Even after lowering our forecasts, we think Tencent is severely undervalued. The wide-moat Internet giant has the largest social networking platforms in China, Weixin/WeChat and QQ, and monetises them through selling in-game items, virtual items, premium service subscriptions, online advertising, payments, financial products, and other products.

We now expect a 10-year compound annual growth rate of 20 per cent for operating profit, compared with 29 per cent previously, and a 10-year compound annual growth rate of 19 per cent for revenue, versus 29 per cent previously.

The other revenue segment, which is mainly composed of payment and cloud, has slowed faster than our expectations in recent quarters. This has led to a 10-percentage-point reduction in our 10-year other revenue CAGR to 30 per cent.

As a result of a pause in games approval in China, we now assume year-over-year online gaming revenue growth to be 6 per cent in 2018. We estimate there will be a rebound in online gaming revenue growth to 16 per cent in both 2019 and 2020 as approval resumes in mid-2019.

Our assumption of lower revenue growth is partially offset by a better outlook on margins. We believe the operating margin (excluding other gains and interest income) will gradually decrease as a result of investments to transition to industrial Internet and will bottom at 22.5 per cent. But as scale amasses, we expect the operating margin to increase to 30.3 per cent by 2027.

china

Tencent has good growth prospects over a 10-year timeframe, according to Morningstar

Given Tencent’s strong network effect - WeChat has 1.1 billion monthly active users - we believe temporary suspension of game approval and a weak macro environment provide a good opportunity to accumulate this high-quality name. Tencent’s repurchase of 2.8 million shares is a testimonial to our view. We think smaller game companies will be squeezed by the regulatory headwinds and Tencent will be able to gain market share.

Third-quarter revenue was up 24 per cent year over year, led by payment, advertising, digital content sales, and cloud. Operating profit excluding interest income and other gains was up only 1 per cent year over year. Net income was up 30 per cent year over year as a result of a CNY 8.8 billion higher valuation of investees such as Meituan Dianping; this compares with CNY 3.9 billion in the year-ago period.

There was an increase in monthly active users of Weixin and WeChat of 11 per cent year over year and 2 per cent sequentially. More important, there was growth in user engagement as a result of more use cases offered by mini programs and Weixin Pay. Mini programs have penetrated into more industries such as transportation and healthcare. We think user engagement will continue to grow as penetration of mini programs and Weixin Pay deepens.

The online game segment was in the spotlight, with smartphone games revenue up 7 per cent year over year and 11 per cent quarter over quarter due to 10 new game releases, but PC client games revenue down 15 per cent year over year and 4 per cent sequentially.

Growth is weak as online multiplayer game PUBG and other new titles have not been monetised due to a suspension in game approval. Key title Honor of Kings has continued to see sequential increases in revenue driven by more paying users, which should give added comfort to investors in the near term.

The market appears to be concerned that the slowing economy will put pressure on the online advertising segment, but the third-quarter results in this business were very solid. The segment’s revenue was up 47 per cent year over year, an acceleration from 39 per cent in the second quarter, while revenue was up 15 per cent sequentially, similar to the sequential increase in the third quarter of 2017.

We believe Tencent still has a lot of room to increase its Weixin Moment ad load to increase advertising revenue, and this will largely offset the impact of the lower advertising budget of customers. Better monetization of its video content and expanding the advertiser base by converting Weixin Pay merchants to advertisers can also lift advertising revenue.

Other revenue, which mainly consists of payment and cloud, slowed to 69 per cent year over year, lower than our expectations. LiCaiTong’s assets under management grew to CNY 500 billion versus CNY 300 billion in January this year. The gross margin was 22.8 per cent in the quarter, same as the year-ago period.

 

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Chelsey Tam is an equity analyst for Morningstar in Hong Kong.

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