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Tencent Holdings (TCEHY) Stock | OTC: TCEHY

Covered by Stratosphere

Building China's Most Important Technology Ecosystem

Tencent is a Chinese Internet giant with businesses and investments in a wide variety of Internet services and contents. Major services include communication and social networking (Weixin / WeChat and QQ), online PC and mobile games, content (news, videos, music, comics, and literature), utilities (email, app store, mobile security, and mobile browser), the cloud, and financial technology. Tenpay in Weixin / WeChat and QQ is a payment solution that enables closed-loop transactions in Tencent's ecosystems and has been adopted by many third-party partners and offline merchants. Tencent has an aggregate monthly active user base of almost 600 million for QQ and over 1.2 billion for Weixin / WeChat.

Stratosphere Score

8

Growth

9

Valuation

9

Quality

7

Margins

6

Dividend

8

Balance Sheet

7
Braden Dennis

Author

Braden Dennis

Founder

Investment Thesis

  1. Tencent has built a technology ecosystem that revolutionized the way people interact with the internet in China.

  2. The business is dominant in fast-growing secular trends including social networking, video gaming, online advertising, cloud, and fintech.

  3. Tencent owns WeChat and QQ, which have over a billion active users combined. It is clear that Tencent's dominance has a profound lead and moat around its core offerings. The ecosystem in gaming and social media it has created is sticky and a fundamental aspect to how China interacts with the modern web.

  4. The founder-led business has a powerful vision for the future of technology and has created a wildly impressive portfolio of sizable investments in leading businesses. Tencent owns 25.6% of Sea Limited, 40% of Epic Games, 5% of Tesla, 6.8% of Spotify, 100% of Riot Games, among hundreds of other businesses.

Key Company Metrics

A set of metrics we constantly keep updated to monitor the investment thesis.

Competitive Advantages

Massive Ecosystem

With its DNA rooted in social media, Tencent offers a strong combination of connection and content. The company has built a technology ecosystem that revolutionized the way people interact with the internet in China. Its breadth of content continues to draw new users while retaining existing ones.

Tencent's complex ecosystem is undoubtedly vast, tapping into a variety of industries that has looks much like the massive ecosystems of large non-Chinese technology conglomerates, like Amazon or Microsoft. Tencent owns and operates some of the world's best technology assets. We believe this is a competitive advantage in and of itself. Below is a list of the standing of some of these assets:

Online Gaming
  • #1 online video gaming platform in China across PC and smartphones as measured by users

  • Known as the largest online gaming company in the world

Communication & Social Media
  • #1 smartphone community active users

Utility Platforms
  • #1 utility apps in the App store, mobile security, and mobile browser

  • #1 by mobile daily active users for video streaming

FinTech
  • #1 mobile payment by monthly and daily active users

Media
  • #1 news service by monthly active users

  • #1 music service platform

  • #1 online content library and publishing platform

Cloud
  • #2 cloud service provider by revenue

Tencent's dominance has created a profound lead and moat in its primary offerings. Its gaming and social media ecosystems are particularly sticky and proven to be core components of China's interaction with the modern web.

Tencent owns the fifth largest social networks (combined) in the world, Weixin and WeChat, behind Facebook, YouTube, Whatsapp, and Instagram. Tencent's social media platforms dwarf the next most popular social platform in China, Sina Weibo, which is large by its own standards, but has less than 600 million monthly users - roughly half the size of Weixin / WeChat.

Tencent's social networks benefit from network effects due to its massive user base. It attracts additional users as social media users hold much value over apps that are useful and engaging. For the purposes of social media and connecting with others, a social media platform is only valuable if other people use it. Weixin and WeChat are immensely popular in China and some surrounding regions and the US, drawing in people to the platform if they are not already users.

WeChat initially started as a messaging app in 2011, and it rapidly gained popularity. Tencent simultaneously built out its ecosystem by adding useful features to the app that users would interact with on a daily basis.

Most notably, Tencent added WeChat Pay - a mobile payment and digital wallet service - to the WeChat ecosystem.

Similar to other person-to-person services, like those offered by PayPal, Tencent takes a cut of every transaction made on WeChat pay.

It is China's most popular online payments platform and executes over 1 billion daily transactions alone.

Now, paying through a digital wallet is the standard in China, and is used for everyday transactions. Nearly all businesses, from upscale hotels to roadside stands, accept payments via WeChat. A vendor simply displays a QR code that customers can scan with their smartphones and pay for things. Simple and convenient.

Tencent scaled and currently operates its other social platforms, QQ and Qzone, using similar approaches.

Because of high-value integrations like this, a typical WeChat user will log in multiple times each day to interact with other people, pay for things, play games, buy goods and services, market businesses, access public services, and even book trips. Users can do virtually anything, all on one super app.

Mini Programs

Whatever WeChat is unable to provide natively, it can provide through its third-party development partnerships.

These programs are hosted within the WeChat ecosystem and are known as Mini Programs. There are millions of such Mini Programs that reap the benefits of the Tencent ecosystem and the network effects therein. This is a win-win situation for Tencent, its users, and the third parties looking to scale their products or services.

WeChat's Mini Programs turn the social networking app into a highly capable and versatile platform, allowing users to share photos like Instagram, pay for things like PayPal, shop online like on Amazon, and order food like DoorDash, among other things.

Mini Programs can be seen as apps within an app, strengthening the ecosystem through instant loading and by being easy to use. With these third-party integrations, it would take a highly compelling value proposition (and a lot of effort and research) for a user to do things outside of the Tencent ecosystem if they could just be done through Tencent's services.

Furthermore, many third-party websites offer WeChat login, similar to Facebook. The majority of users in China leverage these capabilities by seamlessly linking their day-to-day apps and services through WeChat. People's lives are deeply entrenched in the WeChat ecosystem. If WeChat were to shut down, it would certainly result in major disruptions to businesses and people's daily lives. As a result, we believe WeChat users face high switching costs. This makes it highly unlikely users would simply switch over to other similar apps or services.

No other social network offers such a comprehensive experience, even those found in North America, like Facebook or Instagram. They can do a lot, but not as much as Tencent's invaluable social network assets.

Intellectual Property

Currently, the company owns 100% of Riot Games, creator of one of the most popular multiplayer games, League of Legends.

Tencent has a droolworthy investment portfolio with stakes in over 15 companies, all well-known by the global audience to publish quality video games that attract millions. Besides League of Legends, Tencent has major stakes in Supercell (Clash of Clans), Miniclip (Indie Games), Epic Games (creator of Fortnite), and more. Epic Games is also the developer of the Unreal Engine, a leading gaming engine.

These video game companies also benefit from powerful network effects - the more players that play these games, there more likely other players will play those games too.

Additionally, Tencent Games is the largest developer and operator of online games, enabling Tencent to have control over generating its own revenues from the gaming industry. A few of its hit games include Honour of Kings, PUBG, QQ Speed Mobile, and Peacekeeper Elite.

This control over its robust intellectual property portfolio allows the company to morph its successful content into other categories. For instance, Tencent Pictures creates film productions based on popular books, comics, and video games.

Tencent's vast portfolio of media assets allows the company to exploit a myriad of opportunities across many industries. This is inherent optionality, something that many companies simply do not have (but wish they did).

An Impressive Investment Portfolio

Tencent has shown an impressive ability to allocate capital and owns sizable positions in some of the world’s greatest businesses.

These investments are more than just speculation or trades to make a gain. Tencent mainly invests in its portfolio companies to:

  • generate synergies with its core businesses

  • capture emerging opportunities

  • create value for investees

Its investment portfolio includes positions like:

  • 25.6% of Sea Limited, Southeast Asia’s fastest-growing technology company.

  • 100% of Riot Games, maker of the hit game League of Legends.

  • 18.1% of JD .com, China’s massive e-commerce business.

  • 40% of Epic Games, creator of hit game Fortnite and The Unreal Gaming Engine.

  • 5% of Tesla

  • 6.8% of Spotify

  • 5% of Activision Blizzard, creator of hit series Call of Duty

Tencent also holds stakes in over 700 other companies, a whopping amount.

Opportunities Ahead

  • Tencent's vast ecosystem captures several powerful secular trends that we believe will dominate this decade. Its social networking, online advertising, fintech, and video gaming products and services all make up substantial portions of total revenue generated. With world-class assets in these sectors, Tencent should experience outsized growth relative to the average companies in the markets in which it operates. However, the regulatory environment in China may suppress some of these trends (more explained in our "Risks" section below).

  • Tencent will face challenges over the next few years, but over the long run, it should return to a state of durable growth. The company has powerful competitive strengths and a strong balance sheet that should help it weather the regulatory storm. Without these traits, we would have a far more pessimistic outlook on Tencent in light of the challenges posed to the advertising and video gaming industries in China.

Risks

Government Oversight

Tencent has influence over practically everything that goes on in China. It manages the largest social media platforms, operates massive gaming companies, and essentially controls fintech in the country. It brings up the question, isn't this monopolistic activity? What can't Tencent do?

Until recently, the Chinese government was fairly lenient with Tencent, its empire, and the entire regulatory environment for large corporations in China. However, this environment has rapidly shifted over the last 1 - 2 years.

The Chinese Communist Party ("CCP") essentially deemed Tencent too big of a company to bring down for its alleged anti-competitive practices because of the deep embeddedness of its services in everyday life in China.

Instead, the CCP targeted (and is still targeting) certain aspects of Tencent's business to bring it into greater alignment with the Chinese government's goals.

Tencent was under scrutiny in 2021 for not following antitrust laws and reporting M&A filings incorrectly, primarily around its music division. They were fined about $1.54 billion.

The government also cracked down on Tencent for not complying with laws protecting minors on WeChat. The company set screen time limits on its gaming apps for users under a certain age to protect their privacy, but the CCP felt it was not enough.

Additionally, The State Administration of Market Regulation has barred Tencent music to exclusive rights on online music in attempt to "restore market competition".

On top of this, Tencent announced a "common prosperity program" whereby Tencent pledged about $7.7 billion for healthcare, rural revitalization, and scientific education initiatives in the country. This was an effort Tencent took on after the country announced its goals around common prosperity for its people.

These regulations and fines are severe, and make it highly uncertain for shareholders to understand how much of Tencent's profits are rightfully theirs. With risks like this, we may be able to measure free cash flow and other profit figures, but if Tencent will be giving this money away to massive philanthropic programs and other unexpected fines, it makes it extremely difficult to value the company based on cash flows available to shareholders.

Other Risks

There are many other risks Tencent is facing that we find to be rather self-explanatory:

  • China is currently facing a massive COVID-19 wave. There are lockdowns in certain regions of China, and economic activity is certainly being negatively impacted.

  • Regulations have been put in place to battle video game addiction in China. These regulations may be prohibitive to the growth of the video game industry in China.

  • Monopolistic activities are not warmly welcomed in China. As such, Tencent will likely face growing competition, rising input costs, and potentially lose share to these competitors if the government orders the divestiture of any of Tencent's businesses or sub-businesses.

  • Tencent's ability to make new investments or exercise optionality in new sectors may be impaired given its already-large scale in the country. We believe the government will keep a close eye not only on Tencent's existing businesses, but also any new ones. If the government feels Tencent is overstepping, new investments and business ideas may be blocked. This would prevent potentially massive new growth sources for the company.

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