Tencent reported before market open and beat estimates today, with the advertising segment accelerating nicely year-over-year by 9-points. Where Tencent is stronger than it appears is on the margins, which we had outlined in our analysis last month.

The beat on revenue was marginal at 159.5 billion Chinese yuan (RMB) reported ($22.5 billion USD) compared to 158.4 billion yuan (RMB) expected. However, the beat on the bottom line was more than double digits. On a Non-IFRS basis, the company reported 50.3 billion RMB, which was up 54% YoY. On a IFRS basis, CNBC is reporting a 14% beat on the bottom line. Due to currency conversion differences, USD estimates are not as reliable as the RMB expectations.

Across the board, we have strong margin expansion. Despite strength in advertising, Fintech and Business services posted weaker growth YoY as did Revenues from VAS (gaming) and social networks. Overall, gaming is weighing on the revenue whereas AI is helping to drive the acceleration we are seeing in advertising. We break this down for you below with key points from management commentary.

Revenue and EPS:

As stated, gaming is weighing on Tencent’s revenue yet the bottom line is expanding.

Revenue:

Revenue growth of 6% compares to growth of 11% in the year ago quarter. This is also a 100-bps contraction from last quarter, although it’s common to see seasonality in consumer facing companies.
The 6% RMB revenue growth and 3% USD revenue growth should mark a near-term bottom for Tencent. Estimates for the next three quarters show growth sustaining at 9% to 10%. These are rough approximations due to fluctuations in currency exchange.

Earnings and EPS:

The company reported GAAP EPS of 4.39 RMB compared to 2.64 RMB last year, up 66% YoY.
The company reported non-GAAP EPS of 5.26 RMB compared to 3.35 RMB last year, up 57% YoY.
Profit attributable to shareholders, non-IFRS basis was at RMB 50.3 billion or US$ 7.1 billion, up 54% YoY. Profit attributable to shareholders on a IFRS basis was RMB 41.9 billion or US$ 5.9 billion, up 62% YoY.
EBITDA was $9.2B USD. Adjusted EBITDA margin was 43% for RMB 69.3B (USD $9.8 billion) compared to a margin of 39% in the year ago quarter.

Margins:

The margin expansion in the earnings report shines, and has been steadily improving since 2021.

Gross margin of 53% expanded 800 bps from 45% in the year ago quarter. This equals gross profit of RMB 83.9B or USD 11.8B, up 23% YoY.
Operating margin of 33% was also up 800 bps from 25% in the year ago quarter. This equals RMB 52.6 billion or USD 7.4 billion, up 38% YoY. Adjusted operating margin was up 700 bps for RMB 58.6 billion or $8.3 billion.
Net margin of 27% was up 900 bps from 18% in the year ago quarter for net income of RMB 42.7 billion or US$6 billion. Adjusted net margin was up 1000 bps for RMB 51.3 billion or USD of $7.2 billion.

Cash and Debt:

The company reported very strong cash flows with margin expansion. There is net cash of $13 billion although the company is a large shareholder in other companies with a portfolio value of USD $73.6 billion. United States investors may recall a company like Shopify that sees drastic fluctuations in cash depending on the value of their investments (Affirm, etc). However, due to the sheer size of Tencent’s holdings, there is considerable value to this portfolio at the current moment, which was discussed on the call and is detailed more below.

Operating cash flow of RMB 72.3 billion or USD $10.2 billion reported a margin of 45%.
Free cash flow of RMB 51.9 billion or USD $7.3 billion for a margin of 33%. This represents “stable” growth YoY and was up 52% QoQ. Stock based compensation was 3.8% of revenue.
There is USD $62.8 billion in cash on the balance sheet and debt of USD $49.7 billion for net cash of $13 billion.

Operating Capex of 6.6 RMB was up 557% YoY and Non-Operating Capex of RMB 7.8B is up 127% YoY. Total Capex was up 226% YoY to RMB 14.4B, up from RMB 4.0B in capex in the year ago quarter. The rise in capex was mainly due to the increase in investments in AI. The CFO said in the earnings call, “Operating capex was RMB 6.6 billion, up 557% year-on-year from a low base quarter last year, mainly driven by investment in GPUs and servers to support our Hunyuan and AI recommendation algorithms. On a quarter-on-quarter basis, operating capex was down 1%. Non-operating capex was RMB 7.8 billion, up 127% year-on-year due to acquisition of land use rights during the quarter. As a result, total capex was RMB 14.4 billion, up 226% year-on-year.”

The fair value of shareholdings in listed investee companies is at USD $73.6 billion, up from USD $68.8 billion in the year ago quarter. As you can imagine, this depends on the health of the Chinese stock market. The book value of unlisted investments was a $46.3 billion USD, which is flat YoY and fluctuates less due to infrequent reporting on private valuations.

During the quarter, the company repurchased 51 million shares on the Hong Kong stock exchange for HKD 14.8 billion. The company also made 3.7B RMB in payments for media content and lease liabilities of 1.5B RMB.

Key Metrics:

VAS or value-added services is comprised of gaming and social networks. This segment is 49% of revenue and declined 0.9% YoY to RMB 78.6B compared to RMB 79.3B. However, this was up 14% QoQ from RMB 69.1B. In. In that regard, Q4 could be the bottom for gaming. VAS gross profit increased 5% year-on-year to RMB 45 billion, representing 54% of total gross profit.

International gaming revenue was up 3% due to a “lengthy revenue deferral cycle for Supercell’s games.” This compares to 25% growth in the year ago quarter.
Domestic games receipts “returned to growth” and was up 3% YoY. However, domestic games revenue declined 2% YoY to RMB 34.5B “due to revenue deferral.” As stated, the receipts returning to growth may be indicating the early signs of a bottom for gaming (we will see).
Social networks revenue declined (-2%) by RMB 30.5B. This compares to 6% growth in the year ago quarter. Music subscription revenue increased 39% year-on-year, reflecting growth in subscriptions and ARPU. According to management: “Revenue from music subscriptions, video accounts live streaming, mini games and video subscriptions increased, while revenue from music and games related to live streaming services declined sharp.”

Fintech and Business Services is 33% of revenue and decelerated YoY with 7% growth reported this quarter compared to 14% growth last quarter. Fintech and business services gross profit increased 42% year-on-year to RMB 24 billion, contributing 28% of total gross profit. Fintech and business services gross margin increased to 46%, up 11 percentage points year-on-year. This is being driven by wealth management services, which translates to money market accounts where users are holding their cash, plus ecommerce technology fees and monetization of business services.

Online advertising is 17% of revenue and was up 26% YoY for RMB 26.5 billion, which is a 900 bps acceleration from 17% growth in the year ago quarter. The highlights were Weixin video accounts growing over 100% YoY and mini programs revenue growing 40% YoY. Online advertising gross profit increased 66% year-on-year to RMB 15 billion, contributing 17% of total gross profit. Online advertising gross margin increased to 55%, up 13 percentage points year-on-year driven by growth in video accounts and Weixin Search.

Overall, this segment has been accelerating on a YoY basis over the past few quarters, although can be lumpy on a QoQ basis. Per management: “The first quarter for us is a slightly unusual quarter because it’s a small quarter for advertising due to the Chinese New Year effect, and so sometimes the accelerations or the decelerations get magnified as a result. We would expect our advertising growth to be less rapid in subsequent quarters of the year than it was in the first quarter, more similar to consensus expectations for our advertising revenue growth for the rest of the year.”

AI is showing initial signs of impacting advertising revenue growth. According to the earnings call: “Ad spend from all major categories except automotive increased year-on-year, particularly from games, internet services, and consumer goods sectors. During the quarter, we upgraded our adtech platform to help advertisers manage ad campaigns more effectively and we made generative AI-powered ad creation tools available to all advertisers.”

There are additional, smaller segments that are too small to breakout in terms of revenue: business services “grew at a teens rate year-over-year,” Tencent Cloud Media grew “over 50% YoY,” and within business services “WeCom revenue tripled” and “Tencent Meeting also doubled.”

Risks:

The risks are plentiful with this stock, and thus we use technical analysis fully to determine our entries and exits. The setup could fail in as soon as 1 day or it could remain intact for a few months. The fundamental analysis helps to identify the probability of a technical setup remaining in tact. In this case, we think the margin story helps support the risk of entering while adhering to all stops.

As a reminder, United States stocks have less risk than Chinese stocks. The first risk to consider is United States-China tensions, the second is that Tencent’s financials are unaudited, and third that Tencent is an over-the-counter stock which means the stock is not traded on an exchange.

Earnings Call:

How AI Can Help Social Networks:

Since are in the first inning for how AI will impact Big Tech, and we have many innings to go on how AI will impact all industries, it’s worth our time listening to a broad range of management teams on the subject. Here are a few comments from Tencent’s vantage point on how AI can provide a lift to social networks:

[…] historically as a social media platform, our click-thru rates were low, and so starting from that lower base, we have seen we can double or triple click-thru rates in a way that’s not possible for ad services that are starting from much higher click-thru rates.”, we have seen we can double or triple click-thru rates in a way that’s not possible for ad services that are starting from much higher click-thru rates.”

“[…] We believe that tools like Advantage Plus are extremely important in terms of helping social media companies, whether it’s Meta or ourselves, grow into being all that they can be on the advertising front, because they simplify and automate the advertising buying and advertising targeting processes so that the social media companies can deliver experiences to advertisers that are more competitive with those that had already been delivered by search engines and by ecommerce platforms.so that the social media companies can deliver experiences to advertisers that are more competitive with those that had already been delivered by search engines and by ecommerce platforms.

But with the advantage that the social media platforms have much greater time spent, user engagement than search engines or ecommerce platforms, and so to the second part of your question around–a number of competitors are obviously applying AI as well, and we believe that all of them will benefit from AI too, but we think that the biggest beneficiaries will be those companies, of which we are one, that have very substantial under-monetized time spent and are now able to monetize that time spent more effectively by deploying AI, because the deployment of AI enables an upward structural shift in click-thru rates, and that shift is most pronounced for those inventories where the click-thru rates were lower to begin with, such as the social media inventory.”the social media platforms have much greater time spent, user engagement than search engines or ecommerce platforms, and so to the second part of your question around–a number of competitors are obviously applying AI as well, and we believe that all of them will benefit from AI too, but we think that the biggest beneficiaries will be those companies, of which we are one, that have very substantial under-monetized time spent and are now able to monetize that time spent more effectively by deploying AI, because the deployment of AI enables an upward structural shift in click-thru rates, and that shift is most pronounced for those inventories where the click-thru rates were lower to begin with, such as the social media inventory.”

The Value of Tencent’s Portfolio:

Below is a discussion on how Tencent’s holding are valued according to the non-IFRS associate income and the stocks current multiple. If PE Ratios are based on GAAP earnings, then one could argue that Tencent is undervalued given the “several hundred billion renminbi” in profits its holdings contribute.

Ronald Keung (Goldman Sachs)

Okay, and then my follow-up question is on our investment portfolio. Given it’s very sizeable, nearly US $130 billion in value, do we have any thinking on consistent or any distribution policies after the JV and Meituan distributions in the past? I’m thinking about any predictable policies so that the market will more actively value this part of the value, given the substantial market value within Tencent. Thank you.

James Mitchell (Chief Strategy Officer)

On that front, we have been working with some of our investee companies, and many of them have been working unprompted by themselves to enhance their profitability, and so if you look at the non-IFRS associate income that we reported this quarter of a little over RMB 5 billion, that’s up very sharply year-on-year and it annualizes to a number in the 20s of billions renminbi. To the extent that investors are valuing Tencent’s overall earnings at a certain multiple, then implicitly they’re now valuing our investment portfolio at several hundred billion renminbi.

There is still a gap between that implicit valuation through our multiple and the associate income contributing to our multiple of several hundred billion renminbi, versus the intrinsic value or the market value of the portfolio, which is substantially higher, but as the associates–you know, as companies like Pinduoduo become steadily more profitable, then more and more that gap will narrow itself as the profitability of the associates gets directly reflected in our own net income.

Conclusion:

Tencent came in as expected with notable strengths within the report. Margins are expanded, there is promising signs of AI-powered advertising, and key metrics point toward a bottom in gaming (needs to be confirmed). Our most recent technical analysis can be found here. Advanced Members can expect to hear more in the weekly webinar and also in Knox’s next Positions Report ETA last week of May or first week of June.

Royston Roche, Equity Analyst for the I/O Fund, contributed to this analysis

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