms within China, and introduce new features (some experimental) in We-chat, to not only pertain to the older businessmen but also the newer generation (social dating and meeting, food delivery, payments, gaming, social media etc)

Operating cash flow has also been improving and it does not incur too much visible debt.




3) Does business have favorable Long term Prospects (sales) and powerful moats?


Porter's 5 forces - choose franchises that products are needed and desired, with no close substitutes, highly regulated posing high barriers to entry, market leader, high switching costs,  strong reputation allowing company to retain market and pricing power to pass on costs to users,

A: Gaming Yes. We-chat Yes. Acquisitions hard to decipher. 



Management Tenets
4) Is management rational and track record of competence? (Beware SMRT clowns) - Yes

A: For Pony Ma, yes. There is strong founder - owner orientation and the company is not haphazard undergoing acquisitions, but building on to its tech ecosystem . Nonetheless, there is considerate risks involved and position size must be carefully managed. 

The lines of business isanaged by its LOB managers and it is hard to analyse it from an external  standpoint.


5) Does business have strong track record and consistent good leadership and management (management changes, adopting of technology, recognition of fundamental changes in economy)

Yes. It's beginnings stem from innovation, competition and product improvement. It can copycat successful models but also add on original insights to create new products that is sticky with its clients. 



6) Does management resist institutional imperative?
(Manager Mismanagement and inertia to change)
    The organisation resists any change whatsoever in its current direction, and will seize upon any evidence that they are doing the right thing while fastidiously ignoring evidence to the contrary.
    Just as work expands to fill time, and waistlines expand to fill belts, projects and acquisitions will materialise to soak up all available capital.
    Any business plan of the CEO, however stupid it may be, will receive immediate support from a legion of lackeys who will produce copious data and detailed rate of return and strategic studies to support the boss's thesis.
    The behaviour of peer companies, irrespective of differences in circumstances, whether they are acquiring, expanding, setting dividend policy, downsizing, putting the troops through customer service training or setting executive compensation will be immediately and thoughtlessly copied.
    Poor capital management skills. Buffet buying over entire companies to control financing policy )


Difficult to determine. Tencent adoption of technology industries practices for accounting purposes could lead to inflated performance. Heavy acquisitions is strongly opposed by Value investing as they distort the quality of analysis and lead to inflated balance sheets and goodwill. 



Financial Tenets
7) What is the ROE?
(Revenue, Expenses, Cash Flow, Labour relations, pricing flexibility, capital allocation needs). Look out for cash flow, indebtness, ST / LT loans affecting sensitivity in interest rates

Strong operating revenue

Expenses poorly managed. Shall monitor the restructuring program to see how does it improve bottom line. 

Strong operating cash flow. But will incur near term headwinds due to game approval delays. 

Relatively high indebtness making it a risky play. Position size should be controlled. 

8) What is the company's owner earnings? (ROIC)

Great. 

9) What are the operating margins? Are they satisfactory?

Yes. 

10) Has company created at least 1 dollar of market value for every dollar retained? How is the money retained in the company utilised? Is it trending towards diwosification or poor budget control?

So far yes. Share buyback conducted. Exhibited ability to pay dividends. Restructuring to rationalise acquisitions and diwosifying. Might be looking into cost management. 

Value Tenet 

11) What is the value of the company (Intrinsic, Book, Market). 

 
Buy a very good company at a fair price as good companies are closely monitored

Tech companies PB PE and forecasted. cash flow models are not similar to traditional value metrics. Based on its existing cash flow, margin of safety and conduct of share buyback, it should be relatively undervalued. 

12. Can it be purchased as significant discount to its value

Yes. But do not overweight on this difficult industry and company

Others 
Risks in video gaming industry

Regulators have also been concerned about violence and gambling in some games. Online, mobile and console games have all been affected.

Smaller players complain they are struggling to survive without new titles.

There are risks of inability to profit from its most popular games, including the hit PlayerUnknown’s Battlegrounds.

Tencent don’t have visibility on when exactly the official approval will start yet

China has one of the world’s most stringent approval processes for video games, an extension of Beijing’s obsession with maintaining control over online content so it can root out dissent and other ideas it considers undesirable, from sex to graphic violence. But its massive smartphone and web population also makes it the world’s largest gaming market with an estimated $37.9 billion in revenue

Tencent and Netease Inc. are among the biggest game distributors in China, and they license titles from some of the world’s biggest developers, includingActivision Blizzard Inc. and Electronic Arts Inc. in the U.S. and Capcom Co. in Japan. Nexon Co. gets 45 percent of its revenue from Tencent, according to data compiled by Bloomberg.

Even if the regulators resume approvals immediately, the typical process takes about two to three months, signaling potential weakness in the third quarter for companies like Tencent.

China’s internet sector is undergoing a stringent crackdown ahead of an important Communist Party gathering later this year. Tencent has been forced to curb playing time for children, as regulators step up scrutiny on online gambling and gaming addiction.

Streaming and digital sales channels have not only made buying premium PC games in China more convenient for consumers, but also exposed them to other games for purchase. This is combined with the explosion of influencers in China, who introduce new games to their subscribers. Based on our survey, 25% of premium PC game purchasers learned about a new game by watching a streamer.

More than 70% of respondents in this group admitted that they used to play pirated PC titles.

While the initial loss of revenue due to piracy was frustrating for game makers, IP owners, and distributors in the west, it resulted in a generation of consumers who are now well-versed in PC gaming and willing to pay for premium content. Gamers in this segment are economically independent, earn above-average salaries, and can now afford to buy games. In our survey, 79% of this group cited “financial independence and a willingness to pay for premium games” as a reason to purchase PC games. Additionally, 65% of this group indicated that they’re planning to spend more on premium PC titles in the future.

Links 

Economics of video gaming industry 

https://medium.com/@makers.kowloon/how-premium-pc-games-continue-to-rise-surprise-in-china-efc2b95b0019

https://www.bloomberg.com/amp/news/articles/2018-08-15/china-is-said-to-freeze-game-approvals-amid-agency-shakeup