Tencent DCF Analysis

Introduction: Tencent is one of the largest and most influential companies in China, it created a super app, WeChat that is used by more than a billion users daily. With its close ties to the Chinese government, Tencent has flourished into a large company with a global presence through its multi-faceted investment ventures in areas such as Gaming, FinTech, and Cloud Services. It is the early architect of the “Ecosystem Model” which many successful companies such as Google, Apple, and Tesla have replicated. the unique thing about this business model is that they already have built out the necessary infrastructure and there are built-in customers within the super app, so there is no need for additional customer acquisition cost and any subsequent addition to the super app will have very high margins.

Market:

Tech Crackdown

China has begun to crack down on the technology industry for many reasons, such as anti-competitive behavior and increased concerns over privacy and security. This has led to investors being worried that the Chinese market would become increasingly restrictive and any future opportunities to profiteer would dry up. However, in recent years the government has taken notice of the negative response to their strict crackdown so it published a public statement calming investors and has even approved a large batch of video games as a gesture of goodwill.

Internet Penetration

China places very heavy emphasis on digital connectivity where “broadband infrastructure is defined as a national–level public infrastructure equivalent to basic services such as water, electricity, and roads, and its goal is to create a next-generation information infrastructure.” (SOURCE). This emphasis on digital connectivity can be seen in China’s broadband policy in 2013, where China promoted digital connectivity through its policy. Chinese homegrown brand Huawei, a manufacturer of smartphones has also contributed to the growing internet penetration rate. Huawei can locally source most of the materials necessary to produce their smartphones and even design their chips using domestic technology all while maintaining quality. This keeps the cost price of manufacturing smartphones low and affordable, granting internet access to millions of Chinese citizens.

Artificial Intelligence

Due to US trade restrictions, Tencent has been unable to get some of Nvidia's most powerful chips such as the A800 and H800 which could lead to difficulty training their LLM, Hunyuan. However, Tencent has a stockpile of powerful chips it created just before the exports came into effect (SOURCE). However, I believe that solely relying on stockpiles would be insufficient in the AI arms race. This has led to the breakthrough innovation of Chinese firm Huawei to meet the demand for powerful chips (SOURCE).

Revenue:

The global expansion plan for Tencent has to be based on the value provided to customers rather than on pricing. As an example to illustrate the importance of value, Temu an e-commerce platform that prides itself on its cheap price has placed so much emphasis on cheap pricing that its retention rate is only at 30%, whereas Amazon’s retention rate is at 90% (SOURCE). There is also a large need to focus on data protection as seen from the recent concerns raised about TikTok’s privacy issues, where due to privacy concerns TikTok was banned from the US.

Value Added Services (VAS)

VAS revenue includes revenue generated from Tencent’s Social Networks like QQ and WeChat and video game companies such as Riot Games and Epic Games. I opted to split VAS into “Video Games” and “Social Networks”

Taking a look at China’s population, the UN forecasts population growth rate for developed economies to grow at a Y/Y CAGR of 0.037% for the next 14 years (SOURCE). In developing countries, the birth rate is significantly higher as children are seen as a necessary addition to the family’s labor force. However, in developed countries, children are seen as a drain on family resources (Education, Housing, and Healthcare) which reduces the appeal of having children and hence a lower birth rate in developed economies (SOURCE). However, China’s population has declined as a result of the long-term effects of the one-child policy skewing gender ratio and the rapid development of the Chinese economy which also gave rise to a workaholic culture (996 culture). In fact, “China's current economic downturn is not cyclical, but structural and irreversible…United Nations experts see China's population shrinking by 109 million by 2050.” (SOURCE). Therefore in my base case, I followed the UN’s forecast but in my best-case scenario, I assumed that China’s population grew at less than half the rate of developed economies.

When forecasting MAUs, taking a look at (SOURCE) 67.5% of users that use WeChat are from China, with the rest mainly coming from different parts of Asia. A significant factor to consider is the language barrier, as most people using WeChat social media are likely fluent in Chinese and speak Chinese as their first language, this heavily limits the number of countries that Tencent can enter as Chinese is the hardest language to learn and master (SOURCE), limiting the total addressable market for Tencent. For users outside of China, I believe that the main benefits of using WeChat come from the convenience of being able to access services in China whilst traveling. Therefore, I believe that MAU would grow more or less in line with the projection outlined by the UN which projected population decline (SOURCE).

Social Media

When forecasting Revenue/MAU, given that Tencent earns money through sales of stickers or charging businesses yearly fees to be authorized to advertise on WeChat. Although I believe that Tencent has strong pricing power due to its near monopoly-like status on messaging platforms, however, the CCP has begun cracking down on WeChat’s monopoly (SOURCE). So, I believe that Tencent would be very cautious about raising prices for fear of being accused of abusing its monopolistic powers hence I assumed that Tencent grows Revenue/MAU at a Y/Y rate in line with the perpetual inflation rate.

Video Games

When forecasting the total number of high-grossing games, given the uncertainty of whether video games would succeed or existing IPs would continue succeeding. In my base case, I forecasted the total number of high-grossing games to grow by 1 every 2 years to avoid being overly optimistic.

When forecasting Revenue/Game, given that Tencent has begun publishing international games to skirt the harsh gaming laws set out by the CCP. I assumed that over the long run, Tencent’s Revenue/Game is slightly divorced from the harsh domestic regulations in China. However, a common issue faced by gaming companies is a lack of pricing power as any noticeable rise in price will be deemed as “Corporate Greed” and be condemned by the gaming community. A recent example would be when League of Legends by Riot Games, a subsidiary of Tencent released an in-game skin “Immortalized Legend Ahri” for $450 and was harshly criticized by the gaming community for being a cash grab. Therefore, In my base case, I assumed that Revenue/Game grew in line with the perpetual inflation rate.

Historically, the split between Social Media and Video Game was 40-60. However, I believe this split will shift to almost 30-70 as I believe that as Tencent grows its video games IP to have an even larger international presence their video game arm would be more valuable and grow at a faster rate than their social media arm.

Online Advertising

Online Advertising revenue includes revenue generated from the sale of Tencent’s advertisement inventory on their social network platforms. I looked into the MAUs for Online Advertising as I believe that the more MAUs that Tencent manages to capture the more valuable this arm of the business becomes, as the number of monetizable eyeballs increases.

When forecasting Revenue/MAU, given that advertising is a cyclical industry, advertising made a sharp recovery in FY23 a reflection of China’s strong recovery from its Zero-COVID policy which frightened advertisers. In my base case, I assumed that the strong recovery from the advertising sector sustained for the next 6 years before growing in line with the perpetual inflation rate. 

FinTech and Business Services

FinTech and Business services include revenue generated from multiple financial services offered by Tencent and their cloud services. The capability of cloud-computing from global competitors such as Google Cloud, Microsoft Azure, and Amazon Web Services is very limited in comparison to domestic players due to the Great Firewall of China affecting the compatibility of these global players with the domestic market. Another prominent feature is Weixin Pay which allows users to make mobile payments and online transactions. I looked into the MAUs for FinTech and Business Services as the more MAUs that Tencent manages to capture the more valuable this arm of the business becomes, as the number of transactions made will increase.

When forecasting Revenue/MAU, there was a large spike in growth rate in FY23 as “WeCom and Tencent Meeting deployed generative AI-powered functionalities and increased their monetization.” - 2023 Q4 10-K. On top of that China’s lifting of its harsh zero-covid policy has allowed firms and consumers to resume their spending activities. I assumed that this recovery would resume for the next 6 years before tapering down towards the perpetual inflation rate.

Cost:

COGS

Tencent enjoys higher gross margins as it has already incurred high fixed costs at the start. “This incremental revenue is generated predominantly from our leading social and payment platforms, which have already been built and have their costs covered.” -2023 Q4 earnings conference. On top of that, there is a large revenue shift from lower-margin revenue sources into higher-margin revenue sources. “margin improvement was primarily driven by a shift in revenue mix towards high-quality revenue streams” - 2023 Q4 10-K.

When forecasting COGS, I assumed that Tencent would maintain its FY23 margins as they have already incurred most of the larger fixed costs and are now able to benefit from their previous investments.

Marketing

When forecasting Marketing, “streamlined operations and cut back in overly aggressive marketing spending” - 2024 Corporate Presentation. So I assumed that management would continually slightly cut their less profitable marketing spend and as Tencent gets bigger it is less reliant on marketing to increase awareness. 

G&A

When forecasting the total number of employees(SOURCE), Tencent has been cutting back on headcount in the recent few years (SOURCE) and (SOURCE) due to the aggressive overhiring during the post-COVID-19 global recovery. I assumed that headcount reduction would continue for another year in my forecast before the global macro-environment stabilizes and hiring picks up again.

When forecasting cost/employee, I assumed that Tencent cost/employee grew at a slightly elevated pace to remain attractive to employees before growing in line with the perpetual inflation rate.

WACC:

China 10Y T-Bond Yield (1M Avg) = 2.30%

Market ERP (SOURCE) = 5.63%

Beta (SOURCE) = 0.54

COE = 5.34%

Tencent is rated “A+” (SOURCE)

COD = 5.31%

Marginal Tax Rate = 25.00%

AT COD = 3.98%

Stock Price (5D Avg) = $375.60

Shares O/S = 9455.00M

Market Value of Equity = 3551298.00M

Weighted Average Maturity of Debt = 8 Years

FY23 Interest Expense = 1011M

Market Value of Debt =  261936.42M

%Debt = 6.87%

%Equity = 93.13%

%WACC = 5.25%

CapEX and D&A:

When forecasting CapEX and D&A, opting for less granularity I forecasted it as a % of revenue in line with historical averages. 

Conclusion:

Ultimately, in my base case, I value Tencent at $HKD 527.86 per share. I believe that this disconnect between the forecasted and actual price is due to the fear that investors have about the CCP’s future policies and stance towards video games. The sudden harsh crackdown on tech companies such as Ant Group and on Video game companies has led investors to perceive the Chinese market as high risk. I believe that over time, as Tencent grows its gaming portfolio to encompass more international games with an international audience it will be able to diversify the risk of being so heavily connected to the CCP’s policies.

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