Strong Quarter Affirms the Bull Thesis for Tencent Holdings Stock

Luke Lango

Updated Fri, May 18, 2018, 12:00 AM

Chinese internet giant Tencent Holdings/ADR (OTCMKTS:TCEHY) just reported first quarter numbers, and they were much better than expected. Revenue growth remained robust, while earnings came in well above expectations, easing concerns surrounding persistent margin-compression headwinds. As a result, Tencent stock traded more than 6% higher to just over $53.

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But Tecent earnings are more than just a near-term catalyst for a jump in TCEHY stock. Tencent earnings affirm the bull thesis that Tencent stock is worth a lot more than just $50 and change.

Indeed, given the company’s exposure to multiple nascent hyper-growth markets, I think Tencent stock is worth at least $60. As such, I think this post-earnings rally in Tencent has a lot of firepower left.

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Here’s a deeper look:

Tencent Is a Big Growth Company

Tencent is often labeled as China’s Facebook Inc (NASDAQ:FB) because of its massive WeChat and Weixin user base, which crossed the billion user mark for the first time ever this past quarter (up 11% year-over-year).

That is a reasonable and flattering comp, as Facebook is a big growth company with a powerful advertising business. Tencent, too, has a really strong advertising business that is growing at a comparable rate (both Facebook and Tencent reported roughly 50% ad revenue growth this past quarter).

On that basis alone — that Tencent is China’s Facebook with a huge and growing advertising business — Tencent is a big growth company.

But Tencent is also much more than just China’s Facebook. In many senses, it is also China’s YouTube, China’s Spotify Technology SA (NYSE:SPOT) and China’s Paypal Holdings Inc (NASDAQ:PYPL). Plus, Tencent operates a red-hot online gaming business and an equally hot cloud business.

Those businesses are also growing at robust rates. Value-added-services revenue, which is mostly from online gaming and music and video subscriptions, rose 34% last quarter. Meanwhile, other revenues, which is mostly cloud and payment revenues, more than doubled last quarter.

Clearly, this is a very big growth company with multiple growth drivers and broad-based exposure to the Chinese consumer.

Because of this broad-based exposure, Tencent stock really is just a pure play on the continued boom in China consumerism. Considering per capita spending in China is 15% as big as per capita spending in the U.S., the most likely path forward for China consumerism is upward and outward.

Tencent Stock Is Materially Undervalued

Tencent stock bears want to pound on the table about margin compression headwinds. While it is true that margins are in retreat, this is simply a near-term and naturally occurring phenomena of a hyper-growth company.

In order to dominate a market (or multiple markets), you need to invest big, run on lower margins, and win over customers quickly. Then, once you’ve dominated the market, you curtail spending and ramp up margins. Amazon.com, Inc. (NASDAQ:AMZN) and Netflix, Inc. (NASDAQ:NFLX) executed this exact strategy, and it is working out really well for both of them.

In other words, margins will be depressed here and now, but not forever. And when they ramp back up, they will ramp back up on a much larger revenue base, implying huge profit growth.

Consequently, I think earnings growth will be quite robust in a 5-year forward window. With revenues growing at a 50% and only marginally slowing rate, I think it is fairly likely that TCEHY grows revenues by at least 30% per year over the next 5 years. Meanwhile, net profit margins, which currently hover around 26%, may compress further, but should stabilize around 25% in the long-term, as big investments moderate.

That combination of 30% revenue growth and 25% net profit margins leads me to believe that TCEHY can net about $3.75 in earnings per share in 5 years. A Facebook-like forward multiple of 25 on those $3.75 earnings implies a four-year forward price target of nearly $94. Discounted back by 10% per year, that equates to a present value in the low to mid $60’s.

Bottom Line on TCEHY Stock

Near-term, this is a big revenue growth company with margin issues. Long-term, those margin issues will be resolved, and this will turn into a big revenue growth company with big earnings growth.

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Tencent stock still isn’t priced appropriately considering its significant growth prospects. Consequently, this stock should continue to outperform over the next several quarters.

As of this writing, Luke Lango was long TCEHY, FB, AMZN, and PYPL.