After analysing Tencent’s interim results for 2018 we would recommend zero percent exposure based on the following key aspects, says PSG Wealth’s team of equity analysts.
We believe a high growth rate has already been priced into the valuation and that Tencent is fairly valued.
Negative impact of regulation
Accurate forecasts are difficult to make due to regulations set out by Chinese authorities and due to a slower advertising market. This could negatively impact their gaming and advertising operations, which are the primary contributors to sustained earnings growth.
The group’s P/E is trading at a discount to its historical average, however, we estimate that growth is likely to be lower than the historical five-year compound annual growth rate (CAGR) of 35%, due to the higher base and the maturity of the online advertising market. We believe a lower P/E multiple going forward is appropriate.
Even after the recent price declines in Tencent, the group is still trading at a substantial premium to international peers.
Market expectation too optimistic
We feel that the current market expectation for revenue growth is optimistic given the slower macro-economic environment and the potential impact of regulation.
Despite the recent downgrade to earnings estimates and expected net margin, we believe current earnings estimates are at risk.
The group is profitable with attractive operating margins, high cash generation, and low financial gearing, which translates into our good quality rating.
Given that the share is not a constituent on the Dow Jones Global Top 50 Index (DJGT500), our benchmark weighting of Tencent is zero. As such we do not recommend an active position in the counter, which translates into our portfolio guidance of 0%.
The group’s net debt decreased by 46% to RMB 7.205 billion; net debt to equity fell 3.8 percentage points to 2.4%. The total debt to EBITDA remained low at 1.55, with the group receiving net interest.
The weighted average cost of capital almost doubled to 13.94% while the return on invested capital only increased by 1.73 percentage points to 15.8%. The economic value add (EVA) has therefore been declining, indicating that the cost of capital used is nearing the earnings generated from investments.
Revenue increased by 38.7% to RMB 147.21 billion. Adjusted operating profit increased by 27% to RMB 40.27 billion. The operating margin declined by 250 basis points to 27.4%. And the diluted headline earnings per share increased by 25% to 430 cents per share.
The group aims to increase contributions by publishing games developed in China on the international market. However, management expects any meaningful impact to take several months.
There are signs of ongoing growth in the number of daily active user accounts playing the group’s mobile games.
Management believes monetising the accounts of daily active users, could offer a substantial upside, matching levels seen by peers.
However, Chinese authorities have frozen approval of new games and prevented Tencent from making money on existing games. There is no clarity as to when the regulatory blocks will be removed.
At the beginning of October, the group announced that it will be restructuring its operations.
A new group will be created to focus on the cloud and smart industries.
Another new group will combine social media, mobile internet, and online media operations, to make coordination more strategic.
A technology committee will also be created to focus on R&D and push for innovation.
The current DJGT50 weighting of Tencent is 0%. And because we do not recommend an active position, our recommended portfolio exposure is 0%.