Chinese internet giant Tencent (TCEHY) is perceived as an extremely strong growth company and its share price reflects that potential. However, when we start to dig a little deeper, some surprises start to present themselves -- namely, that Tencent is not growing as strongly as its valuation would lead one to believe. Ultimately, Tencent's shares are best avoided right now.
Is Gaming Losing Steam?
Tencent is an asset-light business with three segments. Tencent's Value Added Services (VAS) is its biggest segment, accounting for approximately half its total revenue as of Q4 2018. Within VAS, Tencent holds its Online Games unit.
Despite having a broad portfolio of famous blockbuster games in its Online Games unit, such as League of Legends for PC and PlayerUnknown's Battlegrounds (PUBG) on mobile, this segment's overall revenue is surprisingly volatile.
This can be seen through the recent deceleration of its growth rate. For example, in Q4 2016, VAS revenues grew by 27% year-over-year, and in Q4 2017, this soared to 37% year-over-year. But more recently, in Q4 2018 its growth rate stood at just 9% year-over-year.
Growth Stock With Poor Growth?
Tencent is viewed as a high growth stock, but the facts simply don't support that narrative.
As shown above, Tencent's growth rate presently finds itself below 30%. What's more, the likelihood of Tencent reigniting its growth and sustainably keeping it above 40% appears low.
Astonishing MAU - Poor Cash Conversion
One positive element of Tencent continues to be its 1.1 billion MAUs within its combined Weixin and WeChat platforms. Having such a huge number of monthly active users on its platforms should allow Tencent more levers to monetize.
Accordingly, it is entirely possible that down the road, Tencent succeeds in improving its advertising targeting capabilities. However, at present, it appears that Tencent is struggling to translate its billion-plus monthly users into sustainable cash flows.
For example, in 2015 Tencent generated RMB 32 billion (approximately $4.8 billion) of free cash flow while carrying a balance sheet with a net cash position of RMB 18 billion (approximately $2.7 billion). Fast forward to Q4 2018, and while its free cash flow more than doubled to RMB 52 billion (approximately $7.0 billion), its balance sheet is now materially weaker with a net debt position of RMB 12 billion (approximately $1.8 billion). Thus, as Tencent has gotten bigger, its overall capital structure has gotten weaker, although some of the reason for that may the need for increased investments in areas Tencent deems promising.
Valuation - Better Opportunities Available
In the U.S. we have seen as of the most recent quarter that Facebook's revenue growth is still at close to 30%. Yet as highlighted above on a cash flow basis, Facebook remains meaningfully cheaper, carrying a multiple of just 18.2x compared with Tencent's 29.7x.
The Bottom Line
Up until the end of 2017, Tencent's strong growth was visible in its balance sheet. In fact, as of Q4 2017, Tencent's balance sheet carried a net cash position of RMB 16 billion ($2.4 billion). Then, as of December 2018, this position has now reversed and Tencent finds itself with a net debt position of RMB 12.2 billion($1.8 billion).
Tencent said that macro headwinds in Q4 2018 were in part responsible for the pace of top-line deceleration, as advertising spend slowed down. However, I contend that Tencent's top line deceleration appears to be more than just a one-time event.
That's why I argue that as Tencent's top line growth continues to slow down, shareholders are overpaying for a company with an increasingly inflexible balance sheet. Tencent will release its Q1 2019 earnings on May 15, so stay tuned to see how events unfold.
Michael Wiggins De Oliveira is LONG FB.