Excerpts from OCBC Investment Research report

Tencent Holdings (HKG: 0700)

• Weak revenue trends but outlook is turning positive
• Cost discipline helped margins and EPS beat
• Meituan shares distribution a reward for shareholders
• Advertising and financial services businesses to drive growth going forward; FV of HKD428

Tencent Holdings investment thesis

Tencent Holdings 3Q22 revenue trends were still relatively weak but there are glimpses of light at the end of the tunnel, with management citing advertising demand turning positive.

Cost control efforts helped a significant beat at the bottom-line, with the company scaling back on loss-making activities in search of profitability.

Tencent also delivered further positive news this quarter, announcing the distribution in specie of 90% of its stake in Meituan shares to shareholders.

All in all, this turned out to be a relatively positive earnings season for Tencent. Over the long-term, we expect advertising and financial services business to be the growth engines for Tencent going forward while the domestic gaming business matures.

Tencent continues to be a good allocator of capital, returning close to USD40b of capital (JD shares distribution, Meituan shares distribution and share buybacks) to shareholders in an extremely challenging macro environment in the past 12 months.

Following adjustments to our estimates and assumptions, our fair value (FV) declines from HKD428 to HKD420, while maintaining our ESG discount of 5%. This FV includes the Meituan dividend in specie distribution of HKD16.

3Q22 results a beat on cost discipline

Tencent revenue trends were still relatively weak, with Value Added Services revenues missing estimates. Domestic gaming revenues declined 7% year-on-year as the gaming industry continues to face negative impact from regulations on the sector imposed in Sep 2021.

Domestic gaming business should start growing again from 4Q22 as comps get easier. Advertising business was the bright spot in the revenue trends, improving from a revenue decline of -18.4% YoY in 2Q22 to -4.7% YoY in 3Q22.

Gross margins across all major businesses improved quarter-on-quarter (QoQ), as company focused on more disciplined spending on channel and distribution costs, as well as content costs.

Gross margins on Fintech and Business Services business improved almost 500bps from 3Q21, as Tencent scaled back loss-making activities and cloud deployment costs.

Selling and marketing costs also declined 32% YoY due to cost efficiency efforts. Although 3Q22 revenue missed by 1%, adjusted EPS beat estimates by 10% due to higher margins.

Distribution in specie of Tencent’s stake in Meituan (3690 HK) to shareholders

Tencent announced a distribution in specie of 15.5% out of its 17% stake in Meituan to shareholders, with an entitlement of 1 Meituan share (Class B) per 10 Tencent shares.

The stake to be distributed amounts to a valuation of USD20.3b, and implies a yield of 5.5% based on the closing prices of Tencent and Meituan as of 16 Nov.

This is a positive surprise to investors, coming on the back of the distribution of Tencent’s stake in JD.com (9618 HK) earlier in 2022. The company cited this distribution as a move to return capital to shareholders

Tencent Holdings valuation

During the conference call, management highlighted improving trends in online advertising business, with strong advertising demand for Video Account (VA) in-feed advertisements.

Vendors have been asking Tencent for more advertising inventory so it suggests that this business should improve going forward. Management mentioned during the call that they are on track to exceed CNY1b quarterly revenue in VA monetisation by 4Q22.

They also clarified that their growth in VA live streaming will be more incremental rather than cannibalising their existing advertising business such as Weixin Moments.

For the domestic gaming business, although the company is seeing a more supportive regulatory environment and expects more licence awards going forward, they also highlighted that the Chinese government wants to promote a healthier gaming ecosystem.

Given the recent news around Riot Games taking back the publishing of League of Legends (LoL) from Sea Limited (SE US), we believe Tencent could focus efforts on growing their international gaming business.

Over the long-term, management believes that their financial business should return to a strong growth backdrop once macro headwinds start easing.

We agree and expect the FinTech and business services segment as one of the key growth drivers both on the top-line and bottom-line as margins expand with operating leverage.

We tweak our FY22 and FY23 estimates downwards and adjust our FV down slightly to HKD420. This FV includes the Meituan dividend in specie distribution of HKD16.

You can find the full report here and the company website here.